A Housing Bubble
The most asked questions today is, “Are we in a bubble, when it is going to burst and how much are housing pricing going to drop?” Based on my personal observations of the housing market in the downstate New York area I feel that we are not in a bubble and any softening of prices will be negligible.
I will present to you my reasoning for this conclusion and welcome any comments you have either in support or against my arguments.
As we see more and more stories in the news media warning us of the potential perils of the “housing bubble” I’m afraid it’s encouraging people that are currently renting to postpone their decision to become homeowners. Deciding to wait could condemn them to being tenants for the rest of their lives.
There are 3 general categories of buyers. There are those who are looking to buy a place to live in and raise their families. They could be moving from a rental to their first home, trading up to a more expensive property or downsizing to something that fits their current lifestyle. Individuals purchasing a vacation home also fall in this category. These buyers are buying for their own personal use and enjoyment. These purchases are made with a long-term time horizon. History shows that in the vast majority of cases, when the time comes to sell, these individuals will sell for a higher price than when they bought the property.
The next category is that of an investor. This individual is purchasing a property for its cash-flow potential in the near term and for long-term capital appreciation. The investor studies the property’s cost to operate and compares it to the income it produces. If the property generates the proper rate of return on his investment, the purchase is made.
The last category is that of a speculator. It’s the activity of these individuals that is drawing the majority of the media attention. A speculator is looking to make a purchase with the intention of reselling it as quickly as possible and at the highest possible price. This is a high-risk investment, which generates the highest potential profits. It also can yield the greatest loss of any investment.
Obviously, each category of buyer affects the marketplace in different ways. The speculator magnifies price changes whereas the owner-occupied purchaser has a stabilizing effect on short-term appreciation, for the property is primarily for his own use and its growth potential is of a secondary concern. The investor also has a stabilizing effect but in a different way. If prices increase to where the cash flow doesn’t meet the desired rate of return the investor simply doesn’t make the investment. He will keep looking until he finds a property where the purchase price and rental income are more in line.
As for the speculator, time is his enemy. For him to make a profit, he needs to get in and out of a deal as quickly as possible. Because of this if the number of speculators in a given marketplace grows too large then a bubble is definitely being created and will eventually pop.
This brings me to my first reason as to why we are not facing a bursting bubble in our local real estate market. The majority of purchases are currently by people looking to use the property for their own use. Based on recent data on mortgages, over 70% are for owner-occupied use. The remaining 30% is comprised of second homes (which for our analysis impacts the market similarly to owner-occupied), investors and speculators. Although there is no hard data available as to what portion of this 30% is made up of speculators, it would be reasonable to assume it’s no more than 10%.
How can I make this assumption? Most speculators want to sell off their purchase while it’s still in contract. Meaning they have no intention of ever placing a mortgage on the property. Those that do either got caught short and were forced to close on the purchase or were planning a longer-term holding period. Since the market price of real estate has been going straight up for the last couple of years, it’s not likely any noticeable number of speculators got caught short. The rapid rise in values covered any mistakes in the speculator’s calculations. The ones that did close by choice must have decided to hold the property for a year or more in order to justify the cost of arranging financing. This small subset of speculators could not possibly represent a sizable percentage of closed mortgages.
My second reason relates to the demographics of our region. The population has been increasing over the years. This has been due mostly to an increase of immigration into the area. The most recent census data released by the Federal Government confirms this. We are also in a region where the cost to produce additional housing stock is prohibitive. We have an increase in demand for housing, due to an increasing population, and a limited inventory of housing, due to the costs involved. This is a formula for increasing housing costs, not a decrease.
This cannot be said about most areas of the country. Many of the high growth areas, Florida and Nevada to name two, are able to increase their housing stock to keep up with demand. If demand tapers off and building continues you have the potential of decreasing prices. The rate of decrease becomes the issue.
As long as there are more people looking to move into our communities than there is housing available the cost of housing can’t drop substantially.
Looking locally over the last few years you would think that we have seen unprecedented appreciation. Looking closer you will find that is not the case. Based on data provided by the Office of Federal Housing Enterprise Oversight, the rate of appreciation we’ve seen is roughly half of the rate of appreciation we had during 1984 through 1987. So when you hear the comment, “I’ve never seen prices jump like this,” you know there is no basis in historical data to support the comment. It is nothing more than a short-term observation of the market.
This brings me to reason number 3. People are becoming more cautious. Being afraid of a bubble actually aids in preventing the bubble from occurring. The fear of “buying at the peak of the market” being supported by daily news reports of the upcoming housing bubble is having a dampening effect on buyer’s enthusiasm. The psychology of the market is changing. From a buy now, no matter what the cost attitude we have moved to I’m only going to offer what I think the property is worth. If the seller isn’t willing to negotiate, I’ll just buy the next house.
