Real housing demand or speculation?

Home prices have increased more than 10% year over year nationwide. In many markets, including ours, buyers are engaging in bidding wars and submitting offers greater than list value.

Headlines and talking heads are beginning to describe this positive development as a housing bubble. Just mentioning the words “housing bubble” in a headline generates buzz and viewers. In reality, this is no bubble, but rather genuine demand for shelter paired with a low inventory of desirable homes.

Many may not understand the difference. All this buzz begs the question of what is the difference between housing demand and speculation? Let’s review some basic parameters for projecting housing growth. For starters, job growth is paramount. For every two jobs, you can count on needing one additional housing start. Apartment developers like to say for every 2.5 to 3 jobs, one new apartment. If you don’t have job growth, there is no need for additional housing.

Let’s look at the four basic laws of supply and demand: demand and the price of a commodity (real estate) have an inverse relationship.

1. If demand increases and supply remains unchanged, a shortage occurs, leading to a higher equilibrium price.
2. If demand decreases and supply remains unchanged, a surplus occurs, leading to a lower equilibrium price.
3. If demand remains unchanged and supply increases, a surplus occurs, leading to a lower equilibrium price.
4. If demand remains unchanged and supply decreases, a shortage occurs, leading to a higher equilibrium price

Speculation is known as the practice of engaging in risky financial transactions in an attempt to profit from short or medium term fluctuations in the market value of a tradable good such as real estate. In real estate the common term is ‘flipping’. I liken speculation to gambling, both are risky and usually involve participants that don’t fully understand the business and the risks.

A good example of a speculative market was Las Vegas in the boom years. In 2005, Vegas had 58,000 jobs created and 39,000 home starts, a ratio of 1.5 homes to 1 job. Now that extra 10,000 starts might not seem much, but when you compare it against actual demand the market gets out of whack quickly. Most of the homes starts were speculative, with little thought of who or when somebody was going to move in. Builders were building just to sell as quickly as possible.

Once you start building for a speculative market, it is hard to stop quickly. It takes a while to understand where the demand is. In the aforementioned example they were building speculatively for a speculative demand. As non-construction employment did not keep up with supply, the market was soon overbuilt, which in turn caused values to decrease.

It is also important to know the lag times in completing new product. In Austin it is 2.5 to 3 years from inception to actual completion of development and housing.

Using Austin as an example, we have 60,000+ people immigrating to Austin on an annual basis.

Not all units available are desirable (cost vs. value, geography, schools, etc). Because of this, and because there has been a limited number of units delivered to the ‘home’ market, the market is playing catch up from the last five years. Presently that places demand stronger than supply, creating a seller’s market.

• 142,669 total rental units Austin SMSA
• 95% occupancy = 7,133 units available

• 10,260 units under construction to be completed 2013

Total of 17,393 rental units available in the next 12 months

• 7,800 to 9,000 home starts this year
• 5,200 listings presently
Total shelter 31,593 units available

When you have demand that is greater than supply it forces prices to price. In Silicon Valley, demand is being driven by a flood of new (Facebook, Google) tech money. This has resulted in employees that have a tremendous amount of new money, but all are chasing after a shrinking supply of homes. Transactions are still below boom levels over the last 25 years and half the level seen at the peak in the mid-2000s. Prices would have to skyrocket, as we’ll see below, to get back to peak levels, so presently although some areas are experiencing record values from the depressed values of the last five years they do have a way to go.’

During the housing bust, the anchor slowing the economy was lack of construction, which in turn was a drag on the economy due to large mortgages and lower home values. Where are values now?

First, prices as measured by Case-Shiller, are still down 27 percent from their peak seven years ago. Case-Shiller calculates nominal prices, not real values. And the (inflation) is up 15 percent since 2006. So real house prices are about 37 percent below 2006 levels and are just now returning to where they were 13 years ago. Bill McBride of Calculated Risk has a great chart showing real house prices going back a few decades:

first chart

And here’s a tip for the math-challenged out there: It takes a larger percentage increase to offset a percentage decline. Take a $100,000 house at the peak. If it fell the real national average 42% percent in the bust, it would have been worth $58,000 at the bottom early last year. But to get back to $100,000, it would take a 72.4% percent increase from the trough. Even now, after the sharp bump off the bottom, prices would have to jump 60 percent to get back to their bubble-era peak.

