The Housing Bubble

The New York Times has a look at how to spot a housing bubble. “Gary and Margaret Hwang Smith, economics professors at Pomona College, concluded that not only was the Los Angeles region not in a bubble, but many markets that others were calling overpriced, like Chicago or Boston, were probably underpriced.”

“In a paper the two presented at this week, ‘Bubble, Bubble, Where’s the Housing Bubble?’ they argued that the value of a home is determined by the rent it could fetch. Calculate the future rents, subtract mortgage payments, taxes and other costs, factor in a good annual rate of return of 6 percent or more, and one should be looking at the proper price of a house or condo.”

“At at the risk of sounding like a real estate agent, Mr. Smith said there are two risks to consider when buying a house. One is that you buy and the price goes down. The other is that you don’t buy and the price goes up. ‘The second is more scary,’ he said.”

“Robert J. Shiller, the Yale professor who has few doubts that a real estate bubble exists in many American cities. He said he did not buy the Smiths’ point that certain markets were not overpriced. The way the Pomona professors reached their conclusion, however, has generated a lot of interest among fellow economists. ‘I think the paper is a sign of the times,’ Mr. Shiller said, because it emphasizes the link between home prices and rent as the proper way to understand the value of real estate.”

“Richard Peach, a vice president at the Federal Reserve Bank in New York who studies home prices and their relation to income, echoed that view, saying, ‘This is an important paper.’”

“Karl E. Case, a Wellesley College economics professor who has been studying real estate prices for more than 25 years, calls the paper’s method ‘absolutely the correct way to think about it.’ Of course, few people do that math when they buy a house. They look at what other houses in the neighborhood are selling for and base their bid on some expectation of what the house may be worth in the future.”

“Those expectations are far too optimistic, numerous studies have shown, most notably a 2003 study by Mr. Case and Mr. Shiller that found, for instance, that homeowners in San Francisco expected annual price increases of 15.7 percent. ‘It’s clear a lot of people are nuts,’ Mr. Case said.”

“Several economists, like Mr. Case and Mr. Shiller, quibble about the assumptions the Smiths make in doing their calculations, for example, homeowners spending only about 2 percent of the house price a year on maintenance or that everyone can obtain a mortgage interest deduction. One-third of taxpayers do not itemize their deductions and many more are getting hit with the alternative minimum tax that removes some of the advantages of home ownership.”

“The questions many people want to know about housing prices are not answered by the Smith research: when will they fall and by how much? ‘Some people think we are trying to predict prices and we are not,’ Mr. Smith said. Sure, he said, if prices drop you would have been better off if you had waited. ‘If you are a house flipper, we aren’t talking to you,’ he said.”

From the Washington Post. “Homeownership makes Mary Casey feel as if she has more control over her destiny, even though she pays 75 percent of her net income for a 600-square-foot co-op in the District, including the monthly co-op fee. ‘I’m willing to live that way if I buy,’ she said. ‘I’m not willing to live that way if I’m not buying.’”

“An even better indicator of how divorced home prices are from their underlying economic value is the price-to-rent ratio. Consider the example of a townhouse in Fairlington, a venerable apartment and townhouse community in the Virginia suburbs just a few miles from the nation’s capital. It’s an instructive example because there are hundreds of similar units.”

“A typical three bedroom townhouse in Fairlington recently sold for $575,000. Assuming the owner put 10 percent down and took out a traditional 30-year fixed-rate mortgage, the monthly payment would be just under $3,200. Add in property taxes, a condo fee, and the tax breaks for home ownership, and the cost of owning this unit comes to about $3,000 a month. (Note that this analysis takes into account the lower cost of owning due to low interest rates and ignores the $57,500 down payment.) Yet the very same place rents for no more than $1,700 a month, or just over half the cost of ownership.”

“Why own it? One powerful reason must be an expected profit down the road. As with the stock market during the tech bubble, many are basing purchasing decisions not on underlying economic value, but on what they think they can sell a property for in the future, the very definition of a speculative bubble.”

Several readers want to discuss the cost of capital. “Topic suggestion: How much further will the ten year treasury note yield have to increase (a lot of mortgage rates are being effected too) before the housing markets really implodes.”

