Trulia's Ralph McLaughlin and Wharton's Benjamin Keys discuss the housing market recovery.

It has been almost 10 years since the last big bubble in the U.S. housing market began to pop — the leadoff to what became the Financial Crisis and the Great Recession. In many respects, the U.S. economy has rebounded nicely from that disaster: Broadly speaking, stock indexes are setting record highs, unemployment is back in check, and consumer confidence has returned.

The question of whether the housing market has genuinely recovered, though, is more complex. A recent report complied by real estate website Trulia reveals a wildly uneven housing recovery, in which some parts of the country are seeing prices for nearly all homes above their earlier peaks, while in other areas, most homes are still far below those levels. Nationwide, just over a third of homes have reached pre-recession prices, and the forecast is that pricing won’t fully recover until 2025. Trulia chief economist Ralph McLaughlin and Wharton real estate professor Benjamin Keys, who is also a faculty research fellow at the National Bureau of Economic Research, recently visited Knowledge at Wharton’s SiriusXM show to discuss the housing recovery.

An edited transcript of the conversation follows.

Knowledge at Wharton: Ralph, please go through the report and really break this down as to what we’re seeing, and how far we are from getting back to full pricing on a lot of these homes across the U.S.

Ralph McLaughlin: The highlight of the report is that only a little over a third of homes in the U.S. have recovered to their pre-recession peak values. But that distribution varies pretty widely across space. For example, in places like Denver and San Francisco, nearly 100% of homes have recovered, whereas in areas such as Las Vegas, Tucson or Bakersfield, fewer than 3% of homes have recovered. The secondary takeaway … is that income growth is perhaps one of the biggest differentiators that explains why some places have recovered and others haven’t. A few other factors that are correlated include things like population growth and job growth.

As far as predicting when the housing market will fully recover, if you use our measure of recovery, from a linear perspective it might not be until 2025. But the housing market, as you both know, can take sharp swings upward or downwards, so that could be either sooner than 2025 or much later.

Knowledge at Wharton: What was your reaction to this report, Ben?

Benjamin Keys: The economist in me first wondered if these were in nominal dollars or real dollars; people have this very artificial sense of a nominal value in the housing market. There’s been a lot of really nice research that has shown people are very sensitive to loss aversion. If I buy a house for $200,000, I’m really reluctant to sell it for even a dollar less. Those losses feel much more painful to me than the similar gains would feel in terms of making me feel better.

So there’s an artificialness to this as a benchmark, but I’m thinking of this as something that’s going to resonate in a lot of people’s minds who bought in 2005, 2006 or 2007 at very high prices. But whether these kinds of trends are going to persist, and whether we’re going to see this recovery reach these other markets, I think that’s a much deeper and really important question. The markets that have been left out of the house price recovery are some of the ones that had the most inflated and exaggerated bubbles, where we had the worst behavior in terms of mortgage market discipline, where we had the most teaser-rate contracts and low-documentation loans.

You look at Las Vegas, where almost none of the houses are back to their peak levels, and you really begin to appreciate just what distortions were going on in the market at that time, and how long-lived the recovery has to be to get the market back to a place that looks like it did prior to that bubble period.

Knowledge at Wharton: Ralph, Ben mentions Las Vegas, and it’s a well-documented story about how much trouble that metropolitan area had in terms of the drops in price. You have a list of the top 10 cities that have not recovered to this point, and what I found interesting was there were a couple of markets in there that are, for the most part, considered to be more lower-income cities — Camden, New Jersey, across the river from us here in Philadelphia, being one of them. Those are cities that obviously lost a good bit after the housing bubble burst and the recession hit. The question is whether or not they can regain it to any degree when you think long term.

“Just because your housing market hasn’t recovered to its pre-recession peak doesn’t necessarily mean it’s a bad thing.” –Ralph McLaughlin 

McLaughlin: There are a couple of interesting points that Ben brought up that relate to this that are important to dive into a little bit more. One, is the pre-recession peak an acceptable benchmark given how inflated some of these markets were? Our measures are nominal, which is the point that Ben makes. We chose to use nominal values because we think that for most homeowners, that’s their benchmark. Most homeowners are not adjusting for inflation in their head, and so it affects the psychology of the market. From a nominal perspective, yes, these markets eventually will recover, at the least just because of inflation.

