Economist's Commentary: March 31, 2008

The Impact of the Homebuyer Tax Credit

By Lawrence Yun, Chief Economist

The U.S. housing market is facing an unprecedented downturn. The national median home price fell in 2007 for the first time in modern history and is expected to fall again in 2008. This unique phenomenon of falling home prices is leading to a situation where financially capable buyers are holding back from purchasing a home — preferring to buy at a much later time. The postponement of home buying is appropriate for those not yet financially ready. However, this pattern of hesitancy and delay by those who are financially capable is adding unnecessary stress to the current weak housing market and the economy, resulting in unnecessary loss in output, income, jobs, government tax revenue, and also unnecessary loss of peoples' homes through foreclosure. It may also result in a situation where many of the currently financially able homebuyers will no longer be financially qualified at later stages once the economic downturn accelerates.

This vicious cycle can be self-feeding and self-fulfilling. A pullback by able potential homebuyers leads to homes sitting on the market for a much longer period and a buildup in inventory. High inventory pressures home prices to decline. Declining home prices result in lower equity conditions for homeowners — including placing many homeowners "underwater." When home values become lower than outstanding debt, it is rational for homeowners to simply foreclose on a home. Rising foreclosures lead to even lower home prices which in turn lead to rising foreclosures. This self-fulfilling prophecy is a result of the rational decision to delay home buying in a climate of falling home prices.

The falling home prices impact not only foreclosures but also the economy due to 75 million homeowners cutting back on spending. Many studies have shown the housing wealth impact on personal consumption expenditure to be approximately 6 to 8 cents per $1 change in housing value. The latest data from the Federal Reserve showed a decline of $95 billion in national home value from the third quarter to the fourth quarter of 2007. Some economists anticipate as much as a $1 trillion home value decline in 2008. Such a decline would translate into a $60 to $80 billion reduction in consumer spending - essentially assuring that the economy will fall into a recession.

However, the cycle of pessimism and the self-fulfilling destruction of the U.S. housing market and the economy can be stopped. Fear can be defeated. There is some indication that the housing market may be turning around. However, a bold policy measure specifically targeted at homebuyers will quickly help restore buyer confidence, stimulate housing demand, stabilize the housing market, and jump-start the economy. Tax credit for homebuyers will be the magic needed to turn reasonably hesitant homebuyers into actual homebuyers.

There is a sizable pent-up housing demand that can be released into the market place. Home sales have been falling consistently from mid-2005. Interestingly, the economy added over 4 million net new jobs ever since home sales have been falling. Home prices are more favorable for buyers now than in 2005 in many parts of the country. Moreover, interest rates are at historic lows. With average income rising by 10% from the height of the housing boom, affordability has improved measurably in many parts of the country. Yet, current home sales activity is at a 10-year low — back to 1998 figures when no one talked of frenzy or exuberance. Pent-up demand exists, yet consumers are rationally holding back due to pervasive pessimism about falling home prices and rising foreclosures.

A broad $5,000 tax credit for any owner-occupying homebuyer - for foreclosed, existing, or new homes and by a first-time or repeat homebuyer — will, according to our estimates:

• Create 1.07 million additional homebuyers
• Have a greater impact on first-time homebuyers
• Have a greater impact on minority homebuyers
• Have a greater impact in the more affordable areas of the country such as the Midwest and South regions
• Cost $35 billion in tax expenditure
• Generate $45 billion in tax revenue from nearly $130 billion in increased economic activity
• Reduce inventory by 900,000
• Lower the supply of inventory from the current 10 months supply to a more manageable 6 to 7 months supply — which historically has been associated with about 4% annual price growth
• Move home prices into positive territory and strengthen home prices by 6% to 10% points (based on a wide varying price impact — with NAR currently estimating, in the absence of a homebuyer tax credit, a 2% national median price decline, while many Wall Street firms have been calling for 10% or larger price declines)
• Decrease home foreclosures by 420,000 to 700,000
• Bring about sustainable homeownership without re-introducing excessive speculative home buying frenzy

Some may argue that the $5,000 (the same amount currently in existence for homebuyers in Washington, D.C.) is not enough of an inducement in areas where home prices average $500,000 and more. However, it is quite difficult to imagine how a financially capable person would leave $5,000 on the table — particularly knowing that others are likely to take advantage of the tax credit, hence leading to stabilizing home prices in the very near future.

Some argue that the tax credit should be targeted very narrowly to only homebuyers of new homes or vacant homes in foreclosure. Such a policy would not restore consumer confidence. New home inventory makes up only about 15 percent of overall inventory. As new homes are typically larger and more expensive, the tax credit for new homes will benefit high-income home buyers. It does nothing to decrease the bulk of home inventory from existing homes. Homebuilders will still have to contend with high existing home inventory before considering revving up production.

As to foreclosed homes, it is unclear if hesitant homebuyers will be enthusiastic about realizing the American Dream by inducing people to purchase such a property — often in poor physical condition. Foreclosed home inventory makes up about 10 to 20 percent of overall inventory — again a rather small slice of the overall inventory.

There is also a question of fairness and perverse incentives. Why should a homeowner who has been making mortgage payments lose potential buyers to new homes or foreclosed homes? Should this particular homeowner go into a foreclosure on purpose? A broad-based, clean $5,000 tax credit to any owner-occupying homebuyer is the best solution.

These homebuyers are not exposed to subprime loans and many will be entering the market with the much safer mortgage loans of FHA, VA, and now GSE-backed "jumbo" loans.

The housing market and the economy are near the tipping point of becoming fully trapped in a vicious negative cycle. The cycle of fear can be broken with a modest tax break for homebuyers. Congress and the White House need to get together to seriously discuss the proposal. The communication also needs to be clear on the retroactive nature of the tax break — in order not to provide an incentive to postpone — to anyone purchasing a home in 2008.

This is one in a series of commentaries by the Research staff of the National Association of REALTORS®. Read more commentaries >

Comments? Questions? E-mail NAR Research.