I haven't been writing (or thinking) much about real estate lately. This weekend I had some friends over to share my favorite past-time (watching MSU win games) and we got into a discussion about real estate and whether my wife and I will move soon.
The answer is yes: We will move but into a rental not a purchase.
I think the big gains in real estate are over. If you didn't get in already, it is too late. Buying a property now is akin to buying Microsoft stock during the dot-com boom in 2000. Instead of buying property, it makes more sense to rent and invest your housing money in the stock market. It make take 5 more years but the housing market will run out of steam and a few years after that, it will be time to buy property again.
At least that is my take on things. Buy low, sell high and all that stuff.
An article in the local paper today suggests that home prices in Seattle (although they define "Seattle" as the area from Tacoma to Everett which is huge) could increase up to 40% over the next two years. The numbers come from a PhD (wahhahaooo!) and confirm what my friends seem to think: real estate never goes down.
Are area housing prices getting ready to pop?
Feb 18, 2006
While recent real-estate buzz has centered on a slowing home-sales market — with some doomsayers even questioning whether greater Seattle's high prices are ripe for a fall — Lawrence Yun has crunched several economic numbers and come to a startlingly different conclusion:
Median home prices could shoot up 30 to 40 percent over the next two years.
I dont have a PhD, but I have been accused of having common sense so here is my argument against these rosy predictions:
$200! $400! $800?
Over the past 5 years, property values have pretty much doubled all over the West Coast. That $200,000 ranch home still looks the same but it is now worth $400,000 on the market. Given that rate of increase, will it double again? Will that same property be worth $800,000 5 years from now?
To answer this question one needs to ask why prices have doubled and whether those increases can continue? Prices are negotiated by the forces of supply and demand. In this case, the demand for housing and the supply of money to pay for it vs the supply of new homes.
On the demand side, was there a population explosion that caused demand for housing to increase prices? No, there have not been any huge migrations or influxes of people.
Was there a huge increase in salaries which would provide buyers with so much money to spend, prices would increase due to price inflation? No again, salaries have been flat for years and that does not look to change.
If the demand for housing and the income of buyers has not changed, what about the supply of housing? Has there been a sudden shortage of housing, such as a massive earthquake, that would cause people to bid for new home en masse? Actually it is quite the contrary. Because of the sudden increase in prices, developers have been throwing up luxury condos and homes as fast as they can find financing. At last count there were 12 luxury condo developments in downtown Bellevue alone, ie big supply increase not decrease.
why are prices increasing?
We just ruled out the basic fundamentals of supply and demand for housing so what has caused the prices to increase so dramatically? The answer is asset-price inflation caused by an unprecedented supply of cheap money. This money has come from two places: money that used to be or go into the stock market and money borrowed from mortgage lenders.
After the dot-com crash, millions of individual and institutional investors got spooked by the market and started to look for alternative investments. Some went into gold. Many went into real estate. From the individuals using their 401K to purchase a 2nd, 3rd and 4th rental property to the big institutions funding big condo high rise developments, money has been pouring from stocks into the "safety" of property.
To protect us all from the irrational exuberance of the dot-com bubble, Alan Greenspan robbed Peter to pay Paul by using the Federal Bank to lower interest rates and create a new world era of cheap money. If you have a pulse, you are pre-approved for a 4% ARM somewhere right at this moment...
While the amazing availability of all these loans may have helped some first time buyers, the immediate effect is that is has raised prices (asset-price inflation) on all real estate. Of course, rising prices are good for home owners because their asset is growing, but instead of paying off their mortgages people have been taking out more and more loans. People have been using this "home equity" to subside their spending habits and to purchase more real estate. And like all bubbles, as people continued to see prices rise, they continued to invest in the bubble becoming "millionaires" who dont actually own anything. (Wealth or net worth is what you own minus what you owe. If the bank owns everything, you really arent rich. In fact, you might soon be bankrupt.)
This type of rapid appreciation fueled by debt is a classic investment bubble. The problem is that the growth is not sustainable.
Before I talk about why the bubble will burst, let me go out on a limb here and say why this whole situation is so disconcerting. As the saying goes, "real estate is local" but the irrational exhuberance feeding this, the largest speculative real estate bubble in human history, is not just national, it is international. For the first time ever, we are seeing price parity in every significant city and luxury vacation spot around the globe. Real estate prices are rising to the same levels everywhere because the same investment money is now easily moving around the world, money that has been seeking a better return since the collapse of the dot-com bubble. The investors behind this money are not experienced real estate investors (ie they have never lived through a real estate collapse) and more importantly, the price increases are happening without regard to the local economies. $200+/sqft may make sense in NYC, San Francisco, or Tokyo but Michigan? Texas? Washington?
dont burst my bubble
A lot of people say, it is not a bubble because real estate prices always go up. They arent making any new land, right? A lot of people also say that you can't lose if you buy real estate. Stock is just a piece of paper but a house is "safe", they reason. People also tell me that if i dont get in now, I am only going to miss out of the big gains. Of course, I heard the same things about internet stocks in 1999.
