Real estate plays an integral role in the U.S. economy. Residential real estate provides housing for families. It's the greatest source of wealth and savings for many Americans. Commercial real estate, which includes apartment buildings, creates jobs and spaces for retail, offices, and manufacturing. Real estate business and investment provide a source of revenue for millions.
In 2018, real estate construction contributed $1.15 trillion to the nation's economic output. That's 6.2% of U.S. gross domestic product. It's more than the $1.13 trillion in 2017 but still less than the 2006 peak of $1.19 trillion. At that time, real estate construction was a hefty 8.9% component of GDP.
Real estate construction is labor-intensive and a major force in job creation. The drop in housing construction was a big contribution to the recession's high unemployment rate.
The Ripple Effect of Real Estate
Construction is the only part of real estate that's measured by GDP. But real estate 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. This ultimately reduces consumer spending as more homeowner cash is tied up in home projects.
Almost 70% 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
There's no better example of real estate's impact on the economy than the 2008 financial crisis. Falling home prices initially triggered the downturn, 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. But economists couldn't agree on how bad that was. Definitions of recession, bear market, and a stock market correction are well standardized, but the same is not true for the housing market.
For perspective, many compared it to the 24% decline during the Great Depression of 1929. They also likened it to the decline ranging from 22% to 40% in oil-producing areas in the early 1980s. By those standards, the slump was barely noteworthy.
The crash quickly gained steam, however. Some economic studies showed that housing price declines of between 10% and 15% are enough to eliminate the homeowner's equity. That occurred as early as 2007 in some communities in Florida, Nevada, and Louisiana.
Death by Derivatives
Almost 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. They were thought of as "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 then tried to exercise their credit default swaps that AIG ran out of cash. It threatened to default itself. The Federal Reserve had to bail it out.
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 officially kicked off the 2008 financial crisis.
Is Another Crash Looming?
A majority of Americans believe the real estate market will crash in the next two years. They see housing prices stagnating and the Fed beginning to drop interest rates. To them, it looks like a bubble waiting to burst.
But there are many differences between the current housing market and the 2005 market. For example, subprime loans make up a smaller percentage of the mortgage market (though they are growing again under the "nonprime loans" name). In 2005, they contributed 20%. Also, banks have raised lending standards. Home flippers have to provide between 20% and 45% of the cost of a home. During the subprime crisis, they needed 20% or less.
Most important, homeowners are not taking as much equity out of their homes. Home equity rose to $85 billion in 2006. It collapsed to less than $10 billion in 2010 and remained there until 2015. By 2017, it had only risen to $14 billion. A big reason is that fewer people are filing for bankruptcy. In 2016, only 770,846 filed for bankruptcy. In 2010, 1.5 million people did. Some economists are attributing this to Obamacare. Now that more people are covered by insurance, they are less likely to be swamped by medical bills. These differences make a housing market collapse less likely.