Ready for the Next Bubble?
A bubble is forming in real estate, and when it bursts, the impact on the U.S. economy will be detrimental, significant, and widespread.
By Salim Haji
April 28, 2004
As interest rates begin to rise, concern has increased about a potential housing bubble and its effects if it were to burst. As individual investors consider the likelihood and implications of a real estate bubble, three questions have to be addressed: First, does it matter if there is a bubble and it bursts? Second, what is the likelihood that there is indeed a real estate bubble forming? And third, what can be done about it? Each of these questions is addressed in turn below.
Does it matter?
The existence of a real estate bubble matters to individual investors on two levels. First, it matters on the macro-economic level, because the bursting of a property bubble will have a broad detrimental impact on the economy and the stock market. But it also matters on a micro-economic (or household) level, as the bursting of a real estate bubble can significantly hurt the average household balance sheet.
On the macro-economic level, the data is compelling. The International Monetary Fund (IMF) published an in-depth analysis of equity market and real estate crashes in its April 2003 edition of the World Economic Outlook. In this study, it concluded: "Housing price busts were associated with output effects about twice as large as those of equity price busts. The worse case output effects exceeded those of equity price busts by a substantial margin. Moreover, the slowdown after a housing price bust lasted about twice as long." The average real decline in prices in a housing market crash (30% after four years) was found to be less than for a stock market crash (45% decrease in equity prices, on average, after two-and-a-half years), but at the end of each of those periods, GDP (or "output") had fallen 8% after a housing bubble burst compared to 4% after a stock market bubble burst.
The reasons for why the bursting of a housing bubble has such a big macro-economic impact are intuitive. First, consumers, on average, have a lot more of their wealth tied up in real estate than they do in stocks, so any change in the prices of homes has a bigger impact on consumer spending than a change in equity prices. Second, consumers are more likely to borrow to buy their homes, thus amplifying the impact of price swings on their wealth by being leveraged.
The macro-economic impact is nothing more than the aggregation of the impacts at the household level. To illustrate, let's take an example of a household that has $100,000 in net assets. Of that $100,000, one-half, or $50,000, is tied up in equity on the family's home. The home is worth, say, $250,000, and there is an outstanding mortgage of $200,000 on the home. A pretty typical situation.
Now suppose that housing prices drop by 20%, and the family is forced to relocate because the head of the household has lost her job. The price of the home has fallen by 20%, to $200,000 by the time the family sells their home. They use all the proceeds to repay their original mortgage, and their equity is completely wiped out. Their net worth has just been cut in half from $100,000 to $50,000.
Does a real estate bubble matter? You bet it does.
Is there a real estate bubble in America?
Although many people currently believe otherwise, real estate crashes do occur, albeit infrequently. The IMF study cited above looked at 14 countries between 1970 and 2002, and found 20 instances of real estate bubbles bursting (defined as a housing price contraction of 14% or more), and 25 examples of equity prices crashes (defined as a drop in equity prices of 37%).
When housing crashes do occur, they are severe. The average housing price crash in the IMF study lasted four years and had a total decrease in housing prices of 30%. In addition, the study found that real estate busts were more likely to have been preceded by a boom where home prices increased sharply for a number of years.
American house prices are up 30% since the mid-1990s, the biggest real gain over any such period in recorded history, according to the Economist magazine.
As the experience in the recent stock market bubble demonstrates, identifying bubbles is an extremely difficult task. But valuation metrics similar to the ones used in the stock market apply to the real estate market. The equivalent of the P/E ratio in the real estate market is the ratio of house prices to rents. In the U.S., according to the Economist, that ratio is now at a 20-year high and more than 15% above its average value between 1975 and 2000. Another ratio used for valuation is the ratio of house prices to average household income. According to the Economist, that ratio is also at a record high, 14% above its long-run average.
These averages mask differences by market. In some markets, like New York City, housing prices and valuation metrics indicate a much more overheated housing market than in other parts of the country. The Economist predicts that housing prices will fall in the U.S. in the next few years by 15% to 20% on average -- significantly more in certain markets, and less in others.
Like the recent stock market bubble, forecasting when the bubble will burst is near impossible. Potentially, if inflation picks up and interest rates rise, that could cause the bubble to burst. Or some unforeseen external economic shock -- a big spike in oil prices, for example -- could also occur and cause the bubble to burst. But robust, fundamental economic analysis suggests that a bubble is building in the U.S. real estate market, and like all bubbles, it will sooner or later burst.
What can be done?
Unfortunately, as the recent Motley Fool article "Who Cares about the Housing Bubble?" pointed out, there is little that individual homeowners can do to protect themselves, other than plan conservatively. Potential ways to hedge financial exposure are all problematic. One option could be to short housing stocks, such as KB Home (NYSE: KBH), D.R. Horton (NYSE: DHI), Lennar (NYSE: LEN), or Centex (NYSE: CTX). But shorting stocks is highly risky, especially in a situation such as this one where a bubble could easily persist for a long time. Theoretically, one could rent instead of buy, but for most people who already own a home that is not a very practical alternative.
