In my September, 2002 newsletter, I suggested that the stock market bubble was transferring into real estate. Today, you can’t pick up a financial publication without seeing a reference to the real estate “bubble” both in the U.S. and abroad
What is a bubble? The term bubble is used to describe a financial market that has been blown out of proportion (inflated in value too rapidly) compared to other financial markets and economic growth in general. For a while, virtually all participants appear to make outsize returns simply by being in the right place at the right time. In the long run, capitalism and financial markets have repeatedly demonstrated that the vast majority of people do not earn outsized returns. Just as the vast majority of investors never captured the large returns from tech stocks (they rode the market up and right back down), so will it be for real estate.
What causes a bubble? Generally, bubbles are caused by an overabundance of inexpensive money and the illusion of scarcity. During the tech bubble of early 2000, inexpensive money was in the form of equity; investors were willing to pay ridiculous prices for unproven companies that had no operating history, so companies were able to finance themselves cheaply by issuing common stock (equity). In effect, investors were saying, “I’ll take a negative return (the company isn’t profitable) or extremely low return (I’ll pay 50 to 200x earnings) on my invested capital.” The tech bubble’s illusion of scarcity was created by brokerage firms. Underwriters would sell only a small amount of the outstanding company shares to the public, thus creating perceived scarcity (new issues were many times oversubscribed) and inflating share prices.
There is also a big psychological component to a bubble. It is the reason that history repeats itself. Human beings find comfort in doing what others are doing, and if what others are doing provides a rewarding short term outcome, that group mentality is strongly re-enforced. The behavior is repeated even when it stops producing positive outcomes. Las Vegas was built on this phenomenon. But the positive psychology of a bubble can change dramatically in a short period of time. Once the bubble of a particular asset class has been popped, it can be decades before those assets regain their previous highs.
Real Estate Today
Real estate prices have inflated as low interest rates and easy credit terms have provided home buyers with access to inexpensive money. This has enabled borrowers to hold down their monthly payments via interest only loans and flexible payment loans that include negative amortization. Regarding scarcity, while demographic trends can account for a portion of the demand (which is positive), there is increasing evidence of speculation.
Recently, a client in Southern California related how an acquaintance now bragged that he ‘owned’ 10 houses and that real estate brokers are encouraging pyramiding of real estate holdings (buy one, borrow out the equity to buy a second one, borrow equity on the second to buy a third, and so on). It is no different than investors buying tech stocks on margin in 2000, using their initial gains to finance additional purchases. This strategy can work – for awhile. Now it creates the illusion of scarcity, as speculators soak up part of the supply of homes.
Another contributor to the illusion of scarcity is well-meaning parents financing their children’s down payments, because they don’t want their children to be left out of owning a home. These actions are pulling future demand forward. The echo boomers are as big a cohort as baby boomers themselves. To the extent that parents are willing to continue to facilitate the purchase of real estate by their children, it certainly provides a boost to housing demand. Collectively, I see it as a mistake. Lower housing prices would be more desirable for new home purchasers, but lower housing prices conflict with the parent / home owner’s self-interest. At a time when our children’s wage or salary growth is likely to be constrained by the forces of technology and globalization, is it wise to encourage debt accumulation at a rate that’s far faster than their incomes can possibly grow?
Rationalizations like ‘they can’t make any more of it’ are also common to justify scarcity. In fact, they are making more of it by ‘going up’ (building multi-story condominiums) or reclaiming a desert by building a golf course. Building codes and land use laws can also have a significant impact on the perception of scarcity, however, what can be legislated can be changed. It’s worth noting that codified scarcity did not prevent a significant decline in Japanese real estate, which has severe land use restrictions.
Residential real estate is also a more complicated asset class because, although you must live somewhere, no one ‘needs’ multiple homes. Single family homes make poor income producing investments due to their high ‘per unit’ costs and low liquidity, and they only earn decent returns if prices continue to appreciate. The top of the market is typically seen when condos and apartment to condo conversions become popular with attendant speculation i.e. ‘investors’ are buying multiple units to flip at some later date.
Another sign of speculation is when a great deal of energy is put into getting around the rules that specify new homes are to sell only as owner-occupied.
Any real estate bust is likely to be a multi-year affair accompanied by still lower bond yields. Whether those lower yields rescue housing will depend on whether buyers believe that lower rates more than offset the risk of a continued decline in home prices. My experience is that once there is a perception that prices are headed down, lower rates will not stimulate renewed buying. This is what happened in Southern California in the early 1990’s. It also happened in Texas after the oil sector imploded in the early to mid 1980’s. In Texas, after houses declined in value, refinancing at lower rates wasn’t possible for many because their loan to value ratios no longer met the lenders’ criteria.
One of the great ironies of the recent decline in investment yields among stocks, bonds and income producing real estate, is that as prospective asset returns shrink, an investor must save more to maintain the same amount of income. For example, to produce $60,000 per year requires a 1 million dollar portfolio assuming a 6 % annual return. To produce the same income at a 4 % return requires $1,500,000 or 50% more savings, and at 3% your assets must be doubled to maintain your income! Yet, rather than save more, Americans have borrowed more.
The fact that so much debt has been accumulated in the face of falling investment returns and an aging populace will have profound negative consequences for investors, global economies and the retirement prospects of millions of Americans. A likely consequence is that complete retirement for most will simply not exist; they will continue to work (assuming their health holds up) to supplement their income.
What’s on my mind:
- If interest rates decline in anticipation of an economic slowdown, but before buyers postpone purchases in the expectation of lower housing prices, then it is possible that lower interest rates will ignited another round of refinancing and home buying, extending the economic recovery.
- If, on the other hand, the interest rates decline after it’s believed that housing prices are heading down, purchases will be postponed. The economy will slide further into recession. Short term yields will stop rising, and then fall, once it becomes apparent the economy is slowing too much. Bond yields will drop even lower than in previous cycles. I find myself agreeing with Bill Gross of PIMCO, who thinks a 3% 10 year Treasury Note will be part of the next cycle.
- Low interest rates may provide some support for stock prices of companies that have reasonable dividend yields and can maintain some earnings growth. Cyclical companies like autos and airlines will do poorly as will most tech companies.
- Most financial institutions and investor will not fare well when the housing tide recedes and we find out who’s been swimming naked. If deflation sets in, it will be terrible environment for stocks.
- The next recession will likely be severe. It will be deflationary because the foundation for the previous recovery was built on consumer debt accumulation (rather than an increase in savings) and a reliance on housing gains. Timing? – begins within the next two years.
The next 5 years may be very challenging for investors. Clients that prospered despite of the tech bubble know my investment strategy considers how to mitigate risk as well as profit from opportunities present in economic downturns. Please contact me with questions regarding your real estate investments.