 Real Estate
Bubble
Scott Wright, Zeal LLC
[Adam Hamilton's partner]
May 14, 2005
The ever-popular water-cooler
gatherings and happy-hour clambakes used to bring friends, family
and co-workers together to discuss important topics such as politics,
sports and interpersonal gossip. In the late 1990s general conversation
shifted towards tech stocks, as everyone was an analyst and had
that hot tip or sure pick.
Today's conversation has taken
on a different buzz. "What Real Estate holdings do you currently
have?", "Did you hear about the development coming
up down the street?", "The house next door to mine
sold for asking price first day on the market!", "My
realtor gave me a tip on some condos coming up for sale in Uppity
Heights, those will be worth a small fortune in a year or two!"
Never before in history has
financial and mainstream media allocated so much airtime to Real
Estate. Critics of the current boom are even getting public face-time
daring to use the dreaded "B" word, hinting at a bubble.
I happen to fall on the side of the critics and will contend
that today's housing market stands on the pedestal of its largest
bubble in history. The boom turned bubble we've witnessed the
last 5+ years has fostered an explosion of epic proportions as
interest rates have declined to implausible lows and home prices
have soared to all-time highs.
There's been a great deal of
debate as to whether or not today's housing market is truly in
the midst of a bubble. In order to flesh out our case for bubble
status, we must first address some of the popular opposing objections.
Every critic has a critic, and as skeptics come out of the woodwork
to challenge the legitimacy of the Real Estate boom, the defensive
trenches are dug and lined with ever-optimistic challengers.
Their discrepant position of
thought simply claims that Real Estate bubbles cannot exist.
The anti-bubble script usually goes like this, "There cannot
be a Real Estate bubble, because there is no such thing as a
national Real Estate market. Even if there was a Real Estate
bubble, it would be isolated in certain hot-spot metropolitan
areas or fetching geographically limited locations such as mountains
or beaches and it certainly wouldn't crash like a stock market
bubble would!"
Regionalized Real Estate bubbles
certainly are prevalent, but I would contend that a national
bubble does exist. A Real Estate bubble simply implies current
Real Estate prices are at a level much higher than fundamentals
sanction. Bubble lore of any kind holds the investor to believe
prices of the asset in question will continue to rise even though
the asset is already overvalued. Whether an investor understands
value or not, the bubble asset can be purchased at its current
market price with the irrational assumption it can be sold in
the near future at an even higher price. You can take a high-level
glance at today's national Real Estate market, and it will reveal
such case in point.
The bubbleology of today's
Real Estate market occurs in various orders of magnitude across
the country, but we are experiencing a national bubble. According
to the Office of Federal Housing Enterprise Oversight (OFHEO),
national housing prices have increased by nearly 50% in the last
five years. In 2004 alone national housing prices increased by
11%.
Sure, there are some hot metropolitan
regions in Nevada, California, Washington DC and Florida that
saw 30%+ annual gains in 2004, but there would need to be many
more regions with gains of this magnitude in order to carry a
national average. Not all towns and regions are witnessing this
first-hand, but most are, and those that aren't will still experience
the economic effects of such. The rampant cash-out refinancing,
building and buying today is not limited just to those hot regions,
it is happening from coast-to-coast and throughout the heartland.
A crash in Real Estate, whether
you deem possible or not, may or may not be less dramatic than
a stock market crash. Either way, the macroeconomic fallout of
a popping bubble would be devastating. We need to keep in mind
that in addition to internal economic factors that are capable
of deflating a bubble, external factors can certainly play a
large role in crashing markets of any kind. We don't have to
look back too far in history to provide us with real-world examples.
The Asian currency crisis in
1997-98 caused housing prices in Indonesia as well as other regions,
in dollar terms, to decline some 80% virtually overnight. Currency
instability is one of many external factors that can contribute
to a Real Estate bust, and the United States is certainly not
immune to financial crisis of that sort!
In this three-part series focused
on today's Real Estate bubble, we'll examine its core economic
cause and effect. We'll also discover the role of the federal
government in the creation of this bubble, as well as the socioeconomic
implications that have and will come to light. Today we will
focus our attention on the speculative mania that has inflated
this bubble to where it is today and where investor and homeowner
sentiment currently lies in the housing market.
World-renowned economist and
author Robert Shiller provides us with a high-level look at one
of the many components that has led to this bubble. From his
recently updated best-seller, "Irrational
Exuberance," he states, "In the United States
before 1960, people were living in a less avowedly capitalist
economy, and they were not primed to believe that their well-being
depended in large measure on their property. Today, with good
public information about prices widely available, our increasing
public commitment to market solutions to economic problems has
led people to worry more about home prices, and hence to make
them more prone to the kind of feedback that generates bubbles.
