We hear plenty of speculation today about a housing bubble on the horizon, leading to fears of an imminent housing price crash. Yet, the continued boom in housing prices does not show signs of waning. And, since many have plans to eventually sell homes as part of a retirement plan, this is an issue that bears scrutiny.

On the surface, rising real estate prices appear to be a simple economic application of the laws of supply and demand. As many like to say, “Since they aren’t making any more, prices must go up”.

True, to a degree, as in the simplest of terms housing prices are driven up by land availability, employment rates, consumer pre-tax income growth, new household starts, interest rates and immigration rates. Alarmists point to these factors and see a bubble forming.

By changing how we think about the laws of supply and demand, we get a different perspective on the “housing bubble”. Consider that in our capitalistic society the greater the demand for something, the more likely that capitalists will figure out a way to provide it at a profit. In an unfettered world of growing demand and the infinite ability to meet that demand, more and more companies would create more and more of a product or service leading to a glut and falling prices. Not the case with housing.

A brand new study done for the National Bureau of Economic Research (NBER) by Edward Glaeser points out that demand alone does not drive housing prices. Soaring home prices are primarily coastal phenomena that have left the growing states of the American interior untouched.

By taking a look at the supply side it is easy to see why prices have gone up in certain parts of the country. Land-use regulation and a desire to live in bigger homes are largely responsible. Where local laws limit new construction, higher prices result as an area adds population by the creation of new jobs, new immigration and new household formations.

Glaeser points out that California has grown by 2 million people since 1999. This translates to a demand for more than 800,000 new single and multifamily units to keep up with the growth. There have only been 200,000 new apartment units and houses built since then.

Add to the above the fact that an investment in a personal residence is an investment in the one asset that carries with it all the tax benefits our system can provide…deductibility of interest and property taxes and tax-free gain up to $500,000. This makes the after tax return higher than most other assets.

That being the case, economic theory tells us that asset prices go up relative in price to the after-tax return of other assets. With the unique tax benefits a personal residence affords it should be valued relative to other assets by its tax preferences as well as supply constraints noted above.

The Glaeser report notes that two-thirds of Americans now own their own home or condo…a percentage far greater than in any other civilization where fee-simple ownership of land and property exists.

Home prices will fall where there are substantial decreases in employment rates, more restrictive land zoning, building rates in excess of immigration, demographic shifts when a larger percentage of the population moves from larger, family homes to smaller retirement homes, and a drop in new household starts.

One other factor could cause a sharp decline…when too many homes are bought simply for speculation, as was the case in Australia where more than 40% of homes bought in 2003 were for speculation and prices have plummeted. Subtracting second homes in the U.S., we are around 5%, not close enough for a bubble!