The newest argument to support the bubble theory goes like this. The increased presence of exotic mortgage products that allow people to buy more house than they can readily afford will create a landslide effect once prices begin to soften. These mortgages allow buyers to buy with little or no money down, defer paying down principal till a later date and work with artificially low interest rates. The concept being that the purchaser will pay off the mortgage before the mortgage payments increase to a level that is no longer affordable. If things don’t go as planned, the homeowner can’t pay off the mortgage, can’t meet the increased payments and ends up losing the house. If the number of mortgage defaults gets too large, lenders will be reluctant to lend money, potential buyers will be scared off due to the scarcity of financing and prices will fall quickly.
As good as this argument sounds, there is one outstanding flaw. The presumption here is that the number of these exotic mortgages in existence is large enough to cause the cascading of pricing. Statistics compiled by the Mortgage Bankers Association show that 35% of homeowners own their home free and clear. Another 51% have fixed rate mortgages. This only leaves only 14% of homeowners with adjustable mortgages of any kind. Depending on the adjustable used the “payment shock” occurs somewhere around year 3 to 5. Anyone who took out one of these loans 3 to 5 years ago has won their bet. They have built up enough equity and rates are still low enough that they can sell their home or refinance their mortgage as planned. Someone who took on one of these mortgages within the last year or two may not be as lucky, but are still several years away from their “day of reckoning”. In the event the housing
market begins to slow you can be sure that the availability of these mortgages will begin to dry up. Lenders have much more to lose in a down market then borrowers do. If they perceive a declining real estate market, they will immediately tighten their lending criteria.
Reason number 4 is that even with the recent increased use of exotic mortgage products the majority of property owners are not at risk to adverse rate changes. They are either mortgage free or have fixed rate mortgages. You also need to keep in mind that these exotic products were initially designed for the more sophisticated borrower. Individuals that made a calculated decision to use their capital for investment instead of in their home. This reduces the number of borrowers that can potentially be in over their heads even more.
Real estate has historically been considered a safe place to invest. Housing prices may not go up every year but over the long term prices consistently have gone up. People who have invested in the stock market over the last few years have been on a roller coaster ride. Add an accounting scandal or two and some major corporations declaring bankruptcy and you begin to wonder why any one invests in the stock market. The safe haven of real estate has attracted the attention of many. This attitude has caused the local housing market to see an extraordinary rate of appreciation. As the rate of appreciation in the real estate market begins to cool off and interest in the stock market begins to increase money will begin to flow out of real estate and into the equity market. The result being a decline in property values and the bursting of a bubble.
Real estate as an investment is different than other investment vehicles. By its very nature you don’t have the luxury of picking up the telephone, instructing your broker to sell your home and buy ExxonMobil. There is an investment of time to price the property, market the property and wait for the buyer to arrange financing before you have the proceeds of sale to invest somewhere else. Also, if you happen to be living in that property you will need to find somewhere else to live. Another unique attribute of real estate is, unlike a stock or bond you don’t know the value of your property until you actually market it. Real estate simply is not a liquid investment. The momentum of a stock market crash or an internet bubble bursting can not be built up in real estate. The pace of transferring ownership of real estate has a cooling effect on the panic responses of individuals.
My fifth reason is that the inertia of a real estate transaction is in itself a barrier to a bubble. Transactions are time consuming, costly and the majority of properties are being used for another reason besides an investment vehicle. They serve as a place to live for the owners. A rational individual will think long and hard before relocating his family due to his fear of declining real estate values. It’s more than a simple return on investment calculation; it’s an emotional one, affecting the entire family.
We’ve been going through a very interesting time for the real estate market. The “nesting” mindset of the population due to the terrorist attacks of 9/11, unprecedented low interest rates combined with the shocks that the equity markets have sustained has made real estate the investment of choice. The real amazing thing is that this all occurred at a time the inflation rate in this country has been extremely low by historic standards.
Typically, paper investments (stocks and bonds) do well during periods of low inflation. Hard assets (collectibles, gold, real estate, etc) become the investment of choice during periods of high inflation. If you believe inflation is going to be kept in check than it would be reasonable to conclude the real estate values will most likely flatten out or decrease somewhat in price. If you feel that with the increase in the federal deficit, raising interest rates and increased oil prices that the days of low inflation are behind us then you are laying the foundation for an argument in support of even higher real estate values. |