Don’t Buy Housing Bubble Propaganda

UPDATE: The original version of this is still available on Real Money (subscription only). The 2005 article details was a pushback against the gloomers predicting a Nasdaq like collapse in RE prices. Instead, we detailed why this was a CREDIT (not a HOUSING) Bubble, and that while we should expect a 25-35% peak to trough drop in prices, it would not be a Nasdaq like 80% debacle. (35% was bad enough). We also noted that an extended period of high unemployment might make those numbers even worse.


The latest subscription only Real Money column, Don’t Buy Housing Bubble Propaganda, is now available on Yahoo (no subscription required).

In writing it, I decided to forget everything I thought I knew, and look at housing from scratch.  Consider the factors that make Real Estate very different than stocks. Lose the assumptions, check out the numbers driving Real Estate, and see if Housing is truly the bubble everyone claims it to be.

Turns out there’s much less of a bubble than commonly believed by many people believe. While anecdotal evidence of regional excesses are interesting,
they doesn’t mean we are about to see home prices get cut in half (or worse) over the next few years.

There are three key drivers hardly discussed by pundits opining on the U.S. housing market “bubble”:

1)  Purchase prices don’t matter to buyers — monthly payments do;
2)  US has the fastest growing population of industrialized nations;
3)  “Only 3% of all buyers sell their home in a year or less,” a survey found.

These issues, taken together, suggest that while Real Estate may be an extended asset class (i.e., two  standard price deviations above historical trend) that doesn’t maeke it a bubble.

Of course, its interesting to note that a Playboy bunny gave up her modeling career to go into real estate speculation (mentioned previously here), it doesn’t mean the end is nigh.

Now if I can only figure out how these columns end up at Yahoo . . .


Don’t Buy Housing Bubble Propaganda
Barry Ritholtz
RealMoney by, Thursday May 26, 2:04 pm ET


UPDATE June 12, 2006 9:39am

I just noticed that the Yahoo page expired; The full RM article is after the jump . . .



Don’t Buy Housing Bubble Propaganda
Barry Ritholtz

5/26/2005 2:04 PM

• Housing is overextended, but not to bubble proportions.

• There are three different drivers of housing prices, which separate them from stocks.

• The biggest risk to the housing market is a significant decrease in national employment.

The old saw is true: Every general fights the previous battle. And after missing the tech and telecom bubbles, the generals of the financial media are now battling more bubbles than we can count:

There are bubbles in debt, credit and interest rates. There is the oil bubble, the import bubble, the China bubble and the current account deficit bubble. In short, we have a veritable bubble in bubbles. Indeed, it is astonishing how many people who failed to either acknowledge the tech bubble in the 90s — or at least failed to act on it — now have no hesitation to declare real estate to be a bubble. This despite their lack of expertise or past track record in spotting bubbles on a timely fashion.

The bubble du jour though is the housing bubble. From Greenspan’s testimony to CNBC’s Housing special to (uh-oh) this month’s Fortune magazine cover, it seems to be all anyone wants to talk about.

My position is that housing is not in a bubble — yet. But it is an increasingly extended asset class that may be subject to a significant correction in the future. But a 25%-35% retracement is a very different situation than a bubble (recall that the Nasdaq dropped 80%), primarily because there are very different consequences for both homeowners and investors.

Not Your Grandson’s Bubble

That said, comparing real estate with other true bubbles — most especially the tech/telecom/dotcom bubble of the 1990s — is  imperfect, due to several factors.

Homes are illiquid assets that take several months to sell; stock can be liquidated instantly.

The housing market is regional, with an uneven distribution of asset appreciation: Equities are national, and even global.

Lastly, there is an intrinsic value of a house as a place where you can live; Compare this with a company whose only asset was a sock puppet — the tulip bulb of its day — and it’s clear why a profitless, assetless, publicly traded company can go to zero. Barring an external disaster like Love Canal, houses will not.

When we compare what the key drivers are for price appreciation between these two asset classes, other crucial differences appear.