As matter of common sense, can people continue to pay these increasing prices? Can this ride really continue?
The price of a home is fairly elastic and largely set by what the buyer can bear which means the price of a home or its "value" can vary widely. When someone goes to purchase a home, they compare their income and collateral to the selling price. If they can make the payments somehow, that sets the "value" of the property. Moreover housing norms are a local thing. In the San Francisco bay area, it was normal to pay 50% of your income for housing, whether you were rich or poor. The rule of thumb is 30% everywhere else in the nation. At least it was.
In contrast to homes, what sets the prices of rentals? Landlords and tenants both determine the value of a rental by the price of substitutes, ie supply and demand. Landlords have bills to pay so they need to rent their units. Rents will rise if they can but if there are many alternatives, empty units will cause landlords to cut prices. In other words, unlike homes, the prices of rental property has very clear checks and balances to keep them from getting out of balance. The pro's make money every month so one of the biggest checks is personal income and whether tenants have the ability to pay the rent.
So how do price increases in homes and rentals compare? Home prices have doubled in the past 5 years but have rents? Not even close.
So what do we have here? People are buying properties as an investment using low rate mortgages. The price of properties is going through the roof but the income from rents are not which means the owner will need to rent the place for less than the monthly mortgage and make up the difference themselves. This is a negative cash-flow investment, ie a bad investment.
But the price of properties has been appreciating so fast, people tell themselves they just have to hang on a while and then they can cash out. Many have done exactly that. Of course, this thinking assumes two critical things: prices will keep rising and buyers will keep buying. What happens if the prices stop increasing? What happens if owners cannot sell the properties? What happens if the mortgage rates keep increasing and the owners cannot make up the difference?
What happens if the mortgage rates keep increasing and the owners cannot make up the difference?
Remember when gasoline was $20/barrel? That was only 2-3 years ago. Now the price is staying above $60/barrel or 3x what it was when Bush took office. With Iraq, Iran, Venezuela and Nigeria regularly in the news, expect more oil supply shocks at the same time our nation has actually increased our consumption of and dependence on oil. This price increase has not really hit yet but it will and the Fed will continue to raise interest rates to reign in inflation.
Rising interest rates means rising mortgage rates. Rising rates increases the cost of borrowing which makes it harder and harder for owners to pay for these expensive properties, either as a home or investment. The problem is so widespread it will give the Fed some pause but will it be enough to stop increases?
What happens if they cannot sell the properties?
I would really like to buy a house. So would my wife. But when we compare our assets and our income to the price of that $400,000 ranch home, it is a hard sell. Even harder if it is a $500,000 home that looks like it is worth $50.
We are currently renting for $1100/mo in a neighborhood where homes range from $500,000 to $1.5M. If we were to purchase a $500,000 home, with $100,000 downpayment our monthly mortgage would be $2350/mo plus home expenses. $1100 vs $2300 is a big difference to a family on a budget.
In order to keep the virtuous housing cycle spinning, people need to keep buying houses and they need to keep buying at all levels. Starter homes, mid-level homes and luxury homes. Up until now, that has been the progression as people build up equity by paying down their mortgage and move into larger homes. Extreme price increases stop that virtuous cycle because new home buyers cannot afford to get in and the only people with money to buy a new home are the ones already with a home. But if they cannot sell, then they cannot afford to move either.
What happens if the prices stop increasing?
Mortgages going up. Rents staying flat. New buyers priced out. Current owners leveraged to the hilt. No increase in population or salaries. Call me "doom and gloom" but these are not the signs of growth, folks.
Another noteworthy trend is the savings rate. Are people living within their means, saving money every month for an uncertain future? Apparently not as the US savings rate has actually gone negative! We are addicted to borrowing and people are taking on unprecedented levels of debt at a time when the future is anything but certain.
Closing
Maybe things would all look very different with a PhD. Only time will tell. But all these signs taken together just make me very uncomfortable. Life seeks a balance and things have been out of balance for several years now.
Investment money and real estate prices move in cycles. Unfortunately those cycles are so slow, they would try a farmer's patience. Call me a pessimist but I think the current bull market is dead and just moving forward under its own momentum before its inevitable collapse. We are at the top of a huge bubble and because of its size it will take even longer to work itself out, much like it has taken Japan two decades to recover from its euphoric 80's.
If you just bought a property, good luck. Maybe we wil all laugh at my foolishnness in a few years. If you have been trying to decide whether to buy a property, remember two things: there is no shame in renting and the profit is earned in the sale. If you can get a great price and you love the place, go for it. Life is for living.
