The LA wildfires: I thought house prices were supposed to fall?

Even as the Los Angeles fires raged, reports emerged of price gouging in the local rental market, and of realtors jacking up asking prices for undamaged houses.

The reason this is happening is obvious. Housing supply has just gone down – a lot.  The fires have destroyed around six months’ worth of new home construction by my rough calculations*.  Given that LA was already supply constrained on the housing front, it’s scant surprise that the fires are putting upward pressure on prices.

These supply shocks always follow in the wake of natural disasters.  And yet, every physical risk-related stress scenario I’ve ever seen has assumed that house prices fall relative to baseline as the threat posed by such natural disasters ramps higher and higher. (See, for example, the Bank of England’s 2021 scenario exploration).

I find regulators’ insistence on this topic to be truly strange. To show why, it helps to think about what circumstances would have to apply for prices in a given location to plummet following a climate-related disaster. 

Most obviously, demand would have to shrink more than supply. In order for this to occur, migration away from the affected region in the face of a storm, wildfire, or other calamity would have to occur. On this score, Hurricanes Katrina and Sandy provide contrasting examples.

Prior to Katrina, New Orleans was a rather depressed area with a stagnant population earning below-average incomes and a crumbling economy focused on tourism. In the immediate wake of the storm, the population of the city fell by almost one-third – before slowly recovering. Today, New Orleans is barely the same size in population terms as it was in the spring of 2005.

In contrast, the prime victim of Hurricane Sandy – New York City – had a rather different experience.  The size of the city’s population was unaffected by the storm, despite the fact that hundreds of thousands of homes were impacted.  When Sandy struck in 2012, the New York housing market was still recovering from the subprime crisis.  You could nevertheless argue that the Sandy supply shock kickstarted the market – prices have trended higher ever since. 

The effect of Katrina on the New Orleans housing market – despite the decimation of the local population – can at best be described as mixed.  Vigdor (2008) highlighted the short-term nature of the price shock and mused that the storm had a greater impact on supply than on demand.  Anecdotal evidence suggests that, at least for higher elevations, New Orleans real estate has been boosted by the loss of supply resulting from Katrina.  Elsewhere, Beracha and Prati (2017) provide an interesting discussion of the impact of hurricanes on housing prices more generally.

In general, New York’s recovery from Sandy was faster than New Orleans’ recovery from Katrina.  But this is more a reflection of the relative economic opportunities offered by the cities.  Even in New Orleans, though, house prices have recovered over time.

Now these findings are all based on regional data. Yet regulators’ scenarios invariably suggest that macro-level, national house price indexes will fall sharply as a consequence of increased physical risk.  What gives?

Unless the outward migration is international in nature – for example, US residents leaving the country to find safer locations – aggregate demand for housing will be unaffected by the displacement of people.  Again, it is reasonable to surmise that a country facing increased physical risk will see increased pressure on available housing supply, which suggests that aggregate house prices are more likely to rise than fall relative to baseline scenarios.

The regulators’ argument, I think, is a little different.  In their view, greater physical risk will impact the broader growth of the economy.  The idea is that as the population slowly impoverishes, the amount of wealth devoted to housing must decline.  Assuming that the proportion of private wealth held as housing remains constant, the aggregate value of the housing stock must decline in concert with the broader economy.  Assuming a constant population, this must imply that average house prices will fall.

Sure, it’s a coherent narrative – but it is based on several assumptions that are unlikely to hold.  Right off the bat, if the economic consequences of climate change are muted – in the Nordhaus 3% of GDP range for example – the scope for large house price declines will be fairly limited.

More problematic is the assumption of value afforded to housing by the climate-ravaged population.  I would argue that the relative importance of shelter in the minds of the resident population will increase as the physical effects of climate change worsen. This would lead to a higher proportion of wealth being held in the form of housing.

We should also consider the aggregate real price of housing.  In the Bank of England’s 2021 CBES exercise, this concept is explicitly discussed:

“The UK inflation and unemployment rates are little changed from the counterfactual by the end of the scenario, because of the gradual nature of the macroeconomic impact over the scenario horizon.

Aggregate UK house prices fall gradually relative to the counterfactual, with the cumulative impact of -22% by the end of the scenario. But some property prices are much more adversely affected, for example those properties that become heavily flooded on a regular basis.”

So house prices fall by 22% relative to the baseline while the general price level stays flat.  This implies that, due to physical climate risk, the populace is going to value housing much less than the rest of the basket of goods and services they consume.

To put it crudely, I think they’ve got this ass backward. Regulators obviously want to generate losses on mortgage portfolios under these scenarios and they know that house price reductions are the best way to go about this.

Ultimately, I suspect that the fallout of the LA fires will be similar to that seen in other prosperous, attractive cities post-disaster.  In short, the financial burden will fall on the homeowners and renters directly impacted, many of whom reside in the bottom half of the wealth distribution.  However, the real estate market, and the banks that underpin it, will be fine. After suffering some losses, they’ll make hay in the reconstruction phase.

And so yet again, the uselessness of the stress testing process will be laid bare for all to see.

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*Calculated using info from this USA Today article and Federal Reserve data on housing permits here