What Drives Housing Prices

We can look at three key drivers for equity price appreciation over different time lines: Longer term, it’s a function of earnings. Higher profits support greater prices at historical P/E ratios. Multiple expansion and contraction occurs as a function of our next two drivers. Intermediately, macroeconomic conditions (aka the business cycle) drive the entire market. I expect the cycle, which began post-2001 recession, to end in early 2006. If that’s correct, then prices will retreat as revenue and earnings slow. Over the short term, sentiment — especially when it gets to extremes — is a key mover.

Housing is driven by very different factors. First and foremost are mortgage rates. Something I have yet to hear the pundits opine on is that most home buyers don’t care what they pay for a house. That’s right, you read that correctly — purchase price doesn’t matter. What they do care about is the monthly carrying costs. For the vast majority of home purchasers, the biggest variable in that will be their mortgage rates.

The first house I owned had a $300,000 mortgage. Back when interest rates were near 10%, the monthly payment would equal $2,632.71. If a buyer today were to finance the purchase of that home for $500,000, at a 6% mortgage (and you can get lower rates today), the monthly payment is $2,997.75. That house appreciated 67%, yet the mortgage payments went up only 14%. This helps demonstrate why a big drop in mortgage rates drives prices much, much higher. And that’s not counting the buyers who made larger than 10% down payments via the accumulated equity from the sale of their prior homes. (See this mortgage calculator to run your own numbers.)

The second factor is demographic trends. Here’s a little-known fact: The U.S. has the fastest population-growth rate of any industrialized nation. According to NPG, the U.S. average fertility rate is currently 2.1335 births per woman — the highest fertility rate since 1971. For comparison, the U.K.‘s fertility rate is 1.7, Canada‘s 1.4 and Germany‘s 1.3. If this rate is maintained, the U.S. population will double every 35 years.

Further, the kids of the baby boomers — the echo generation — are now at home-buying age. Thanks to the intergenerational wealth transfers, they can buy bigger and more expensive homes than their parents could at the same age. Their purchases also have been impacting the housing market. (Some analysts believe that the life cycle of the boomers has been a key driver in equities also — so on  this point, there may be some parallels between the two asset classes.)

Take this organic increase in U.S. population, add to it a healthy supply of legal immigration, and that’s a formula for a rising demand for housing. And, there are no warehouses stocked with homes awaiting more births and naturalized citizens.

Muy Caliente

Furthermore, the hottest price appreciation in real estate is directly correlated with population shifts within the U.S.: Las Vegas and South Florida are growing at two to three times the national rate, so it’s no surprise that their home prices have been appreciating rapidly.

The third driver is speculation. In many regions, speculative activity has risen dramatically. The National Association of Realtors (NAR) reported that speculative purchases in 2004 had risen to 23%, from 16% the prior year.

However, if we define speculation as flipping a home within one year, that number drops dramatically. According to an NAR survey, “only 3% of all home buyers sell their home in a year or less.” That is not exactly the picture of excess speculation.

Even if you use the 23% number, compare that with the speculative foment we saw in 1999. I would surmise that somewhere north of 80% of all stock purchases and trading were purely speculative in nature. If these two asset classes are each bubbles, then they are very, very different kinds of bubbles, hardly comparable to each other.

The last, and in my opinion, potentially most damaging factor, is the employment situation. As long as most people are gainfully  employed, they will be able to service their mortgage costs. (For those of you who are buying a home you can barely afford, then let me suggest buying mortgage insurance — just in case your main income source falters).

The biggest risk to the housing market is not just rising interest rates — rather, it’s a significant decrease in national employment. Why? It’s not the leverage, but the ability to service the debt that causes problems. A potentially negative scenario is the Fed tightens too far, inducing a recession. Something else goes wrong – theoretically, China stops buying our Treasuries, and that forces the Fed to become a buyer of last resort (think Bernanke’s printing press). Next thing you know, we have hyperinflation, large-scale unemployment, and a housing market off 50%.

While I don’t believe this is a likely scenario, it certainly is within the realm of possibility, and it’s one of the few ways I can foresee a major drop in home prices.

The most recent asset bubble saw prices drop 80% from peak to trough. That was the Nasdaq from March 2000 to October 2002, and those losses are very comparable with the Dow crash in 1929, or the Nikkei collapse in 1989.

