First, four things have to be available for a housing bubble: tight supply, demand, regulation, and easy financial terms. Statewide, only tight supply and demand are present; only in Austin does regulation come into play. Financing is still a challenge in today’s environment.
What is a bubble? Bubbles have characterized recent economic history, as institutional and other major investors have sought high-return, low-risk investments. These investments have turned into speculative manias that eventually come crashing down. The last decade alone has seen the telecom bubble, the nearly simultaneous dot-com bubble, the housing bubble, and most recently, the oil bubble. Of all of them, the housing bubble seems to be the most significant and far reaching.
On one hand, consumer spending (remember 70%+ of our annual GDP is consumer spending driven) fed by people borrowing against the temporarily increased equity in their homes kept the world economy going after the high-tech and telecom bubbles burst in 2001 through 2006. On the other hand, the eventual deflation of the housing bubble caused far more severe economic problems than the deflation of the telecom and high-tech bubbles would have caused if the housing and financial bubble had not disguised them. A bubble has been defined as ‘trade in high volumes at prices that are considerably at variance with intrinsic values.’ Bubbles are essentially irrational, so they are difficult to describe with a rational economic model. However, the housing bubble can be explained using simple supply-and-demand curves.
Charles Kindleberger’s wrote a classic book called Manias, Panics, and Crashes which describes six stages of a typical bubble. First, a displacement or outside shock to the economy leads to a change in the value of some good. Second, new credit instruments (zero down or non-qualifying loans come to mind) are developed to allow investors to take advantage of that change. This leads to the third stage, a period of euphoria, in which investors come to believe that prices will never fall. This often results in a period of fraud, the fourth stage, in which increasing numbers of people try to take advantage of apparently ever-rising prices. Soon, however, prices do fall, and, in the fifth stage, the market crashes. In the sixth and final stage, government officials try to impose new regulation to prevent such bubbles from taking place in the future.
All of these stages were apparent in the recent housing bubble and ensuing global recession. The key point is that because of easy credit and high speculative demand, consumers were able to speculate with not only their own homes but were driven to speculate on other local real estate, because annual returns were so high (during the boom years, annual state wide appreciation was 40+% or better in the sand states of California, Arizona, Nevada, Florida plus Georgia). The result was an immense price bubble in those states, home to over a quarter of the nations population.
New housing allows accommodation of population growth and replaces both worn out older housing and housing in areas that are being converted to other uses. The price of used housing is set by the cost of new housing. If the price of new housing rises, sellers of existing homes will respond by adjusting their asking prices. Thus, to understand the price of housing, we must focus on the supply and demand curves for new housing. The steepness of those curves—which economists call elasticity—describes the sensitivity of prices to changes in demand or supply. A flat or elastic supply curve, for example means that large changes in demand will lead to only small changes in price. But a steep or inelastic curve means small changes in demand can lead to large changes in price, as we saw in those states that had high real estate speculation.
The demand for housing is inelastic; few Americans are willing to live without a home. The vast majority of Americans, moreover, prefer a single-family home with a yard. The same is true for Californians, Texans, New Yorkers, Canadians, etc. and, likely, the people of most other nations. While people are willing to live in multifamily housing, most Americans see such housing as only temporary until they can afford a single-family home. This suggests that the demand for single-family housing may be even more inelastic than for housing in general. Inelastic demand curves mean that a small change in the supply of new homes can lead to large changes in price. While demand for housing is inelastic, supply can be either elastic or inelastic. The main determinants of the cost of new housing are land, materials, labor, and the time required to construct a house. Although many love to remind people that the supply of land is fixed, it is actually fixed at a high portion of the total equity level.
Supply and demand charts only go so far in explaining bubbles. The housing bubble was exacerbated by money fleeing the post–dotcom bubble stock market and by loose credit. Investors looking for safe places to put their money quickly noted that housing prices were increasing at double- digit rates in California, Florida, Nevada, Arizona and Georgia. At this point, most home sales were driven by speculation rather than the primary need of shelter.
For example, because of the dot-com crash, San Jose lost 17 percent of its jobs between 2001 and 2004. In the same period, office vacancy rates increased from 3 to 30 percent. Yet, between the beginning of 2001 and the end of 2004, home prices increased by more than 20 percent. The rise in prices in the face of declining demand can be attributed to speculation— that is, people buying homes as sources of income rather than for shelter. Exacerbating this was the ease of credit. Not only did this allow many to borrow against the quick appreciation of their homes (sometimes refinancing twice in a year to pull equity out), but even those who were buying for shelter paid more for a house than its fundamental value (as measured by rents). So the sharp rises in price caused people to see housing as a speculative investment and they had the ability to fund that investment easily.
As we discuss speculation, I am reminded of the Warren Buffet quote, “I define a speculator as someone that seeks to buy and sell in order to take advantage of market price fluctuations and doesn’t really understand them. An investor is someone who holds on to securities that provide a good income or capital gain by virtue of them being based on something of real and increasing value. Risk (speculation) comes from not knowing what you’re doing. Consumers did not really understand the dynamics of housing supply and demand. Housing supply should be driven by job growth, not speculation and the ability to see double digit returns.”
