One of the ongoing debates within housing finance is how much homes will appreciate going forward. The outlandish price increases seen during the recent boom were obviously unsustainable -- but what is a normal path for home values? Should they appreciate 5% per year? 1%? Or maybe they should decline in some areas? David Leonhardt wades into the discussion in his New York Times column today, pointing out that two major camps exist on how home prices rise: either with inflation or with income.

Leonhardt writes:

I can't claim to clear up all the uncertainty. But I do want to suggest a framework for figuring out whether you lean bearish or less bearish: do you believe that housing is a luxury good and that societies spend more on it as they get richer? Or do you think it's more like food, clothing and other staples that account for an ever smaller share of consumer spending over time?

If you believe housing resembles a luxury good, then you'll end up thinking house prices will rise nearly as fast as incomes in the long run and that houses today aren't terribly overvalued. If housing is a staple, though, prices will rise more slowly -- with general inflation, as food tends to.

He goes on to examine both sides of the debate and concludes that home prices probably more closely follow income, based in part on some data provided by Robert Shiller. I think the correct answer has more to do with how income changes specifically within the middle class, since their prosperity is a major driver for home sales. But in the near- to mid-term, does this question really matter?

The U.S. is likely in a period of recovery, but very, very slow recovery. Few expect the unemployment rate to dip below 7% through the end of 2012. If we're lucky, we'll be close to full employment a year after that. Then, once the economy finally is back to normal again, the government will almost certainly have to begin chiseling away more aggressively at the debt and deal with various entitlement crises. That will either require higher taxes, less government spending, or both. It would be surprising if it takes less than a decade to make any progress on that front. So we're talking a best-case scenario of 2023 before after-tax incomes have much of a chance of rising at even a moderate pace.

Consequently, it's pretty likely that incomes won't increase much more quickly than inflation for an extended period. So even if housing does track income instead of inflation, homeowners shouldn't expect to see significant appreciation for a very long time.

This analysis reiterates the important point that Leonhardt makes towards the end of his column. If you wish to buy a home in the near future, then do so because you expect to live there for a relatively long time -- not because you view it as an investment. It's hard to imagine a realistic scenario where the return on housing will rise much above inflation over the next decade or two.
