Real Estate Bubble Theory Is Full of Hot Air

A lot of hoopla has been floating around the news media lately about the “bubble” theory of real estate. That is, the theory that the real estate market is going to burst. In my opinion, the theory has no merit.

First, understand that there are three basic premises that undermine the discussion of a real estate bubble:

  1. There is no national real estate market

  2. The real estate market doesn’t explode or crash

  3. The market has limited relevancy to the shrewd investor

The real estate “market” is based on local economies

When people speak of the real estate economy, they are using nationally-based statistics. For example, Fortune magazine reported recently that since the early 1960s, average residential real estate values have never had a down year. This statement is true. But while these numbers are measurable, they do not reflect the intricacies of local real estate markets.

The stock market is based on the national, even the world economy. The real estate market is based on local, and, in many cases, micro-local economies. What’s happening in Los Angeles does not directly affect what’s happening in Toledo.

True, certain factors such as interest rates affect all the markets. There really is no broad barometer to measure the entire housing industry in the U.S. Average prices, average new homes sold, and average homes built nationally have little relevance to your market.

And, within a particular city that is doing well, there may be certain neighborhoods doing poorly for a variety of reasons, such as over-building of new homes.

So while statistics, calculations, and economic factors are relevant, so is common sense: Take a look around and see what’s really happening. Talk to real estate agents, investors, and lenders in your area for a better picture of what is going on.

Don’t look at broad nationwide, statewide, or even city-wide statistics. Be concerned with the average prices in the particular neighborhoods in which you buy houses, the average time on the market, and the changes in sales prices from last year to this year.

Real estate markets do not “crash”

We all remember October 19, 1987, known as “Black Monday.” The stock market lost 22% of its value in one day–what investors call a “crash.”

There have been times when real estate values have taken 22% hits in certain cities and in pockets within cities. However, no real estate market dropped 22% in one day, one week, or even one month. In fact, the real estate “crash” of the late 1980s took several years to bottom out in most markets.

Some people are theorizing the collapse of housing market by comparing it to the stock market. Robert Shiller, author of Irrational Exuberance, claims that the same mentality that caused the rise and collapse of the high-tech market will likely follow in the real estate market. Let’s consider that argument for a moment…

At its core, the housing market, like the stock market, is all about supply and demand; when more people want to buy than sell, prices go up, and vice-versa. However, the stock market is much more whimsical than the real estate market. People often buy into stocks at the top of the market based on future potential, not inherent value.

True, people are buying some properties in some markets for top dollar hoping it will go even higher, but real estate still has inherent value because you or someone else can live in it.

If the neighborhood in which you live goes down 10% in value, are you going to move? Not likely, you’ll just be bummed about it. The transaction cost and headache involved in moving is not worth it for most people. Contrast the stock market where a zillion investors can sell off in minutes by a click on their computers.

Supply and demand also work differently in the housing market. Right now, demand outstrips supply in some hot real estate markets like Los Angeles and New York City. But, people are starting to realize that even if they sell for top dollar, they will have to pay top dollar to stay in the same market, so why bother?

This phenomenon is causing limited supply and even HIGHER prices. In other words, the price increases are not necessarily about “irrational” demand, but rather limited supply. While the old expression, “Trees can’t grow in the sky” is applicable, so is the old adage, “They ain’t making any more of it.”

More people are moving into the U.S. than moving out, and so long as that trend continues, we’re eventually going to run out of room. Likewise, if your city has limited space and more influx than out, prices are likely to stay where they are.

Finally, there’s the possibility that the traditional economic theories of bust and boom are simply flawed and no longer applicable. In other words, just because things have been going up in the housing market for so long, doesn’t necessarily mean they will drop accordingly.

Economic trends causing the market to remain strong

Immigration. Millions are immigrants are moving into the U.S. every year. If the government creates an amnesty program, we now have millions more potential home buyers who can legally show income and qualify for a loan. More demand, means higher prices.

Migration Trends. Face it, baby boomers can’t live on social security and pay the property taxes on their expensive homes any more. They’ve got three choices: continue working, take out reverse mortgages, or sell and move to a cheaper area.

This mass-exodus is likely to increase demand in the cheaper retirement communities over the next ten years. Though prices have skyrocketed in South Florida, Phoenix, and Las Vegas, it’s still a whole lot cheaper than Boston or New York City.

Marriage Trends. People are getting married later, causing more single people to buy houses and condos.

