The Next Bubble to Burst? Posted by: Dale Franks
on Tuesday, March 29, 2005
John Makin argues in the American Enterprise Institute's newest Economic Outlook that the US housing market appears to be in a bubble, and the bubble may be about to burst.
It sure looks frothy, I have to admit. I paid a quarter-mil for my house in 2001, and the market value now is supposed to be around a half a million now. Doubling the price in 4 years seems kind of excessive to me, although I admit that, because I live in San Diego, house prices here may be frothier than those elsewhere.
The concern I would have if there is in fact a housing bubble, and it bursts, is the effect that would have on consumer debt. There's lot of people who have borrowed against the increased value of their homes, and a collapse in price would really damage personal balance sheets for a significant portion of homeowners.
I haven't looked into it but I wonder how much of the bubble problem stems from excessive price increases in selected urban areas like mine, rather than a generalized real estate bubble everywhere.
Meanwhile, Irwin Stetzer writes in The Weekly Standard that the Fed is clearly telegraphing that rates are going to continue to rise, and, perhaps fairly sharply since inflation pressures are peeking in, and real interest rates (rates after inflation is subtracted) are still close to zero.
The Fed's recognition of the possible need for higher interest rates was bad news for bond investors, but good news for dollar bulls. Former White House chief economist Larry Lindsey points out that short rates are now 0.75 percent higher in the United States than in Germany, and long rates are almost a full point higher. Moreover, U.S. rates are headed up, while, as Lindsey puts it, "There is no reason to expect tightening in either Europe or Japan in the foreseeable future." That combination makes dollar-denominated assets attractive, and is a prescription for a stronger dollar, which will keep the price of imports from rising, and dampen inflationary pressures.
Now this has some interesting implications. First, US short-term interest rates are already 0.75% higher in the US than in Germany. Increasing rates implies that we will begin pulling a greater amount of foreign investment, as overseas investors shift toward US assets that offer higher returns. So, keep spending like a drunken sailor on a Singapore shore leave, 'cause the heathen foreigners are paying!
It also means that continued buying of US Securities by foreigners will help keep the dollar valued strongly in the FOREX market, rather than collapsing and whimpering like a little girl because of our current account deficit.
But the implications on the real estate market for higher interest rates is a bit less positive, although that depends a lot on how high mortgage rates actually go. Really steep rises in mortgage rates would really put a crimp on home sales, and hence, prices. But, we have a way to go before getting there.
But knowledgeable home-builders say that so long as mortgage rates stay below 7.0 percent to 7.5 percent—30-year rates are now around 6 percent—the boom will continue. They point out that new home sales in February increased by a stunning 9.4 percent; inventories of unsold houses are falling; the rate of new household formation continues to rise, underpinning demand; and even with interest rates edging up and house prices rising, houses remain affordable by any historic measure.
Which, by the way, does tend to highlight a problem with the "housing bubble" argument, and shows that, like good economists, economists disagree about whether or not there actually is a housing bubble.
They key thing here is how you interpret the new household formation figures. If you assume that new household formation is an indicator of steadily increasing home demand, then you're probably quite giddy indeed. If you're like me, however, you're a pessimist, then you probably think that the new household formation reflects the fact that people respond to incentives. In which case, you suspect that, maybe, rising housing prices are pushing people to form new households more quickly in order to buy a home before prices shoot out of range of their ability to purchase. If so, then the rate of new household formation is not, in fact, signaling greater underlying demand, but rather a response to rising prices. But, don't get too gloomy:
American residences are now worth almost $17 trillion, and mortgages against them come to only a bit more than $7 trillion, leaving what Greenspan calls a "fairly large buffer against price declines."
Ah, well, that's comforting.
Currently, the signs are good for increased economic growth, even with higher interest rates, a slowdown, but not a collapse in the housing markets, and, for the short-term, at least, a strong dollar as US investment yields provide an attractive option to foreign investors. So, we're good to go.
Unless, of course, it worries you that bankruptcy advisers are scrambling to hire staff.
I’m more worried about the effect it would have on taxes. If everyone’s houses suddenly drop in value, all property tax collections will decrease, "requiring" an increase in the tax rates. Add the sudden overload of consumer debt to new, higher tax bills and see what you get.
Of course, then again, knowing government, they will simply keep the assessed values where they are and ignore the real values of the houses to avoid a "loss."
