Challenging the Housing Bubble

Here’s one guaranteed way to get a rush hour seat on NJ Transit.

Turn to the person standing next to you, and with great authority announce that "All this talk about a real estate bubble is nonsense. The increase in home prices is perfectly sensible. I just closed on another investment condo yesterday."

Then simply side step the people jumping up to join the discussion, and grab a seat.

Assessing the future of residential real estate has changed from an occasional article in the real estate section of the paper to a near-obsession by the financial press. Journalists pounce on news releases for housing starts, home sales, mortgage rates, and consumer spending data, hoping to divine the future. But are they any more prescient than their cohorts, the active management stock brokers, who claim to foresee the future? Let’s look.

The Federal Deposit Insurance Corporation (FDIC) found 63 US cities had experienced a boom at least once during the 1978-2004 period, and 55 markets were in boom conditions at year-end 2004. The previous peak was when 24 markets boomed in 1988.

Does a boom lead to a bust? Not necessarily, according to the FDIC survey of the period prior to 1998 (i.e., excluding the current boom) which found 46 cities had experienced housing booms but only 9 times did a bust immediately follow. A bust was defined as a decline in nominal home prices of 15% or more over a five-year period.

The most likely cause of a bust was local economic distress affecting major employers. As an example, nominal home prices fell 40% in Lafayette, Louisiana between 1983 and 1988 when the oil and gas industries fell on hard times. The FDIC study found that "the most common way for a housing boom to resolve itself was through a period of price stagnation that allowed local economic fundamentals to catch up with high home prices."

It's unclear how useful historical home price data may be in forecasting current real estate trends. The FDIC report observes that "applicability of this historical experience to the current housing boom remains uncertain.

Problem is, that’s not going to sell magazines or commercial time!!!

So, as home sales have continued their brisk pace in 2005, the number of voices warning of "irrational exuberance" in property prices appears to be increasing. I did a Google search for "real estate bubble" and found 490,000 references. Perhaps mindful of the meltdown in technology stocks from their peak in early 2000, the financial press appears determined to sound the alarm on residential housing prices.

Recent articles that fan the fires today tend to look this:

"The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops."
"In Come the Waves," Economist, June 16, 2005.

Those suggesting home prices are overvalued often make the following arguments.

• Home prices relative to family incomes or housing rental rates are at record levels. Homebuyers expecting further strong price appreciation are playing the same "greater fool" theory as buyers of internet stocks in 1999 (Cisco anyone?).
• Innovative mortgage products originated by lenders hungry for additional fee income have encouraged buyers to stretch their resources to the limit. As many as 27% of new mortgages in 2005 were interest-only loans, compared to 1.6% in 2001.

Those arguing current housing prices are not overvalued may say:

• Although home prices have exhibited strong growth in recent years, a quality-adjusted priced index for new homes (which corrects for changes in size, features, and appliance) has risen at a much slower pace. ( the "McMansion" or "Corian" effect ?)
• Home ownership rates rise with age, with the highest rate of ownership"above 83%"among those aged 70 to 74. The aging baby boomer generation suggests increasing demand for decades.
  June Kim, "Housing Bubble"or Bunk?" Business Week, June 22, 2005.
• US tax law revisions in 1997 incorporating a $500,000 capital gains exclusion have made housing consumption or investment more attractive relative to alternatives.

So, who is right? Predicting the "bust" has been humbling as prices have continued to move higher despite numerous predictions that lower prices were destined.

A few samples:

2004

"Here's why the bubble is going to pop . . . The gap between home prices and fundamentals like job growth and incomes is greater than ever."
Shawn Tully, "Is the Housing Boom Over?" Fortune, September 20, 2004.

"Why home prices are about to plummet — and take the recovery with them."
Benjamin Wallace-Wells, "There Goes the Neighborhood", Washington Monthly, April

2003

John R. Talbott, The Coming Crash in the Housing Market (McGraw-Hill, 2003).

"This was a week for worrying about housing bubbles. . . . "
Betting the House," Economist, March 6, 2003.

2002

"With stocks in the tank, Americans are counting on home prices to keep rising. They won't."
Shawn Tully, "Is Real Estate Next?" Fortune, October 28, 2002

2001

"A housing bubble may be developing—right behind the Nasdaq bubble."
Editorial, Business Week, September 3, 2001. (one week before 9/11)

Ultimately, the debate over a real estate bubble may prove frustrating both for those predicting a big bust and those seeing no problem. Each year a fraction of forecasters will correctly predict the future, as will a few active managers at the brokerage houses and insurance companies.. Problem in both cases is that no one knows in advance who these lucky few will be…

The one certainty is that the brokers will always have popular explanations for market booms or busts ---- explanations that are not necessarily correct.

Mike