How likely is it that real estate will suffer from similar distressed sales in the U.S.? In my opinion, not very. But real estate is an extended asset class, and it’s likely to come in — eventually. After the 1987 crash, many of my peers rushed out of equities (big mistake) and into New York real estate. Anything purchased between 1987-89 was underwater for the better part of the next decade. By the late ’90s, they were back to break even, and since then, it’s been a strong move upwards

We shouldn’t be surprised if purchasers at present prices see a similar price sequence over the next decade. As the rate cycle plays out, prices will slide. I’m looking at a slow asset depreciation of 10%-30% over the next several years as a realistic possibility.

Perhaps 2008 will be the next great entry into real estate — assuming you are insulated from rates (i.e., paying cash). After the next market washout — my work suggests 2006-07 will not be a period of equity outperformance — I can foresee a gradual economic strengthening in the 2010s, with a new bull equity market beginning mid-decade (2012-15). Then the whole movie starts all over again.

But a 1999 dot-comlike bubble? I hardly think so.

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What's been said:

Discussions found on the web:
  1. jack commented on May 31

    good article,

    some additional points I think are important,

    Being that most homebuyers are highly levered 80%-100% LTV, especially investors, a decline of 30% would wipe out all equity and then some, potentially leading to foreclosure and personal bankruptcy. (All rentals units are owned by investors and there are many renters.)

    Lack of liquidity in real estate is a double edged sword. It allows for bubles to perpetuate even when most people agree prices are inflated but are not willing to bear the disruption in their life to move to a rental or other commmunity.

    It is extremely difficult to short the housing market and so unlike equities a bubble in homes can extend even beyond a bubble in equities.

    measuring speculation by turnover (percentage of units sold within a year) is imperfect as speculators will hold while the trend continues. Another measure to include would be leverage, loan to value, percentage of ARM mortages.

    When people say there is a bubble they are not neccesarily thinking an 80% decline. I never considered that. In my thinking a 30-40% decline is what those predicting a popping bubble are expecting.

    good article.

  2. Jon H commented on May 31

    Seems to me that most Playboy bunnies give up their modeling careers, some sooner than others.

    For every Jenny McCarthy, there are many who rapidly drop into obscurity.

  3. royce commented on May 31

    On one side we have long-term historical rates of price appreciation in housing that are far, far below what we’ve seen over the past five years. On the other side, we’ve got a lot of arguments that sound good, at least to my untutored ear.

    But as someone pointed out recently, you don’t know for sure it’s a bubble until it goes pop.

  4. touche commented on May 31

    Granted, real estate prices are skyrocketing in many parts of the country. But this would constitute a bubble only if the rising prices were being driven by excessive debt. Are consumers in the US taking on excessive debt? Take a look…

  5. Patrick (G) commented on May 31

    From Brad DeLong:
    The late Rudi Dornbusch said that the collapse of unsustainable currencies and other wrong-headed policies invariably took place in four stages:

    1. Enthusiastic investors and speculators chasing immediate short-term returns cause the anomaly to last for longer than economists expect.
    2. Puzzled by the failure of prices to return to fundamentals or of unsustainable policies to generate a crisis, highly-intelligent economists evolve theories explaining that *this* time it really isn’t unsustainable.
    3. Fortified by these theories, yet more investors and speculators chasing short-term returns flood into the market, causing the anomaly to last for *much* *much* longer than economists had originally expected.
    4. The supply of greater fools comes to a sudden end; the crash comes; the crisis comes.

    In the other corner, we have another highly intelligent gentleman who lucidly explains why he is shorting the L.A. housing market:
    Los Angeles housing isn’t a bubble in the sense that Washington, DC housing is reported to be: in L.A., unlike DC, you can’t get appreciably cheaper housing of equivalent quality by renting.

    Still, the current sales prices in relation to incomes make sense only if people buying now are reckoning on price appreciation, as I did eight years ago.
    But I was buying just after the trough of a slump that had taken prices down about 30%, and in an environment where long-term interest rates seemed likely to fall. It didn’t take much nerve to make a big bet on Westside housing.

