How Does Real Estate Affect the U.S. Economy?

Why Buying a Home Helps Build the Nation

couple buying real estate
Real estate is a building block of the economy. Photo: Adam Crowley/Getty Images

Real estate plays an integral role in the U.S. economy. Residential real estate provides housing for families. It's often the greatest source of wealth and savings for many families. Commercial real estate, which includes apartment buildings, create jobs and spaces for retail, offices and manufacturing. Real estate business and investment provide a source of revenue for millions.

In 2016, real estate construction contributed $1.2 trillion to the nation's economic output.

That's 6 percent of U.S. gross domestic product. It exceeded its 2006 peak of $1.195 trillion. At that time, real estate construction was a hefty 8.9 percent component of GDP. Real estate construction is labor intensive. That's why a drop in housing construction was a big contribution to the recession's high unemployment rate.

Construction is the only part of real estate that's measured by GDP. Real estate also affects many other areas of economic well-being that aren't measured. For example, a decline in real estate sales eventually leads to a decline in real estate prices. That lowers the value of all homes, whether owners are actively selling or not. It reduces the number of home equity loans available to owners. They will cut back on consumer spending.

Nearly 70 percent of the U.S. economy is based on personal consumption. A reduction in consumer spending contributes to a downward spiral in the economy.

It leads to further drops in employment, income and consumer spending. If the Federal Reserve doesn't intervene by reducing interest rates, then the country could fall into a recession. The only good news about lower home prices is that it lessens the chances of inflation.

Real Estate and the 2008 Recession

Falling home prices initially triggered the 2008 financial crisis, but few realized it at the time.

By July 2007, the median price of an existing single-family home was down 4 percent since its peak in October 2005, according to the National Association of Realtors. But economists couldn't agree on how bad that was. Definitions of recessionbear market and a stock market correction are well standardized, but the same is not true for the housing market.

Many compared it to the 24 percent decline during the Great Depression of 1929. They also likened it to the 22-40 percent decline in oil-producing areas during the oil-price drop in the early 1980s. By those standards, the slump was barely noteworthy.

Some economic studies showed that housing price declines of 10-15 percent are enough to eliminate equity. That creates a snowball effect that creates severe pain for homeowners. Severe equity loss had occurred in some communities in Florida, Nevada and Louisiana in 2007. In retrospect, more of us should have listened to them. 

Nearly half of the loans issued between 2005 and 2007 were subprime. It meant that buyers were more likely to default. The real problem was that banks used these mortgages to support trillions of dollars of derivatives. Banks folded the subprime mortgages into these mortgage-backed securities.

They sold them as safe investments to pension funds, corporations, and retirees. That's because they were "insured" from default by a new insurance product called credit default swaps. The biggest issuer was American International Group Inc

When borrowers defaulted, the mortgage-backed securities had questionable value. So many investors tried to exercise their credit default swaps that AIG ran out of cash. It threatened to default itself. That's why the Federal Reserve had to bail it out. That's how derivatives created the mortgage crisis.

Banks with lots of mortgage-backed securities on their books, like Bear Stearns and Lehman Brothers, were shunned by other banks. Without cash to run their businesses, they turned to the Fed for help. The Fed found a buyer for the first, but not for the second.

The bankruptcy of Lehman Brothers kicked off the ​2008 financial crisis

A majority of Americans believe the real estate market will crash in the next two years. They see housing prices rising, and the Fed raising rates. To them, it looks like a bubble that will be followed by a collapse. But there are nine differences between the 2017 housing market and the 2007 market. For example, only 5 percent of mortgages were subprime. In 2005, subprime made up 20 percent of all mortgages. These differences make a housing market collapse less likely.