There’s optimism about the health of the U.S. housing market headed into the spring buying season, with hope that a continuing recovery there will boost the rest of the economy.

For a closer look at the state of the housing market, STATEside turned to Department of Finance, Insurance, and Law Professor Joseph Trefzger, in our latest installment of Office Hours.

Home prices are rising, showing the biggest year-over-year increase in prices since June 2006 (according to the S&P Case-Shiller index, which tracks the 20 largest markets in the country). Does this indicate a housing recovery?

Houses nationwide rose in value by 10 percent on average from early 2012 to early 2013; one estimate pegs that gain at $1 trillion. Vanguard’s real estate investment trust index fund (income-producing business and residential property) is up 13 percent in share value since November. Land prices in some areas have soared. Less expensive homes’ prices have risen despite tough borrowing standards, and high-end buyers have paid increasing prices using investments as loan collateral. Modest houses have gotten price support from small and large investors who, earning nothing on savings, became landlords, renting to those who got burned by easy credit and now want to be tenants. Higher rents have made houses more desirable as investments but also made it more attractive to buy so you don’t have to rent. People who defaulted at least three years ago are again eligible to get FHA loans. We can’t blame optimists for saying “recovery.”

So with all these favorable signs, is there reason for caution?

Average prices still lag 2006 highs by 30 percent. Higher prices also are fed by fewer houses for sale, springing from reduced recent construction and “underwater” owners reluctant to sell. Further price increases, which some economists predict, could give millions of underwater owners positive equity and they might sell–increasing supply and possibly dampening subsequent price gains. The “shadow inventory” of properties banks have avoided foreclosing on might also reach the market now that alleged foreclosure abuse cases have been settled. Supplies also could rise as 2009/2010 first-time home buyers can sell without losing income tax credits they claimed. While the relationship between home prices and household incomes is in line with historic averages, prices and rents have risen faster than incomes. And real estate may become more attractive to cash-hungry taxing bodies at all government levels, since it is the one asset class that cannot be moved away or hidden.

There used to be a notion that home prices predictably rise over time. Can new home buyers realistically expect that going forward?

It’s complicated because housing markets are localized and every property is unique. Those who bought right after the bubble burst have seen great results. But now with prices generally up, markedly in some areas, a buyer focused on further price appreciation rather than a place to live is rolling the dice a bit. Expecting price gains is always risky, because housing is a wasting asset. I can sell my house today for more than I paid years ago, but the proceeds won’t buy a newly built house with similar features. A home’s nominal value can rise if the land’s value rises, and if construction labor and material costs go up, like gold jewelry appreciates when gold prices rise. But an older house is worth less than a newly built one with similar size and features on equally valuable land; it suffers physical deterioration and might lack amenities today’s market expects.

What are the chances the home mortgage interest deduction will be eliminated? What happens then?

The ability to deduct interest on up to $1.1 million in mortgage debt encourages many to buy more housing, or pay more for a particular house, so powerful groups would fight any cutback. Contractors, brokers, lenders, and building material producers earn more when people spend more on housing. Even local governments benefit, as higher prices lead to higher assessed values and property taxes. Any change would have to be phased in over time. More interesting to me is the view that fiddling with interest deductibility would hurt home buyers. No, buyers would react by paying less. Finance people say that expected benefits of ownership are capitalized into what buyers willingly pay for assets; fewer expected benefits mean lower offers made. Those hurt would be home sellers who could not recoup tax benefits they had capitalized into prices they had paid – along with the groups whose paychecks relate to housing expenditures.

What’s the biggest mistake first-time buyers make? Is it trying to buy the most expensive house they think they can afford?

The definition of “starter” house has ratcheted up; no one builds anything like the small houses of the post-World War II boom. Some people think housing reliably appreciates over time, such that if nominal values rise by 50 percent over several years a $100,000 purchase increases your wealth by $50,000, while paying $250,000 nets $125,000! Of course, we cannot routinely expect houses to rise even in nominal value, much less in real, inflation-adjusted terms. But even if nominal gains are seen, costlier purchases require not just more interest on bigger loans; property taxes, utilities, maintenance, and insurance costs rise. Consider buying the least expensive house you can be happy and comfortable in. Living in less expensive housing creates an exception to economists’ “no free lunch” adage: People who live in cheaper housing in a given jurisdiction enjoy the same public services as people in upscale homes who pay much higher property taxes.

What happens to the market if interest rates rise, by a small or a wide margin?

Economist Robert Shiller calls the entire current housing market “artificial,” with most purchase loans ultimately provided by the government (FHA, Fannie Mae, Freddie Mac) at astoundingly low interest rates. The Fed encourages this artificiality by buying massive quantities of securities these loans are bundled into–banks aren’t making loans at those rates to collect interest on. Many experts dismissed chances of widespread lending and real estate crises several years back, thinking any problems would be limited to specific localities. But reckless lending occurred systemwide, and artificially low interest rates create systemic problems today. Rates likely could creep up somewhat without causing a market U-turn. But when “quantitative easing” ends we will see whether prices have increased only because of financing benefits capitalized into prices, and perhaps a belief that real estate, housing included, was a sensible asset choice in an environment of dismal savings returns and fears over future inflation.

Kate Arthur can be reached at