Stories have abounded since 2000 of aggressive, even desperate,
bidding on homes. People have been afraid that the price of housing
would soon rise beyond their means and that they might never
be able to afford a house, and so they have rushed in to bid."
Dr. Shiller's wisdom shines
light on the bubble with particular focus on homeowner/investor
sentiment. As you will find in our next section, the Fed and
government-sponsored enterprises (GSEs) played instrumental roles
in fashioning this sentiment. Because of the rush to bid that
Shiller points out, opportunities have presented themselves to
savvy speculators. Acting as the middlemen, speculators have
swarmed into this Real Estate frenzy buying up lots and homes
as pure speculations in hopes of flipping them to the droves
of buyers for quick and attractive profits. Speculation has become
so rampant in today's Real Estate market that a mania-type excitement
has reared its ugly head.
Real Estate speculation has
become so pandemic that 23% of all residential home sales in
2004 were for investment purposes, and 13% were tagged as so-called
vacation/second homes. A staggering one of every three homes
purchased last year was not for primary residence! With no intention
of ever living in these homes, most investors/speculators are
not investing in these 'hard' assets for long-term longevity,
but for short-term appreciation that will capture a quick gain
or as a rental in which they'll be able to make immediate positive
cash flow. There's nothing I appreciate more than logical and
thought-out speculation, but how can what should be a physically
depreciable asset have such volatile financial leverage? "Location,
location, location" does not provide enough logic to drive
speculation of this sort!
With investors and speculators
being the outward forces driving up the Real Estate market, let's
look at how the underlying catalyst of this boom has made their
jobs so much easier. The chart below provides a glance of how
the dramatic increase of buying and selling has panned out over
recent years. Notice the average quantity of new one-family houses
sold per month rocketing well past the one million mark into
2004 while still continuing to peak all-time highs. The last
five years in particular have witnessed an astonishing 36% increase
in houses sold per month as part of the 132% increase we've seen
since 1991. Wow, what a wonderful time to be a home builder or
realtor!
On the other axis of this chart
we plot the average 30-year conventional mortgage rate. The massive
drop in mortgage rates is what set the wheels in motion for this
bubble. The inverse correlation we see here is almost as pretty
as a dollar/gold
chart mapped out over this same period of time. As mortgage
rates decrease there is more purchasing power to build, sell
and buy homes.
This chart really provides one of many a picturesque story of
how this Real Estate boom has been able to flood the market with
massive amounts of capital. With mortgage rates falling and home
prices climbing, a renewed sense of wealth has triggered consumer
spending that has kept this economy afloat in recent years. The
third section of this series will focus on the so-called wealth-effect
this bubble has created.
The interest rate side of this
inverse correlation drives several conclusions as to how the
housing market could have grown so swiftly. With mortgage rates
grinding to their lowest point since the Fed started tracking
them, it becomes easier for renters to turn into homeowners.
As families grow, lower rates more easily allow for upgrades
in size. And, as rates fall, it becomes easier to move out of
that old worn-down home and into a new, more modern home. It
even becomes a little easier for a person or family to relocate
for a job or career change.
These reasons and more make
a case for a natural increase in housing sales, as it becomes
easier for people to move and upgrade. Even so, it comes nowhere
near explaining how it is possible to have such dramatic increases
in new home sales as we see in this chart. According to the Bureau
of the Census, national homeownership has been rising as a percentage
of population, but only by a fraction of a percent year-over-year.
Just barely enough to trend the curve upwards, but not nearly
enough to move it near parabolic like we are seeing above. Population
and wage increases are certainly not the driving forces of this
spectacular housing boom either.
Not only have home sales soared
in recent years, but since 1991 there has been a 111% increase
in annual housing units authorized by building permit. As you
may gather, the supply of homes has been dramatically increasing,
but with housing prices continuing to soar so high, it has apparently
not been enough to meet perceived demand. Who's moving into these
homes? When the bubble starts to shrink, odds are we'll find
an oversupply of homes on the market due to speculative excess.
Home builders are certainly
not the culprit, but they have sure been ramping up their efforts
to take advantage of this boom. If you've owned stock in companies
such as KB Homes, Pulte and D.R. Horton, you'll have seen your
money double in the past 12 months. Any why not, the fixed costs
to build a home stay relatively the same yet they are constructing
vast quantities of homes in record times. Why? Well, in good
part, to keep up with the speculative demand we are experiencing
today.