A bubble is forming in real estate, and when it bursts, the impact on the U.S. economy will be detrimental, significant, and widespread.
By Salim Haji
April 28, 2004
As interest rates begin to rise, concern has increased about a potential housing bubble and its effects if it were to burst. As individual investors consider the likelihood and implications of a real estate bubble, three questions have to be addressed: First, does it matter if there is a bubble and it bursts? Second, what is the likelihood that there is indeed a real estate bubble forming? And third, what can be done about it? Each of these questions is addressed in turn below.
Does it matter?
The existence of a real estate bubble matters to individual investors on two levels. First, it matters on the macro-economic level, because the bursting of a property bubble will have a broad detrimental impact on the economy and the stock market. But it also matters on a micro-economic (or household) level, as the bursting of a real estate bubble can significantly hurt the average household balance sheet.
On the macro-economic level, the data is compelling. The International Monetary Fund (IMF) published an in-depth analysis of equity market and real estate crashes in its April 2003 edition of the World Economic Outlook. In this study, it concluded: "Housing price busts were associated with output effects about twice as large as those of equity price busts. The worse case output effects exceeded those of equity price busts by a substantial margin. Moreover, the slowdown after a housing price bust lasted about twice as long." The average real decline in prices in a housing market crash (30% after four years) was found to be less than for a stock market crash (45% decrease in equity prices, on average, after two-and-a-half years), but at the end of each of those periods, GDP (or "output") had fallen 8% after a housing bubble burst compared to 4% after a stock market bubble burst.
The reasons for why the bursting of a housing bubble has such a big macro-economic impact are intuitive. First, consumers, on average, have a lot more of their wealth tied up in real estate than they do in stocks, so any change in the prices of homes has a bigger impact on consumer spending than a change in equity prices. Second, consumers are more likely to borrow to buy their homes, thus amplifying the impact of price swings on their wealth by being leveraged.
The macro-economic impact is nothing more than the aggregation of the impacts at the household level. To illustrate, let's take an example of a household that has $100,000 in net assets. Of that $100,000, one-half, or $50,000, is tied up in equity on the family's home. The home is worth, say, $250,000, and there is an outstanding mortgage of $200,000 on the home. A pretty typical situation.
Now suppose that housing prices drop by 20%, and the family is forced to relocate because the head of the household has lost her job. The price of the home has fallen by 20%, to $200,000 by the time the family sells their home. They use all the proceeds to repay their original mortgage, and their equity is completely wiped out. Their net worth has just been cut in half from $100,000 to $50,000.
Does a real estate bubble matter? You bet it does.
Is there a real estate bubble in America?
Although many people currently believe otherwise, real estate crashes do occur, albeit infrequently. The IMF study cited above looked at 14 countries between 1970 and 2002, and found 20 instances of real estate bubbles bursting (defined as a housing price contraction of 14% or more), and 25 examples of equity prices crashes (defined as a drop in equity prices of 37%).
When housing crashes do occur, they are severe. The average housing price crash in the IMF study lasted four years and had a total decrease in housing prices of 30%. In addition, the study found that real estate busts were more likely to have been preceded by a boom where home prices increased sharply for a number of years.
American house prices are up 30% since the mid-1990s, the biggest real gain over any such period in recorded history, according to the Economist magazine.
As the experience in the recent stock market bubble demonstrates, identifying bubbles is an extremely difficult task. But valuation metrics similar to the ones used in the stock market apply to the real estate market. The equivalent of the P/E ratio in the real estate market is the ratio of house prices to rents. In the U.S., according to the Economist, that ratio is now at a 20-year high and more than 15% above its average value between 1975 and 2000. Another ratio used for valuation is the ratio of house prices to average household income. According to the Economist, that ratio is also at a record high, 14% above its long-run average.
These averages mask differences by market. In some markets, like New York City, housing prices and valuation metrics indicate a much more overheated housing market than in other parts of the country. The Economist predicts that housing prices will fall in the U.S. in the next few years by 15% to 20% on average -- significantly more in certain markets, and less in others.
Like the recent stock market bubble, forecasting when the bubble will burst is near impossible. Potentially, if inflation picks up and interest rates rise, that could cause the bubble to burst. Or some unforeseen external economic shock -- a big spike in oil prices, for example -- could also occur and cause the bubble to burst. But robust, fundamental economic analysis suggests that a bubble is building in the U.S. real estate market, and like all bubbles, it will sooner or later burst.
What can be done?
Unfortunately, as the recent Motley Fool article "Who Cares about the Housing Bubble?" pointed out, there is little that individual homeowners can do to protect themselves, other than plan conservatively. Potential ways to hedge financial exposure are all problematic. One option could be to short housing stocks, such as KB Home (NYSE: KBH), D.R. Horton (NYSE: DHI), Lennar (NYSE: LEN), or Centex (NYSE: CTX). But shorting stocks is highly risky, especially in a situation such as this one where a bubble could easily persist for a long time. Theoretically, one could rent instead of buy, but for most people who already own a home that is not a very practical alternative.