Another said, “Now that Ben Bernanke has been on the job for 60 days, any revised thoughts on where his policies will take the US economy? Some possibilities:

1) Business as usual, as advertised when he took over. Under this scenario, the housing bubble, commodities bubble, and hedge fund bubble (did I forget any?) keep inflating until they eventually pop in a catastrophic, mutually-reinforcing collapse.

2) A return to normalcy. Under this scenario, he stays the course on tightening until the speculative mania is choked to death. Overvalued stock, housing, and commodities prices suffer collateral damage and T-bonds turn out to have been the place to invest.

3) Other scenarios?”

A reply, “3) It doesn’t matter, either way, the damage has been done; we are in debt up to our eyeballs with the record US deficit, trade deficit and household debts. There’s no end to the madness and any number of scenarios could bring down the whole house of cards.”

Some related reports. “The words of the Kansas City Federal Reserve Bank President Thomas Hoenig explain the inevitable. While speaking at a breakfast organized by the St. Joseph Missouri Chamber of Commerce on Friday, Hoenig said, ‘Only with that constant incoming data will we know where we are in the policy cycle.’ The conclusion? Stay tuned to each incoming economic report, as the Fed has left the markets and the economy guessing regarding its future course of action.”

“‘Even though the Federal Reserve has been raising interest rates, they are also increasing the money supply,’ Paul Levine said. ‘You also have a lot of money that was going into real estate going into stocks now, since the housing bubble is bursting.’”

“‘The problem is that the ten-year note yield is currently standing at 4.85 percent and is pushing toward 5 percent and our friends at the Fed are not telling us when rate hikes are done,’ said Ram Kolluri. Last week, the benchmark 10-year note surged to a 22-month high amid bets that interest rates are set to rise.”

“‘We’ve got a lot of economic news between now and the next Fed meeting in May,’ Art Hogan said. ‘The path of least resistance is higher, but there’s a bumpy road.’”

Have any housing bubble observations this weekend? The springtime open house season is in full swing in the southwest. Here are some from the topics thread:

“Written by a Santa Barbara Realtor, ‘Many buyers are taking a ‘wait and see’ attitude. Now that a soft landing can be expected, with interest rates remaining favorable and the excessive pressure to ‘buy it now’ lessening, buyers can relax a little. They do need to understand, however, that prices in the Santa Barbara area are not going to plummet. Therefore excessively low offers are not appropriate.”

“How about a share the real estate listing that ‘gets your goat.’ Here is mine. It is a 1,336 sf box in the bad part of Westchester (LA, south of Manchester and one block away from LAX). The annoying part is that it was purchased LAST MONTH for 599K and now is up for 769K. No pictures up yet (looking forward to seeing what vast $170K improvement they made in a month), but I’ll be watching this listing closely, hoping that the flippers lose their shirts.”

“Phoenix now stands at 40,192. Leave your prediction for when we will hit 50,000.”

And some reports of builder incentives in various markets. “In Los Angeles County, sales of new homes in February were up by more than half over a year ago, a big contrast to the otherwise slowing housing market. Meanwhile, sales of existing homes are down 28 percent in February compared to the same period last year.”

“One reason for the disparity is that home builders have more flexibility than resellers in offering upgrades and financing deals to buyers, Patrick Duffy said. ‘Builders have more weapons at their disposal in terms of incentives,’ said Duffy. ‘It’s a really smart way for them to compete with the resale market.’”

From Arkansas. “Mike Robinson, a broker and realtor in Bentonville said, ‘It seems to me, we know that we are overbuilt now in new construction in certain price ranges in Benton County, primarily $250,000 to $500,000,’ he said. ‘The inventory that we have is sufficient to last for a number of months.’”

“Also, Robinson has noticed that resale home prices have crept up to almost parallel new construction prices in the last few years. ‘Not only should we see a leveling off of prices in new construction, we should also see a slight reduction of prices on resale houses,’ he said. Robinson has noticed an interesting phenomenon: Instead of dropping prices, builders are offering creative incentives to buyers and Realtors. Builders who own several houses would rather offer incentives and lose on one house, if it keeps prices up on the neighboring houses on the market.”

“According to the MLS, 21 new-construction homes sold or closed in Bentonville in the last 30 days. Four of those houses underwent substantial price reductions, for example, one house started at $236,900, then dropped to $210,000.”