The National Association of
Realtors recently performed a study and polled those that were
buying second homes. Its study showed the majority of buyers
wanted to diversify their investments and/or obtain rental income.
As Shiller hints at, the dynamics of personal net worth have
changed over the years. Only recently has residential property
been perceived and weighted so heavily into one's investment
portfolio and contributed so much to one's wealth.
Investors and speculators across
the country have been gobbling up lots for tract as well as custom
houses/condos/town homes, pre-owned homes, foreclosures, etc
trying to capitalize on today's buying blitz. Many of these speculators
are reselling their investment in six months or less yielding
pretty amazing annualized gains. In some cases, a lot or even
lottery position on a lot for a new home will exchange hands
four or five times before the residence is even constructed.
Similar to the game musical chairs, when the music stops, those
speculators without a buyer will be kicked out of the game with
far more than their feelings hurt.
Now the question looms, who
are today's Real Estate speculators? We've come to find they
are not your average financial speculator, someone that understands
risk and who can afford to take a loss if his speculation fails.
Today's speculator is the person next door. The average Joe whose
full-time job is not Real Estate speculation. This average Joe
is not necessarily a financial powerhouse, but is willing to
risk his hard-earned capital on what he thinks is a fairly riskless
investment.
Today more than ever Joe is
capable of learning and executing the flip of Real Estate in
hopes of realizing legendary short-term gains. There is an abundance
of seminars, books, tapes and tales that will instruct you on
how to do so if you don't already know. What makes Real Estate
speculation easiest of all though is today's mortgage environment.
Joe can now get approved for a six-figure loan with a less than
desirable credit score, a minimal down payment, and a venomous
loan structure designed to procure the lowest payment possible
until the property gets flipped. A loan officer friend of mine
told me competition is so stiff in the mortgage industry that,
if you walk in the door with a pulse, you are virtually guaranteed
loan approval.
Today's Real Estate speculators
are not only professional "flippers" and the average
Joes trying their hand at the game, but a third breed of speculator
exists. This breed of speculator can be construed as those who
have blind faith in the bubble market valuation of their home.
Those with the effervescent belief that home equity can only
increase. Those that will go further into debt and allow increases
in home equity to guide their spending and perceived wealth.
These people in a sense are speculators. "It's OK to spend
now, it's only going higher!"
I wonder if these speculators
ever played around in the tech bubble. Similar to the tech stock
speculative mania of the late 1990s, a so-called "investment"
is being purchased at a price far overvalued fundamentally, but
the assumption is prevalent that it can be flipped in a short
period of time to some other eager-beaver at an even higher price.
That will only fly for so long folks. Just ask those that were
buying CMGI at $300+ per share and ICGE at $250+ per share back
in late 1999 and early 2000 only to watch their speculations
get crushed in the ensuing selloff. They might have a word of
advice for the so-called savvy Real Estate investor/speculator.
In many areas speculators have
pushed home prices so high the underlying demand will just not
be able to meet the supply present. Even today there is an abundance
of empty homes out there. These homes will not be filled until
prices decline enough to become affordable to the targeted populace.
When economic forces reduce the size and bandwidth of the pool
of buyers, investors and speculators alike will take a big hit.
The backlash of Real Estate speculation will likely trigger a
domino effect that can be catastrophic to our already fragile
economy.
Impetuous Real Estate speculation
is proof enough that a bubble exists. As we've learned throughout
history, what goes up must come down. Everything in the markets
is cyclical in nature, no matter what direction a trend is going.
What happens if the Real Estate
bull loses steam? What's going to happen if interest rates rise?
What happens if housing prices come roaring down? What happens
if speculator Joe can't sell or fill his investment home and
has two or more mortgages to pay? What happens if unemployment
rises?
If we are truly in a Real Estate
bubble, which all indicators lean towards, all of these "ifs"
will turn into "whens" when the bubble pops. The fallout
from a bursting Real Estate bubble will almost certainly be disastrous
for our economy. Speculation failures will only be the tip of
the iceberg. As we dig deeper into the intricate design of the
Real Estate bubble we'll discover the socioeconomic nightmare
that has been created and the fallout that will likely ensue.
Please join us next time in
Part 2 of our series on the Real Estate bubble. We will uncover
and analyze the Fed and GSEs' role in the artificial creation
of the Real Estate bubble and the damaging effects it may have
on the global financial markets.
Scott Wright
[Adam Hamilton's partner]
May 13, 2005
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