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 of them. Commercial real estate, which includes apartment buildings, create spaces for jobs in retail, offices and manufacturing. Real estate income provides a source of revenue for millions.

In 2015, real estate construction contributed $990 billion to the nation's economic output.

That's  6% of U.S. Gross Domestic Product (GDP). That's getting closer to its peak of $1.195 trillion in 2006. At that time, it was a hefty 8.9% 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. It affects many other areas of economic well-being that aren't measured as well. 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 it or not. It reduces the number of home equity loans available to owners. They will cut back on consumer spending.

Nearly 70% of the U.S. economy is based on personal consumption. A reduction in consumer spending contributes to a downward spiral in the economy. That leads to further unemployment, further reduction in income, and further reduction in 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% since its peak in October 2005, according to the National Association of REALTORS. However, economists couldn't all 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% decline during the Great Depression of 1929, and a 22-40% decline in oil-producing areas during the oil-price drop in the early 1980s. By those standards, the slump was barely noteworthy.

However, some economic studies showed that housing price declines of 10-15% are enough to eliminate equity and create a snowball effect that eventually creates severe pain for homeowners. In some communities in Florida, Nevada and Louisiana, that had already occurred. In retrospect, more of us should have listened to them. (Source: International Herald Tribune, "When Does a Housing Slump Becomes a Bust?", June 17, 2007)

Nearly half of the loans issued between 2005 and 2007 were subprime, which meant that buyers were more likely to default.

The real problem was that trillions in derivatives were sold based on the value of mortgages to finance those homes. Banks sold these mortgage-backed securities 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 AIG

When borrowers defaulted, these 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. For more, see How Derivatives Created the Mortgage Crisis.

Banks, like Bear Stearns and Lehman Brothers, that had lots of mortgage-backed securities on their books 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

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