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

Just a Minor Drop in Home Prices Created the 2008 Crisis

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House Auction

New houses are up for auction after new-home sales tumbled to the lowest mark in 12 years during December and prices fell sharply, where a recent housing boom has been taking place January 28, 2008 in Rancho Cucamonga, California.

Photo: David McNew/Getty Images

Real estate plays an integral role in the U.S. economy. Residential real estate provides housing for families, and is 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 2013, real estate construction contributed just $925 billion, or 5.8%, to the nation's economic output as measured by Gross Domestic Product (GDP). This is down dramatically from 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. Therefore, this decline in housing construction was a big contribution to the recession's high unemployment rate.

The decline in home prices brought on the 2008 financial crisis. As of 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 economists' 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)

Construction is only a portion of the economic activity associated with real estate. A decline in real estate sales eventually leads to a decline in real estate prices. This then reduces the value of everyone’s homes, whether they are actively selling it or not. This then reduces the amount of home equity loans the homeowner can get. This, then, reduces consumer spending.

Nearly 70% of the U.S. economy is based on personal consumption. A reduction in consumer spending will contribute to a downward spiral in the economy. This results in 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.

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