The real estate bubble

Dr Hans Sennholz - Thu 02 Dec, 2004

...With all that money rushing into real estate, does it blow bubbles - as it did in the stock market, or does it reflect chronic inflation and dollar depreciation? Or does it manifest rising incomes and growing ownership aspiration?...

The real estate bubble

With US stock prices down considerably since 2001, and apparently heading lower, many Americans have joined the trend in Australia, Britain, Ireland and Spain...and taken a liking to real estate.

They have bought homes in record numbers as easy credit and low interest rates have enabled many to buy rather than rent a home. And just like stock prices during the 1990s, the value of homes keeps rising, as does the debt incurred to buy them.

According to Federal Reserve data, American homes now are worth some $13.6 trillion, which is 92% more than a decade ago, while mortgage debt more than doubled to $6 trillion. With all that money rushing into real estate, does it blow bubbles - as it did in the stock market, or does it reflect chronic inflation and dollar depreciation? Or does it manifest rising incomes and growing ownership aspiration?

The real estate bubble: The capital market

Searching for an answer to these questions, we must raise and answer yet another question that enfolds them: Is the capital market that guides and drives economic activity allowed to function freely, or is it controlled and manipulated by government regulators?

The answer is obvious: Capital lending rates are set by the governors of the Federal Reserve System in the US - just as by the Bank of England in Britain - who thereby modify all interest rates and manipulate the capital markets. In recent years, they chose to keep interest rates far below market rates, and thus guide economic activity along lines that differed greatly from those an unhampered market would have directed. They caused massive increases in money and credit and brought about what economists call “maladjustments” which are the very mainspring of economic recessions and depressions.

The real estate bubble: Maladjustments in real estate

Maladjustments in real estate differ visibly from the afflictions of stock and bond markets, which are national or even international in range and scope. Landed property is an inherently local asset that is affected by a great number of local demand and supply factors. The housing market in San Jose, California, has little resemblance to that in Grove City, Pennsylvania, although both are affected by the same Federal Reserve monetary policy. Some places may suffer stagnation or price declines while others experience feverish booms. There may be bubbles in some parts of a country while stagnation and recession hold others in their grip. Yet all prices undoubtedly are much higher than they would be in absence of chronic inflation.

The Office of Federal Housing Enterprise Oversight informs us that average US housing prices rose 38.3 percent from 1997 to 2002. The Office of the Deputy Prime Minister in Britain says UK prices more than doubled over the same period. This knowledge may be of interest to economic historians, but of little use to real estate investors. They are intrigued and lured by local conditions and the possibility of earning high returns through debt financing when prices soar. A home buyer may put down ten percent of the purchase price and borrow the rest; a price rise of ten percent would double his investment. An annual price increase of just five percent would yield a return of 50 percent on his investment, year after year. While the mortgage loan continually depreciates in purchasing power, the owner’s equity rises in step with the rising price of his house. In fact, in less than ten years, a ten percent annual bubble rate will shift one-half of the value of his house to him, without having made a single loan payment. Surely, he will have to maintain the property and pay an interest on the mortgage loan, which may be less than the rent he would have to pay if he were to rent the house.

The real estate bubble: When the bubble bursts...

This leverage of debt financing also works in reverse. When the bubble bursts and housing prices readjust, many new owners would soon lose their entire investment. A ten percent fall in prices wipes out a ten percent owner equity; a thirty or forty percent decline, which is rather common in a bubble crash, not only stamps out his investment, but also may inflict additional losses - unless he walks away from his house, and thereby shifts the losses to the financial institution that granted the loan. When the decline is severe and many owners choose to unload their losses on creditors, the crash may jeopardise the solvency of financial institutions that financed the bubble.

Despite such occasional reversals, our age of inflation has made ownership of a home the most effective way to increase personal wealth. While inflation tends to raise interest rates by adding the anticipated depreciation rate to the basic time-preference rate, it also lowers the debtor’s risk premium, which may offset the higher depreciation rate.

The real estate bubble: The owner's equity

The owner’s equity increases in step with the rising price of the house, which simultaneously reduces the risk to the lender. Before the age of inflation, a homebuyer needed a down payment of 30 to 50 percent of the purchase price; the age of inflation gradually reduced this rate to 20 or 10 percent, but sometimes 3 percent or less. The lender’s price risk is minimal; the buyer may just sit back and let the bubble increase his equity.

Politicians and government officials look with favour on home ownership, as they themselves do benefit from such favours. In the US, homebuyers enjoy big tax breaks. They can deduct property taxes and the interest on their mortgages from their taxable income. And when they sell their homes they may exclude up to $250,000 in capital gains from taxable income; married couples may deduct $500,000. And they can do this again and again, as long as they live in the home for two of five years before selling.

The real estate bubble: Manors and mansions

The prices of manors and mansions in America - as in Britain - have soared above all other housing prices. When the stock market began to retreat and disappoint in 2001, many underperforming funds sought refuge in real estate, and thus caused housing prices to take off. The nouveaux riches of the stock market now sought safe harbours in real estate, and those speculators who could not afford such luxury could at least borrow against the equity in their houses and raise their standards of consumption to manor levels.

A “refinancing” mania gripped the real estate market and lifted the level of mortgage debt. To take advantage of the current low rates, many debtors chose “variable-rate” mortgages that are readjusted frequently. If interest rates should ever return to market levels and cause real estate prices to decline, many such refinanced houses would not be worth the debt standing against them. In the meantime, most homeowners rejoice about their rising equity, which they calculate in nominal prices. If they would compute prices in inflation-adjusted dollars, their profits would be much lower or even turn to losses. In some parts of the country, nominal prices continue to rise moderately, while inflation-adjusted prices actually stagnate or even decline

The real estate bubble: National statistics

National statistics tend to understate the risk of loss for many homeowners. They obscure the extreme price swings in individual towns and cities, and blur the particular forces that may reduce or compound the maladjustment. During the 1980s, for example, several West Coast cities in the US enjoyed feverish high-tech and defence-spending booms. Real estate prices soared.

A few years later, when high-tech production spread to China, India, and many other places, stagnation settled over many places and prices fell noticeably.


Regards,

Hans Sennholz
for The Daily Reckoning

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