In Las Vegas. “Steve Fait said he was able to keep the price at around $1 million because the costs were lower. The homebuilder bought the land prior to the 2004 housing appreciation boom. ‘You can’t build my home for what I did and as cheap as I did, the costs have already gone way up,’ he said. ‘People are getting a bargain because we are at the old (land) prices.’”

“As the National Association of Home Builders draws attention to the vast benefits of new home construction during April’s New Homes Month celebration, one thing is clear: while the record-setting pace of the last several years is leveling off, savvy consumers can take advantage of creative perks offered by many home builders today.”

“‘Understandably, some consumers are concerned about the housing market right now,’ said David Pressly, NAHB president. ‘But the recent decline is certainly no cause for alarm.’ Across the country, builders and developers have been offering home buying incentives including..price reductions and help with closing costs.”

Two reports on the humbling of a king. “Two years ago Miami developer Jorge Perez said the Las Vegas market was ripe for the high-rise condominiums he has built so successfully in Florida. But Sin City has not been kind to South Florida’s ‘Condo King.’ In January Perez canceled a twin-tower condo called ICON Las Vegas. Now he’s weighing selling the 25 acres on which he, along with actor George Clooney, planned to build a massive, and much-hyped, 11-tower condo project, Las Ramblas.”

“But now Perez says demand is lower than expected and construction costs much higher, in fact, he says, Las Vegas’ condo market has dropped off more sharply than any of his other markets. ‘Did we misjudge the levels of demand and costs in Las Vegas?’ said Perez. ‘The answer is yes.’”

“The hope was Las Vegas would do as well with Asian buyers as South Florida had with Latin Americans. Now some South Florida developers are less sure. Fortune International CEO Edgardo Defortuna considered a Las Vegas project but backed out. ‘The reality is that there are such wonderful, gorgeous hotels at very reasonable prices,’ said Defortuna. ‘Why would you stay in a condo when you can stay in a hotel in the middle of the action and not pay that much price?’”

“For Perez’s part, he says he won’t be looking for more Las Vegas projects, at least for now. Meanwhile, Perez still has dozens of South Florida condos to complete.”

The Sun Sentinel. “Closings are scheduled today at The Prado condominium in downtown West Palm Beach. It’s not soon enough for some buyers. The project was supposed to be ready last year at this time, but three hurricanes in 13 months caused delays, said Barbara Salk, a senior VP for the developer, The Related Group of Florida.”

“The city of West Palm Beach issued The Prado a certificate of occupancy weeks ago, but the building has remained empty because several subcontractors had liens on the property. Don Albaum said he won’t close for weeks. He gave Miami-based Related more than $71,000 as a deposit for his $356,900 condo in March 2004. He said Related told him it would be ready early last year, but he’s still living out of a suitcase in a rented condo in Delray Beach.”

“Related wrote letters informing him of a series of delays but still encouraging him to lock in financing, Albaum said. He lost three mortgage rates and has watched as his current rate has climbed from 5 percent to 6.5 percent. ‘It’s been a total disaster,’ he said. Two other buyers, who asked not to be identified, said they also have been strung along by Related, one of the most active condo developers in downtown West Palm Beach.”

“‘We’ve wanted nothing more than to open this project,’ said Salk, adding that Related’s financial losses because of the delays extend into seven figures.”

Several readers responded to the idea of talking with friends about the housing bubble. “Any stories to share?; Friends don’t let friends buy Real Estate. Have any readers tried to convince a friend/acquaintance that right now is most certainly not a good time to purchase real estate? I did, and his reaction was startling.”

“Not only did my acquaintance flatly refuse to accept the very real possibility that real estate could substantially decline in the coming years, but his attitude was one of extreme anger (towards me), delusion and denial (that prices could go down). Our friendship is now strained. Do other readers have the same/similar experiences to share?”

Another said, “I have talked a few people into waiting. It took time to convince them, but eventually they got the picture. Seeing that the entire state of Florida is for sale should be a clue.”

And another, “I live in Langley BC, Canada. I try to warn people that prices cannot keep going up for ever. I know many people who are flipping, and I am trying to give them some warning of what is going to happen. One person thanked me for my advice and told me that they will sell at the end of the year.”

