house for sale. short saleIn a recent New York Times story, economist Robert Shiller, co-founder of the Case-Shiller Home Price Index, warned that the nascent housing recovery might not yet be sustainable. Why?

Shiller believes that public sentiment, fueled by what he terms "sociological processes" such as media coverage and water-cooler conversations, is a fundamental driver of housing demand. When the conventional wisdom about the sustainability of housing's upward trajectory reversed -- in essence, from the belief that "housing never goes down" to an awareness of a historic bubble in valuations -- then the housing bubble burst.

So the recovery in housing prices, in Shiller's view, requires a new public enthusiasm for housing as a great investment.

While public sentiment is one driver, there are three other drivers that Shiller did not address: demographics, the specter of inflation, and rising interest rates.

Demography Is Destiny?

The demographic story is simple: just as the 78 million Baby Boomers drove the housing market higher in the 1970s when they formed new households, their need to downsize will swamp the housing market with homes for years to come, especially suburban homes.

The Urban Land Institute recently issued a report on these financial and demographic trends titled "Housing in America: The Next Decade." The report anticipates a major imbalance between the supply of homes Boomers will be selling and the demand from younger buyers. The generations behind the Boomers -- Gen X and Gen Y -- are smaller cohorts which face their own financial challenges: a poor job market, flat incomes and rising interest rates. The arithmetic is stra: there won't be enough buyers for all the homes Boomers will be trying to sell.

While the report anticipates demand for housing from immigrants, it also notes that immigrant households typically do not have high enough incomes to buy the suburban homes the Boomers will be selling.

The report's conclusion is sobering: many Boomers will be "trapped" in their suburban homes, unable to sell.

Inflation Sneaks In

A recent story in the San Francisco Chronicle illustrates the housing history of tens of millions of Baby Boomer homeowners. The featured couple started their new household in the late 1970s and bought a suburban home in 1980 for $96,000. In 1987 they sold that residence for $110,000 and bought another one for $135,000. They then sold that house for $400,000 in 2002 and bought their current home for a price "in the $600,000s." After peaking in value at the bubble top in 2006 at around $1,000,000, the home is now on the market for $637,000.

The numbers are impressive, but it's important to recognize that typically home prices are compared nominally -- that is, the price is not adjusted for inflation. But inflation is a reality, and a whole new picture emerges when the nominal home prices are adjusted for inflation. To illustrate this, I've laid out each of this family's home sales and purchases along with its inflation-adjusted value in current dollars. The data is drawn from the Bureau of Labor Statistics inflation calculator.

* 1980 purchase: $96,000 -- in 2010 dollars: $252,000

* 1987 sale: $110,000 -- in 2010 dollars: $210,000

* 1987 purchase: $135,000 -- in 2010 dollars: $257,000

* 2002 sale: $400,000 -- in 2010 dollars: $482,000

* 2002 purchase: $650,000 -- in 2010 dollars: $783,000

* 2010 sale: (projected) $637,000

These inflation-adjusted "real" numbers are significantly different from the nominal prices. By the end of the inflationary 1970s, it took $1.36 in 1980 to buy what $1 had bought a mere three years before in 1977. As people fled the stock market for tangible assets and Boomers started families, real estate soared (as did gold).

As a result, the 1980 purchase price of $96,000 was rather bubbly. Seven years later, the house had actually declined 17% in inflation-adjusted terms. To combat inflation, the Federal Reserve raised interest rates in the early 1980s to the point that few could afford to pay 1980 prices for houses when mortgage rates were 13% and up.

Then, as interest rates declined for almost three decades (with brief counter-trends) from 1982 to 2009, the family's home had almost doubled (in real terms) in 15 years when it was sold in 2002. (In nominal terms, the house tripled in value.)

The fact that the 2002 purchase price of $650,000 works out to $783,000 in today's dollars reveals that inflation isn't quite as benign as we are generally led to believe. The $650,000 purchase price in 2002 also reveals that much of the housing bubble appreciation had already occurred (at least in California) as early as 2002.

What is missing from a comparison of nominal valuations is the inflation-adjusted decline of roughly $150,000 from the 2002 adjusted value of $783,000 to the current post-bubble valuation of $637,000.

Yes, mortgage interest deductions and a host of other home ownership tax breaks soften the decline in real terms, but this comparison of real (inflation-adjusted) numbers suggests that even people who bought at the beginning of the housing bubble are facing losses far in excess of what nominal prices reveal.

This shows that even modest inflation is, over time, a strong headwind to any future price appreciation in real terms. If inflation creeps back up as many analysts expect, the equity "trapped" in Boomers' suburban homes will decline in real terms even if nominal prices stay roughly flat.

Interest Rates

There is one other headwind facing housing: rising mortgage rates. Many observers see rising interest rates as inevitable as the Federal Reserve cannot keep rates at near-zero forever.

Rising mortgage rates means buyers can afford less house; housing becomes less affordable and prices have to decline to be within reach of buyers facing higher monthly payments.

Ultimately, public sentiment is based not just on media coverage but on what people see in their own communities and the financial realities of interest rates and supply and demand. Large-scale demographic and financial trends-inflation, rising interest rates and aging Baby Boomers -- all present major headwinds to any sustainable rise in housing prices.

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