Some people are under the impression that real estate and stock markets move in different ways and for different reasons, with no real connection between them. But to think in this way is a mistake. There is a synergy between them, an interaction of economic elements which, when combined, produces a total effect that is greater than the sum of the individual elements.

The last and greatest example of this synergy goes all the way back to the 1980's, when real estate and stock markets took a dive together. The equity markets died on Black Monday', October 19, 1987 when the Dow Jones Industrial Index collapsed 22 percent in value in a single day. The 1987 plunge, as it turned out, was also the beginning of the end of a massive bull market in real estate, which had marked that entire decade. By 1989, sales activity in most major North American markets was petering out just as the average home price was hitting its zenith. Within eighteen months the economy was in full recession and real estate values, especially for condos, sunk dramatically. Twelve years later, at the beginning of the bull housing market of 2001, the average home price still sit below that of 1989.

So what does all this tell us about the future of housing prices? What is the connection between real estate and stock markets?

To be sure, there is a fundamental difference between the two fields of investment. At its core the housing market, like the stock market, is all about supply and demand. But the difference is that investors base their decisions to buy into stocks on future potential whereas investors base their decisions to buy into housing on inherent value. However, specifically because both real estate and stock markets move in accordance with the shifts of equilibrium between supply and demand, they are both subjected to the fluctuations of the individual components of supply and demand as well.

This explains why housing prices soared in the late 1980's, as Baby Boomers swamped the markets; why they tanked in the early 1990's as unemployment rate jumped higher; and why they boomed again beginning in the new millennium, as stock woes, terrorism and accounting scandals drove millions of investors to look for safe alternatives to stocks and equities.

With stocks, supply and demand is dictated by corporate earnings, economic conditions, risk, greed and fear. On the other hand, externalities as varied as immigration, internal migration trends, marriage trends and cultural precepts as well as generation gaps affect real estate markets, but the greatest element is affordability. And affordability, in turn, is governed by the interaction between prices and interest rates.

In the 1980's the real estate boom ended for one single reason: the average house became too expensive for the average family to buy. More specifically, house prices rose sharply during the boom, then interest rates also rose sharply thus making homes far less affordable. Suddenly people saw real estate markets in exactly the same way they saw stock markets - as not giving good value. Conversely, in the post-September 11 boom of 2001 investors were intensely motivated by the combination of relatively low prices and the cheapest mortgage rates in forty years. This was coupled by the fact that all the major banks began to offer below-prime packages in an attempt to get an ever larger share of what was going to become the quintessential cut-throat business: lending.

Affordability in 2001 was the best it had been in more than a generation, just as stock markets started to sputter and move towards a collapse. So long as investors, including foreign investors, saw value in real estate and not in stocks, money continued to flow in. As a direct and proximate result of the new real estate mania, home prices rose by ten times the annual inflation rate. New housing starts repeatedly hit new records and in May, 2002 for the first time in the history of American real estate, sales of new homes passed the one million mark in a single month.

By comparison, today's markets are not nearly as brisk as they were only a few months ago. The combination of higher mortgage payments and steeper house prices has meant an erosion in affordability. The primary culprit and cause of this slowdown is the ratio between wages and real estate market values. This ratio is entirely skewed to values, so that wages have not kept up with appreciation, particularly of residential real properties. Price dropping has been a steady staple these past few months. And all this has come precisely at the moment when a retreating stock market means that stock values and mutual funds are once again shrinking fast.

Many economists do not envision the real estate slowdown as a market downturn, much less the onset of the real estate bubble believers in the Apocalypse have been prognosticating all along. And because of the savvy monetary policies enacted by the Fed, economists forecast that a slower appreciation of real property values will allow salaries and wages to catch up and thus to regenerate the pool of buyers, especially first-time Buyers, entitled to take their first steps into the world of real estate.

There are many reasons to become a homeowner, with the most important of which perhaps being that one has to live somewhere. Additionally one can build up equity and borrow against it, as well as enjoy tax-free capital gains. Because of this, therefore, and since stock markets do not offer investors a reliable alternative, real estate will continue to remain a viable investment venue, though no longer the gold mine it has been in the past.

Luigi Frascati