by Scott Wright
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!
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.
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