Easy to get a loan. Interest rates being so low for so long doesn’t hurt either. But, it’s more than low interest rates; it’s how EASY it is to get a loan.

Lenders figured out over the last fifteen years that instead of lending only to people with good credit, they can make money by lending to people with bad credit. Also, the Internet has led to fierce competition among lenders making it extremely easy and cheap to borrow money.

What about rising interest rates?

A lot of people are worrying about how rising interest rates will affect the market. Certainly, a rapid rise in interest rates may affect prices, since the higher the interest rate, the less house a buyer can afford. But, interest rates alone do not determine prices, but rather supply and demand.

So long as a particular area has more buyers than sellers, the values will remain strong. And, the Federal Reserve is well aware of the interest rates will impact the housing market. Interestingly, while the rise in interest rates in the U.K. has “cooled off” the housing market, there’s been no collapse as predicted.

Finally, keep in mind that even if a real estate market is reaching a peak within a particular area, it doesn’t necessary mean it will necessarily collapse. The fact that real estate values in your city have climbed at twice the rate of inflation last year yet only half the rate of inflation this year doesn’t mean the bottom is falling out.

It is inevitable that the “boom” markets like San Diego, Las Vegas, and Phoenix will cool down. But, there’s no evidence to justify a rapid decline in prices. Most experts agree that the likely scenario will be a “cooling off” where prices will remain flat, appreciating just above average inflation.

The Federal Deposit Insurance Corporation (FDIC), which regulates banks that hold 30% of the credit risk on outstanding U.S. mortgages, doesn’t appear concerned.

In fact, FDIC researchers examined data from fifty-five metropolitan areas that saw a “boom” at various times between 1978 and 2004 and found only nine instances of a bust that followed.And, many of those busts were related to local market factors such as the oil market crash in Houston and Denver in the 1980s.

Finally, keep in mind that just because your city’s average real estate values or home sales went down, doesn’t mean it went down everywhere in the city. The problem is, people see headlines like “Average Real Estate Prices Falling” and panic.

Declining values of $1,000,000 homes skew the average, so you can’t pay attention to broad numbers. You need to look specifically in the price range and location of houses you are buying.

The mass overbuilding of $500,000 homes in many markets won’t generally affect the older $150,000 homes that average investors work. Much of the new home building across the country has NOT been low-end homes.

The market has limited relevancy to the investor

If you buy and hold for the long term (fifteen or more years), you aren’t likely to lose. Real estate values generally go up in the long run, with few exceptions. The same is probably true of the stock market in the long run, but there’s one problem: There’s no guarantee any company you invest in will be in business in fifteen years–not even Xerox, IBM or AOL!

If you buy and flip properties quickly,
the market appreciation or decline is
not all that relevant to your profit.

I had this discussion when I appeared CNBC recently: If the local real estate market is “hot,” you can sell a property quickly, but you can’t buy it as cheap. If the local real estate market is weak, you can steal properties, but you have to account for a longer hold period when you resell.

It is relevant to know where your market is currently going (up or down), but don’t worry too much about the “bubble” bursting; real estate markets DO NOT collapse in 3 to 6 months.

Danger in interest-only loans?

A lot of people are worried that if interest rates rise, many people who bought with interest-only or adjustable rate loans will lose their homes. Certainly, there are some people who are playing a very dangerous game with buying more house than they can afford. However, the entire mentality of the market may actually be changing to adapt to changing interest rates.

Many people are buying homes with adjustable or interest-only loans knowing full well that in five years they will either move or that their house may have no equity. People are starting to treat their homes like car leases, caring only how much it costs monthly to have the best they can afford.

On the other hand, if you are buying investment properties with negative cash flow and expect the values to increase over two to three years, shame on you! What if the values decrease? What’s your backup plan? Can you rent it for break-even cash flow? Can you sustain negative cash flow until the market rebounds?

If so, then don’t sweat it. You’ll also pick up a whole bunch more properties at the bottom of the real estate cycle. If not, then you are a speculator, not an investor, and you are at the whim of factors beyond your control.

Such activity is very risky, to say the least, and it is disturbing to see that many investors are doing just that in some of the hottest markets. And, they are doing so with interest-only loans, with no “Plan B.”

The bottom line is, the real estate market may go up, and then again, it may go down. So what? Don’t bank on appreciation; buy properties below market, and have a “plan B” if it doesn’t work out. Do this, and the you will see that the “bubble theory” is full of hot air.

[For more information on the Real Estate Market, read Bill’s article, How to Investing in a Changing Real Estate Market.]

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