Second is whether or not really they’re going to recover from an inflation-adjusted standpoint. For some of these markets, if they do, it may be decades — and in particular when you’re talking specifically about the markets that tend to be in the Rust Belt — places like New Haven, Connecticut; Lake County, Illinois/Kenosha, Wisconsin; and Camden, New Jersey — those areas are seeing pretty long-term and significant population declines, which are never highly correlated with increases in prices. Usually, population decline leads to decreases in prices.

Now, some of the other markets, in particular, those in the West that may either be fast growing or near markets that are fast growing — think Las Vegas, or in California, Bakersfield, Riverside, and San Bernardino — those markets are probably going to recover, in my expectation, faster than some of those Rust Belt markets.

Keys: Absolutely. I think one of the things that this highlights is the real divergence across cities in the U.S. That’s something that we’ve seen in the income distribution, and something that we’re seeing across cities as well; there’s a set of stagnant cities that are really struggling, and with housing being such a durable good, it’s very difficult to adjust a city’s footprint or the number of houses that are available. We know that places that have a sizable downturn can be trapped in that state for a very long time, and there aren’t a lot of easy ways to pull out of it. It takes a really active local government and local public policies to turn things around.

Knowledge at Wharton: Ralph, when you bring these numbers forward to people, is there a level of surprise that some of these cities are struggling mightily just to get a little bit of the value back in their homes?

McLaughlin: Yes, this report really was met with a lot of surprise. I think one particular reason is, in general, a lot of the other metrics that we use, that we’re currently using as a society to judge housing market recovery — namely, aggregate measures of prices — really mask what’s going on within individual markets. When you look at the value of individual homes within those markets the story is very, very different. In particular, there was a lot of interest from reporters in markets that have yet to recover, in particular in Florida, but also markets in the Midwest that were outside that bottom list. Chicago — they were very interested in the fact that fewer homes have recovered. Their big question is, one, when are we going to come back? And two, is this a bad thing? I think that is the important takeaway. Just because your housing market hasn’t recovered to its pre-recession peak doesn’t necessarily mean it’s a bad thing. That’s the emphasis that I’ve been trying to get reporters to focus on. It’s probably a good thing that homes are not back to where they were in Las Vegas and Bakersfield.

Knowledge at Wharton: We saw for quite a period of time a trend of people investing in a lot of these properties, especially the ones that were distressed, and trying to build them back up to a degree, and flip them. That seemingly is still happening, but maybe not to the degree that it was two or three years ago. Based on this information, it feels like there’s still an opportunity for flippers to benefit by finding these properties and turning them around.

“Markets that really never boomed are the ones that have actually come back.” –Ralph McLaughlin

Keys: Yes, the single-family rental market is one that really took off in the wake of the crisis, and certainly, some savvy investors scooped up a lot of foreclosed properties at a discount. I think what we’re recognizing now — and what this report really highlights — is that some of the places where we haven’t seen as much of that activity and we haven’t seen prices bounce back are stagnant for exactly the kinds of reasons that we were talking about earlier. In those types of places, the returns that you need to get to make that business model work are really outsized, because there are very high costs to maintain all of those properties. There’s a reason why we think of rental properties as usually being more concentrated and more dense, because it’s just much easier to maintain and monitor. You can have one super take care of the whole building. You don’t have that when you have 50 properties spread across a city.

So I think the returns might not be there in some of those markets. It’s certainly a possibility, and I think there are people who are still pursuing some of these single-family rental plays. But you’re also seeing some of the big players in the market trying to get out. They’re trying to spin these off, and the exit strategies aren’t clean, because you don’t want to unload all of these properties onto the market at the same time, especially in some of the markets where things are still on a bit shakier ground.

So I think it’s still an evolving asset class and kind of a new thing. There’s also the question of whether it’s going to be able to persist in good times and bad, or whether it was just a one-shot deal, and some very savvy investors struck gold at the right time.

Knowledge at Wharton: Ralph?