Remember this from economics 101, even with a good handle on supply and demand it is hard to predict hard asset price trajectory (more students would go into economics if there was a true science of predicting returns on assets). Moreover, the last seven years should make everyone wary about predicting gold, silver or housing price changes. The housing price volatility of the last six years has been so extreme that it confounds conventional economic explanations. Certainly, those price increases cannot be explained by increases in average income. Income growth was quite modest from 2002 to 2006. Nor can the boom be explained by a dearth of new housing supply. Construction rose dramatically during the boom.
While low interest rates, on their own, cannot influence the real estate bubble, perhaps the increased availability of credit to subprime borrowers has more explanatory power. The correlation between housing price growth and subprime lending across markets is likely to indicate that lenders took more risks in booming markets as that those risks caused markets to boom. The most plausible explanations of the housing bubble require levels of irrationality that are difficult for economists and analysts either to accept or explain.
I don’t think people actually believed that housing prices would never, ever go down before the housing bust. What they thought is that housing prices would go up in real terms, on average, over time – that housing was/is a good long-run investment. They knew there would be variation around that trend, but they expected the variation to be relatively mild, they didn’t expect the severe variation in prices and associated problems that actually occurred. Even those who had been through late 80’s housing bust in Texas and California didn’t expect values to decrease much.
But this still leaves the original question unanswered. Is there any reason to worry about a local or regional ‘housing bubble’?
First, the true need for shelter in all four metros is there. All Texas metros like the rest of the country cut back dramatically on producing housing and any type of real estate investment. Secondly, in the last five years if any of us would have approached lenders or equity about housing, office, or most real estate development they would have kicked us out of their office based on how volatile the market has been. However, the continuing job creation in Texas will fuel demand and continue to put pressure on supply. The challenges of the financial markets (mortgages, banking, Dodd Franks legislation, Enforcement of Basel 3, etc.) will slow the ability to speculate on real estate that we saw in the last few bubbles.
Most Texas metros have seen a healthy appreciation of rents over the last couple of years. This has put more pressure on the consumer feeling the need to buy. The relationship between rent and housing prices depends heavily on borrowing / interest rates – both the real portion and expected inflation. A house is like a utility company. Instead of providing power services, it provides shelter services and keeps you from having to pay rent.
Most financial folk are familiar with the rule-of-thumb that utilities tend to trade like bonds. Higher interest rates lead to lower bond and utility stock prices. Lower interest rates lead to higher bond and utility stock prices. This is because – like a house – you are receiving a fixed stream of services over a long period of time. When the market is balanced the monthly mortgage payment should be slightly higher than the rental payment because 1) Mortgages get a tax break and 2) Traditional rate mortgages offer you the stability of a fixed payment. So most consumers moving to Texas have displayed a great need to buy rather than rent if able. This has caused increased demand regionally.
Job growth has been one of the primary factors for real estate values improving regionally, much more so than in the rest of the country.
If housing price growth merely stabilized into a sustainable equilibrium with rents then the future probably wouldn’t be too dramatic. We would see a shoot-up in home prices, followed by a long period of little to no price growth as the Fed raised interest rates. Rents would still be going up and monthly mortgage payments would rise with them to maintain equilibrium. However, mortgages payments would be rising because interest rates were rising, not because home prices were rising.
Eventually, the Fed will stop raising rates and home prices would start to drift higher and eventually home price growth would converge to rent growth. However, the Fed is holding rates steady. Should that cause concern about a ‘bubble’? In the near future – the next three to five years – no. Lending is not getting looser. The potential for a local housing bubble will be greater if that happens.
Sometime in the future it is very likely that credit standards for homebuyers will fall. This will allow homebuyers to make larger offers and it will allow young people to buy a home even when they lack a down payment. This rapid increase in the number of buyers and their purchasing power will likely drive home prices into a bubble – likely not as large as in 2005, but it’s not out of the question that the potential for a bubble is there eventually.
We might think – “Didn’t lenders learn their lesson?” Or perhaps, “See, this is what happens when we create a moral hazard.” Neither of these are really correct. A perfectly competitive market in lending could not help but go into a bubble. To the extent our lenders avoid it, it is because regulations and/or tacit collusion among major players prevents the competitive equilibrium from being reached. As standards go down, buyers rush in with more buying power and we enter a new bubble phase. To my knowledge of history neither the government, the lending industry, nor we as a society have done anything that promises to prevent this.
But back to the question, are we in a housing bubble in our region? With current demand, job growth, and more demanding lending standards the potential is there, but not near as much as the run up in 2004 through 2006. Supply and demand will continue to be your governing factors and presently they seem to show favorable strength of the Texas regional market for a while – not parameters for a bubble currently.
This has been the fourth major recession I’ve experienced, and the harshest. I am not one known for optimism. With that in mind, believe me when I say our metro markets look good for a while. Whether you decide to participate or not is you and your financial advisor’s decision. If not now, when?