    Hanging on today would be a different matter. The leverage that worked for me on the way up (I put down only 15%, borrowing the rest from my employer) will work equally powerfully on the way down. And down is the only direction I can see, unless fixed mortgage rates miraculously remain at under 6% as short-term interest rates keep rising, or short rates inexplicably flatten out.
    If prices start to drop as interest rates rise, there are lots of people who will (1) have trouble making the payments on their variable-rate mortgages and (2) find themselves “under water,” with negative equity in their houses. Sounds to me like a recipe for panic.

    It’s hard to imagine housing prices doing what the NASDAQ did — after all, the LA economy is strong, lots of people want to live on the Westside, and they’re not making any more land here — but 30% doesn’t seem to me a safe upper limit to set on the size of a possible drop. (After all, if the rates on ARM’s go from 4.5% to 6% — not at all a far-fetched number — it would take about that much of a drop in prices just to keep payments even.)

  6. spencer commented on May 31

    When discussing bubbles do not forget the lesson of Sir Isaac Neuton, was unquestionably one of the smartest men to who every lived. Not only did he describe gravity first, he also developed the entire field of calculus.

    He also lived through the South Sea Bubble and got in on the ground floor. He made a fortune, and realizing it was a bubble got out with his fortune intact. But the bubble kept going. and he could not resist the temptation and got back in just in time to lose and everything.

    So always be careful when dealing with bubbles.

  7. J Bentham commented on Jun 1

    In the midst of the frenzy, I think there are a couple of other things to keep your eye on:
    1) Number of people buying 2nd and 3rd houses (talk about highly leveraged, these aren’t all millionaires)
    2) Increase in house prices vs. increase in wages
    3) Number of people taking interest only/40-45 yr mortgages (let’s be honest, these people are SOLD these)
    4) Backlog numbers from the house builders

    For a while now I have been very curious as to what WILL happen when it “crashes,” or subsides. Half the people will get hurt, and the half that lives will write it off somehow. I dispute the fact that house buyers only care about monthly payments. My personal experience is that one knows the price is abnormally high at which point you are talked into a means of making it work. Also, interest rates aren’t REALLY going to go anywhere by the end of the year (up to 4?), and the long rates haven’t really budged anyway…so what happens if nothing acts to pop it??

  8. Oz commented on Jun 2

    I think, in the semantic sense, Ritholtz is right on about the housing “bubble.” And his analysis is spot-on. However, I’m not sure that it’s wise to define a housing bubble the same way that one would define a stock bubble.

    The article itself talks about how real estate is different from stocks in ways that form a floor below which it’s difficult for prices to fall. I would add to that a ceiling that limits the velocity of appreciation in real estate, namely that there is a practical limit to buying property. Unlike stocks, where orders can be almost any number of shares, and in a bubble environment, an investor can buy over and over again, it’s difficult for even investors to buy more than one property at a time. And with negotiations, escrow, etc., it’s difficult to acquire more in a timely manner. Thus, even in a bubble-like environment, housing prices will appreciate more slowly than other assets, reducing the amount that it falls when the bubble does burst.

    Moreover, I think it’s somewhat misleading to define a bubble as a certain percentage drop. It’s more useful to define it by its effects on the rest of the economy. A 30% drop in home prices, especially in this environment, where, despite appreciating prices, home equity holdings have actually fallen, could cause as much devastation as an 80% drop in stock prices. And in a “kitchen sink” economy, the government has no tools left to protect the public from its effects, and all the margin left in the other sectors of the economy to buffer shocks has been eaten away.

    Thus, it may be better to treat this situation as a bubble, even if prices haven’t risen as high as one expects in a bubble. Brad’s comment above, which looks at bubbles from a behavioral standpoint, reinforces this point. It may not look like a bubble, but it sure feels and quacks like one.

  9. Marinka commented on Nov 14

    esta pagina es como las pelotas pa mala las cago
    de verdad es como las hueas pa’ mala

    y q esta pagina de &$·”%/ no les va a durar mucho , pq son pa la caga de malos……

  10. The Big Picture commented on Jan 3

    How Far Must Housing Prices Fall?

    Our original thesis back in May 2005 was that Home prices could retrace as much as 25%-35% from the peak to re-establish a normalized pricing. Now, a new study shows exactly how and why that might occur: Home Price to Rent Ratio: U.S. house prices like…

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