The Perfect Storm; Bubble Trubble

This is a reprint from a 2005 Article I wrote regarding the Real Estate Bubble (Before it burst). An interesting re-read for me, after watching the market for the past few years.


The Perfect Storm; Bubble Trouble
By Michael J. Rebibo, CFP®
April 2005

A friend of mine recently asked me if I were interested in going “in with him and some of his neighbors” to buy some townhouses to “flip for a profit”. They were forming a partnership in order “to get in on some of the hot real estate deals” that are now available. These were not traditional real estate investors but successful businessmen in the cable industry. Another friend said she doubled her investment on a second home she purchased at the beach less than a year ago. A few others have purchased speculative condos and are “hoping to make a killing”.

It all reminds me of 1989, the year I purchased my first home. The market was red hot and interest rates were on the rise. I couldn’t wait to get into the real estate market so I could enjoy some of the appreciation everyone else was realizing. I purchased the home for $289,000. Less than three years later, I listed it for $262,000, a drop of nearly 10%. After fix up and closing costs, I had to write a check for $14,000. Most of you will remember this time when rates were increasing, housing prices were falling, and the stock market was stagnant. Is this what the next 3 years have in store for us? As financial planners, it is our job to see through the noise and lead our clients down the safer path.

Real Estate Reaches Record Appreciation Levels
Recently, the Office of Federal Housing Enterprise Oversight, the government entity charged with ensuring the capital adequacy and financial safety and soundness of FNMA and FHLMC, published its House Price Index for 2004. For the 5th consecutive year, housing prices have increased by more than 7.5% nationwide. National housing prices increased by 10.24% in the 2004.

Conundrum
The Federal Reserve has increased short-term rates at a “measured pace” 8 times since June of 2004. Yet long-term rates such as mortgages remain below their levels of 1 year ago. Fed Guru Greenspan recently referred to the current low long term interest rates as a “conundrum” (which by the way is also a great white wine made by Caymus Vineyards)! Fed tightening, higher core inflation, near record oil prices, lower dollar, record federal budget deficit, and above trend economic growth create the perfect storm for higher long term rates and an immediate halt to appreciating property values.

Testifying before the House Financial Services Committee last month, Greenspan stopped short of calling home buyers “irrationally exuberant”, but stated "I think we're running into certain problems in certain localized areas. We do have characteristics of bubbles (in those markets) but not, as best I can judge, nationwide." Publicly traded homebuilders stocks fell 10% on the comment.

Home Sales Slowing
According to Merrill Lynch economist David Rosenberg, “the backlog of unsold homes has risen steadily, and in January approached a five-year high of 4.7 months supply. However, raw data, excluding seasonal adjustments indicate that the backlog has reached six months, which would mark an eight-year high.” While our local markets remain strong, this may be the last rush to purchase property before rates increase by too much.

Home Appreciation Outstrips Personal Income
“Median house prices have risen about 30% since March 2001, well ahead of an 11% gain in personal income”, says Michael Youngblood, head of asset-backed research at Friedman Billings & Ramsey.

Speculation on the Increase
Meanwhile, “unfettered access to easy money has inflated home prices nationwide, particularly on the coasts, and lately has let to an upsurge in speculative buying.” says Kopin Tan of Barron’s. Just as with the stock bubble in 2000, recent increases in speculative buyers and property flippers have driven up values in many urban areas like Washington DC.

“Household real-estate assets now equal nearly 14% of Gross Domestic Product, the highest proportion in two decades and eerily close to the ratio of household mutual fund and equity holdings relative to GDP at the stock market’s peak in 2000.” says Kopin Tan of Barron’s.

David Berson, the chief economist for Fannie Mae, observed in his weekly commentary that investor ownership of housing hasn't been this high since the late 1980s, which led to a crash in housing prices. "Many analysts think that a high investor share in the Northeast and California helped exacerbate the housing downturn that happened during the 1990-1991 recession”.

Bubble
Yale University economist Robert Shiller, author of "Irrational Exuberance," the 2000 best-selling book about the '90s stock-market bubble, said the only similar housing boom in U.S. history was when GIs returned home from World War II, lifting a depressed market. The latest addition of “Irrational Exuberance includes a chapter on the current real-estate trend.He thinks the current boom is a "classic bubble" because people keep buying houses they know are too expensive because they expect prices to rise even higher.

Conclusions
Ultimately it will be the level of long term interest rates that will create a local or national housing bubble. If rates exceed 6%, expect a 10% correction across the board. Larger homes will most likely be hit harder. If rates stay below this threshold, we may still see some localized drop in values in the higher end prices of homes in localized areas. The question is when?

As financial planners, it is our job to help our clients steer clear of disaster. Most real estate acquisitions are highly leveraged. This leverage works against you in a falling market. If your clients have an over allocation of real estate, it may be time to rebalance.