McLaughlin: That’s a great point. Maybe not so coincidentally, in the home-flipping report we released back in February, several of the markets at the top of the list were markets that are lowest in terms of home value recovery. Las Vegas was leading the country where around 11% of home sales were flipped in 2016. And the other market that was a hot spot was the Greater Miami area — so Miami, Fort Lauderdale and West Palm Beach — that also came up pretty high on that list. So it’s very possible that investors are seeing opportunities, at least to perhaps flip homes, number one, that are undervalued, and number two, maybe that went through periods of deferred maintenance. That’s one thing that anecdotally may be there, that with a large foreclosure crisis, there were perhaps high vacancy rates and removed owners, whether they were banks or other investors, and many of those homes maybe experienced a lot of deferred maintenance. So there’s this housing stock that is ripe for improving, or at least was ripe in 2016. We’re not necessarily saying that that’s going to be the market going forward, but that’s what we observed last year.

Knowledge at Wharton: Looking at the top 10 list of metropolitan areas with the strongest recoveries, the majority were west of the Mississippi. All of them were, in fact, except Nashville. That being said, what is the state of the recovery here in the eastern half of the U.S.? Obviously, there are a lot of areas where housing is still very affordable. I have friends down in the Atlanta area that talk about how you can get a beautiful, big, four-bedroom, three-bath house that would cost you probably $500,000 here in the Philadelphia area for $200,000.

McLaughlin: Yes. Most of the housing recovery as you mentioned has been west of the Mississippi, and we think there really is a delineation between those markets that have recovered. They tend to be either markets that are big economic engines of the country — so places like San Francisco, Denver and Colorado Springs, which is outside of Denver — and markets that really didn’t fall, didn’t crash very much during the recession. Texas is one of those markets, as is that part of the country.

When you’re looking at the eastern half of the country, and comparing areas that have recovered to those that haven’t, there is a similar delineation, but it’s on that second part of the delineation. Markets that really never boomed are the ones that have actually come back. Places like Buffalo, New York, Rochester, upstate New York, never really boomed during the bubble. Other places that fit that bill in states along the East Coast include places like Pittsburgh. On the other hand many other markets that are east of the Mississippi are in the lower half in terms of their level of recovery. In New York, only 26% of homes have recovered. In Ohio, only about 20% to 23%. Absolutely, in some of these markets there may be a lot of homes that have not reached their pre-recession peaks, but that doesn’t necessarily mean that there’s potential in those markets to get back to that pre-recession peak, as per our discussion earlier.

Knowledge at Wharton: Part of that, as you’ve both alluded to, relates to the economic situation in a lot of these cities. For some of the smaller to mid-sized towns, the loss of manufacturing at whatever level has really hurt these markets. Some of them may not be able to come back because the manufacturing just isn’t there the way that it was, say, 30 or 40 years ago.

“You have this disconnect where the places where the jobs are being created are also the places where it’s difficult to build or there’s not as much building going on.” –Benjamin Keys

Keys: That’s absolutely right. I think you have an employment base that’s really shifting, and it’s shifting quite sharply in the wake of the Great Recession. We saw a lot of people employed in construction, and housing was actually a real engine for growth during that period. But where there really wasn’t much of a boom, those are places where the local economy and the local drivers of the economy are going to be the big factors in determining house prices. And where employment is falling and where the compositional shift away from traditional industries is happening more rapidly, those are places that are really going to struggle.

Knowledge at Wharton: Ralph?

McLaughlin: Yeah. To put some numbers behind that, Buffalo, New York, for example, has had negative 4% job growth – so, employment contraction — since the recession. And the same with Rochester, about negative 2%. It’s very hard for markets to recover when they’re shedding jobs, because you need job growth to support income growth, which supports price growth. We are really seeing very interesting and stark regional differences in where both income and job growth are occurring in the country.

Knowledge at Wharton: Obviously if you flip the scenario and look at a place like San Francisco, it’s just incredibly surging right now mostly because of what we’re seeing in the tech sector. But it’s amazing to me that the median price for a home in the San Francisco area is more than $1 million right now. It’s incredible to think about the growth that you’re seeing, and the wealth that there is in the housing sector in that area alone.