“I tell people that property prices have started to fall in some parts of California, and the reactions are varied. Some people acknowledge that it will happen here too, and others do not. The ones that do not, get very angry and come up with a thousand reasons why every body wants to live here, the 2010 winter olypics in Whistler will keep our house prices up, they are not making any more land, and repeat a thousand realtor cliches.”

“Recently a popular radio show announced that at the current rate of appreciation, the average house here will cost $820K by 2010, and people believe it. I’ve talked to a number of poeple that take it as a fact.”

A reader concurred. “I’ve experiened the same thing. Even when you tell people about halting markets and falling prices in the US, Vancouverites are sure that ‘it’s different here’ because ‘everyone wants to live here’ and ‘the Olympics’ (2 wks of snow sports) have made the lower mainland invulnerable to downturns experienced elsewhere.”

“I mentioned future price drops to a colleague yesterday, not thinking anything of it as she bought a decade ago…she suddenly looked worried and said that prices might drop a little, but not a lot. I realized then that she’s been using the equity ATM. It all constantly reminds me of 1981, just before the whole thing collapsed in ‘82.”

One reader warned, “I have had to refrain from talking in certain situations. One of the golf girls bought a Toll Brothers condo a year ago and is still waiting for it to be complete. She has a house in Cave Creek that she paid 190K for. She is in complete denial about the market and thought all she had to do is put a FSBO sign in the front yard and sell in a few days for 400K +.”

Another, “I shut my fool mouth. I just gave up telling people my opinions. Now I just smile, nod, and change the subject in a non-obvious way. ‘I really love the area I’m living in.’… ‘San Diego is one of the nicest areas in the US, don’t you think?’”

One relies on statistics. “When I tell people about rising inventories in bubble markets, they look at me like I have 2 heads. They think if I’ve gotten the info from the internet it can’t be trusted and is probably suspect.”

To which one replied, “You raise an excellent point, which is that for those without at least a good college course in economics or its independent study equivalent, there is no objective means to sort out conflicting viewpoints, and at that point it comes down to a matter of religious dogma. So we all may as well agree to amend the list of topics to avoid in polite company: sex, politics, religion, and the housing market.”

The Daytona Beach News Journal has this from Florida. “Skittish investors, leery of the air seeping out of the housing bubble, have left at least one area home builder awash with completed homes and no buyers in sight. Holiday Builders, the 30th largest builder in the nation, is hoping to turn the situation around by selling homes at what the company says are ‘builder’s cost’ this weekend.”

“The company is staging a special sales event in an attempt to sell about 40 new homes that had been ordered by investors. Consumers should be prepared to put down $5,000 and close on the property in 45 days. Changes in the market, including rising interest rates and an abundance of inventory, apparently caused some buyers who hoped to profit from the boom in area housing prices to walk away from the idea.”

“‘We found ourselves in a unique situation,’ Jennifer Youngblood, a spokeswoman for the builder said. ‘This is the first time that we have done something like this.’”

“‘Charles Rinek, president of the Flagler/Palm Coast Home Builders Association, said he has heard of similar situations in which buyers forfeited their deposits and walked away from contracts. ‘I don’t know how widespread it is,’ said Rinek.”

“Most investors look for a quick turnaround, he said. The general slowdown in the market in recent months is an indicator they won’t be able to proceed as planned.”

“Kevin Kronk, president of the Volusia Home Builders Association, said there are pockets of excess inventory in parts of the state, he said. But, the problem is more likely to be found in large cities such as Miami and even Orlando, especially in condo developments.”

And the Wall Street Journal has this report on Naples. “The vacation-home market certainly has changed since I dove into it not that long ago. On Aug. 30, 2004 I wound up making an offer on a second home in Naples, Fla. Buyer mania was so strong that I drove from the airport to my first walk-through inspection of the home in the furious rain and whipping winds of Hurricane Jeanne; at one point, I raced my rental car past a palm tree leaning over the road at an alarming angle and watched in my rear-view mirror as it crashed to the ground. I felt pressure to close the sale quickly.”

“But there are clear signs that the tide is turning in Naples. Inventory levels now are four times as high as they were a year ago, largely because nervous investors are trying to cash out their gains before rising mortgage interest rates topple the market. ‘Big price reduction’ ads are starting to pop up in the thick weekly real-estate sections of the Naples Daily News.”

“So, vacation-home buyers, take heed: The days when you could flip a beach house or ski place for fun and profit are probably over.”