My wife and I have been looking at buying a house in Lynchburg (not an urban center by any stretch of the imagination), and according to friends prices there have quadrupled over the last decade.
So the rapid increase in housing prices seems to be a broad phenomenon. Whether this is due to speculation or strong underlying fundamentals (which could still change and lead to the same effect as if a bubble had popped), I’ll decline to guess.
I think you have to look at the market in a much more complicated way. I moved up form a $125,900 house 8 years ago to the one I’m in now that I bought for $357,900. Its now worth about $450,000. But that price pressure is due to scarcity, not overblown prices. Sure, there is a ceiling at which the product prices itself out of the market, but this house has features that make it worth what its asking: 1) in an urban area it is considered close in 2) traffic from here saves about 1.5 hours per day in a persons commute 3) its next to the country club 4) its next to a state park 5) it has over 6,600 square feet and 1 acre of land. So even if there is a bubble its a bubble only in certain areas. And even then its a bubble that, IMHO, may only affect growth _rates_, not an actual decline.
Houses have to be on land. And they’re not making any more of that stuff.
Plus, even if rates go up I’m still in good shape because that means I can raise the rental rates on my rental property and have a much easier time finding tenants. So even if a ’bubble’ bursts in your area, I would consider that a perfect time to invest in the rental business.
Houses have to be on land. And they’re not making any more of that stuff.
With the population getting older, they sure are. All those folks in their 50s with half an acre of land or a huge house will be looking to move to more modest abodes soon enough. It is only a matter of time before they look to places that are easier to take care of and have less stairs.
"American residences are now worth almost $17 trillion, and mortgages against them come to only a bit more than $7 trillion, leaving what Greenspan calls a "fairly large buffer against price declines.""—not quite, because the $7 trillion does not include the most rapidly-rising debt—home equity lines of credit.
Certainly real estate in general and housing specifically are no longer the undervalued assets they were not so long ago. However, they are not a bubble nationwide. Especially in comparison to prices internationally, compared to the cost of renting, etc. I expect a slowdown. However, if this nationally were to continue for a few more years I would sell and rent. That is usually what ends appreciation; people begin to notice that rents are cheaper than owning and begin to stop buying and selling increases. If housing is a bit bubbly the fall can be rather dramatic.
So is there a risk? Sure, mostly in specific areas of the country, especially on the coasts where valuations are well above what rental rates justify. This implies that what is going on is speculation as people are buying despite the economic rationale because they see a house (or several) as a good investment. Unfortunately the economic dislocation of a collapse in housing prices in San Francisco, San Diego, etc. are not to be dismissed. Hopefully prices will moderate in these markets, and the market will move sideways allowing for a smooth adjustment and therefore a disappointment for owners, but no disaster.
The remarks on household formation are interesting. As an Investment advisor housing stocks have over the last five years been my top holding for clients who purchase individual stocks. This came about because of not only my long term interest in housing stocks, but because of the results of the 2000 census.
Not that anyone here is going to run out and buy them today because of what I write but please don’t use this information in making a decision on these companies now. That is a whole other discussion (past performance doesn’t guarantee future results). Still it should be pointed out that an ignored area some five years ago is getting far more coverage as these stocks have posted returns over the last five years in excess of 50% a year. What were the clues? Well there were many (if anybody is interested, e-mail me) but for purposes of this discussion I looked at what the census said about the pace of household formation. The big surprise of the census (and it has been ignored by the vast majority of political, economic and investment commentary) was that the bulge in the demographic snake (the post war baby boomers) had much more following it. Here are the numbers:
It turns out that the demographic cohort that followed immediately after the baby boom was actually bigger than the baby boom even though fewer children were born! Why? Immigration!Interestingly every following cohort exceeds the baby boom in size. That suggested to me that two trends were going to lead to a continued demand for housing. The group just behind the baby boom was going to be entering their peak earning years and looking for the big house. Simultaneously their children were going to be starting new households and buying first and second homes. So I would suggest that until the end of the decade underlying demand should be fine. How other factors effect that demand (interest rates, unemployment, etc) is another question (once again you can e-mail me) but the baseline demographic demand for housing should still be there. I expect these figures to be relatively similar in the future as immigration over time swells each cohort above and beyond the attrition of mortality. It wouldn’t surprise me if immigration, and the children of immigrants especially, swell the younger age cohorts.