McLaughlin: Absolutely. In San Francisco alone since the recession, they’ve seen about a 30% increase in jobs and about a 25% increase in income. And because housing is a “normal good,” households do tend to put that higher income into their homes in one way or another, either the ones that they’re living in or ones that they use for investment purposes. It’s obviously an outlier. But still, if you compare it to other places that are on that list, job growth in Dallas has been phenomenal, 25% since recession; income growth has lagged a little bit, but it’s still about 11%. But the big difference, at least between those two markets where income growth and job growth are good, is that Dallas actually builds a lot of homes and San Francisco doesn’t. Not only is the San Francisco area booming, but they’re not building a lot homes, so demand is increasing sharply at a time when a supply is pretty stagnant. That’s a situation ripe for increasing prices to, as you said, well over $1 million.

Keys: That’s also leading to an affordability crisis in a lot of these cities. You have this disconnect where the places where the jobs are being created are also the places where it’s difficult to build or there’s not as much building going on. That’s leading to extremely high rental prices, and relatively low homeownership rates. You have this challenge for job mobility. If we’re going to draw people to these drivers of the modern economy, to these engines of growth, but we don’t have anywhere for them to live, this is a real challenge. I think something that we need is policies that do more to encourage affordable housing, and reduce some of the barriers to home construction and more dense construction.

Knowledge at Wharton: Obviously, it’s a big issue and it’s one that needs to be addressed in Washington, and probably even more so at the state level as well, to open up the door for some of these things to happen. And it does, again, throw us back into that economic debate about what needs to happen to allow some of these things to occur, so that people can have the resources they need to be able to buy these homes. We need to get a lot of these homes, whether they be newer construction or older stock, off the market. To turn them back into assets rather than liabilities hanging on the backs of people.

“Maybe not so coincidentally, in the home-flipping report we released back in February, several of the markets at the top of the list were markets that are lowest in terms of home value recovery.” –Ralph McLaughlin 

Keys: That’s right. At the national level, we think about things like federal mortgage policy and federal mortgage finance systems that could potentially alleviate some of the pressure on the rental market, if we could bring more people into homeownership. We’re at a 50-year low for the homeownership rate, which is a pretty astonishing figure. At the national level as well, we can think about support for housing vouchers, support for multifamily construction, and the kinds of things that are going to free up more financing for development that’s denser.

But then we have all these local barriers to development, so those challenges cut across one another and make it really difficult to increase the density in the most desirable neighborhoods and the most desirable cities.

Knowledge at Wharton: Ralph?

McLaughlin: I agree 100% with Ben. You really need a three-pronged approach here. One is to increase market-rate development. I think market-rate development is sort of the elephant in the room, just because a lack of it can put pretty severe affordability pressures on homes that normally, lower-income individuals would occupy. Two, there’s always going to be demand for below-market-rate housing. I think we could do a better job of that. And three — looking at something we haven’t talked about much here – is the inventory problem of existing homes; there aren’t a lot of homes on the market. Some of those may have been bought up by investors and turned into rental units, and investors are holding onto them for good reason; rents have gone up pretty sharply. You could tweak tax codes if you wanted to incentivize owners of existing rental homes to sell. Depending on what side of the political spectrum you’re on, you could either, A, have a one-time exclusion in capital gains tax for those properties — in other words investors could sell them and not pay tax on the capital gains, which might encourage them to sell – or, B, tax rental income at a higher rate. Both of those would have the same effect. Again, depending on what side of the political spectrum you’re on will tell you what side you lean towards, but both should have the effect of freeing up investor-owned properties if there is demand among would-be owner occupiers looking to get back into the market.

Knowledge at Wharton: Ralph, is there a hope that the rental market will ease a little bit in the next couple of years, and that we can flip the script? Can we see more properties purchased, and built as well, to get the new-home market rolling as well?

McLaughlin: I’m much more optimistic about building. I think we’re starting to see upward charges there. On the other hand, I do see signs that rents are starting to moderate a bit, but whether or not they’re going to moderate for long enough of a period for wages catch up and make rents affordable is a question that remains to be answered.