It’s not just the national market, either. The bubble stories have focused on markets like Los Angeles, San Francisco, and even Austin. But these markets, for instance, are just now getting back to early 2000 to 2003 prices and have a ways to get to boom pricing in 2005. To get back to 2005/06 levels, San Francisco’s home prices would have to jump 60+%, by my calculations (using Case-Shiller data). LA would have to jump 65+%, Phoenix 100%, and Miami 105%. Las Vegas home prices would have to skyrocket 149% to reach ‘boom/bubble’ levels.

second chart

Here in the Texas region, even with our limited exposure to ‘bubble pricing’, Texas values still have not caught up to the long-term appreciation experienced by California and Arizona. People and realtors have a hard time understanding that. Remember, these markets experienced 45+% annual appreciation for a number of years. So even with a 60% drop in value since the peak, they are worth more than when they started. In that same time period Texas and the surrounding region did not experience the highs or lows of the housing bubble.

The continued diversity in price performance at the local level will be a function of job creation. Demand will follow jobs, which in turn will increase values. That is the main reason for the strength of the market in Austin, Houston and San Antonio over the D/FW area presently. The same can be said for the San José and San Francisco areas. There simply is not enough housing.

So again, what is the difference between speculation and true demand? Presently the multiple offers are caused by true demand in Austin, Houston, San Francisco, etc. There is not enough housing with respect to the jobs being created. This does present a small opportunity for house “flippers”, however present financing conditions demand larger down payments, slowing the speculative demand the nation experienced during the boom. Here in Texas, ‘flipping’ was tempered by the lack of tremendous appreciation (40+% annual in California and other ‘boom states). Texas and local homeowners experienced less than 3% annual appreciation at the height of the housing boom. They may be seeing a bit better presently. But you have to look at the whole metro market. There are still challenged submarkets. So just because Tarrytown is experiencing 15+% annual appreciation, does not mean you can expect similar appreciation in Round Rock, Georgetown, or Lago Vista. Real estate is local, and your appreciation is going to be somewhere below or above that. An experienced real estate professional will be able to help you find the ‘true value’ of your neighborhood and home.

Should you decide that you want to get into real estate speculation, just because you did well on your last home investment, does not equate to doing well with real estate speculation. Get with a professional, not only in the real estate channel you want to participate in, but in the submarkets you decide on. All real estate is local, as are real estate experts. I would suggest getting opinions from two or three of the local experts before making a decision.

Is now the time? That is a personal decision you need to make with your family and financial planners. But from this analysts view point, two years ago would have been the best time, now is a good time and the next three to five years should remain strong for real estate investment in our region. Remember I am not a broker, financial planner, or lawyer. I’m just an analyst with over 35+ years in this market, and right now I’m seeing one of the better markets of my career.

Now really is the time to buy!

Recovery or another real estate bubble?

There is a broad consensus that the housing market nationally, regionally and locally has bottomed, and is on its way to recovery. The hanging question is if this housing recovery is real, temporary, or if it could grow into a bubble.

Home ownership is down nationally

In April of this year, the US homeownership rate hit an 18-year low, signaling a shift away from homeownership towards rental housing. The homeownership rate in the United States fell during the first quarter 2013 to 65 percent, plunging to the lowest level since 1995, according to the US Census Bureau. The homeownership rate is now far below the 2005 boom peak of 69%. Homeownership was lowest in the West at 59 percent and highest in the Midwest at 70+ percent. Although Americans are still buying homes, tighter credit conditions and limited inventory are still holding back many homebuyers who are opting to rent. The Great Recession slowed down household formation, but it did not stop it. Remember, people are still graduating from college, getting married, having families, etc., so there still is a need for shelter. Here in Texas, the need for housing is great.

Many investors are seeing this as an opportunity. The consumers’ inability to buy for whatever reason has allowed cash investors to provide shelter. Over the past few years equity REITS such as Blackstone Equity and Colony Capital have invested an estimated $6.5+ billion (just these two groups), scooping up thousands of foreclosed and REO single family homes. The single family rental market was a large portion of the market, even before the housing crash, with 16+ million homes designated as rentals nationally in 2010, according to the US Census. Add on top of that at least five million plus foreclosures, many of which could become investor-owned rentals, and the potential scale is apparent.

These properties are traditionally in distressed markets where the ability to purchase at a significant discount is still available (often a 40+% discount to current construction costs). The opportunity provides a long-term income stream as well as the opportunity for appreciation — which may come slowly at first but will improve along with the greater housing market. Historically, buying in downturns has produced a strong return, from 10+% annually to much higher.

The key to their success will be effectively managing these properties, which are spread out over geographic areas rather than concentrated as they would be in an multifamily or commercial opportunity. These REIT’s are trying to get as close to the multi-family apartment model as possible. While there cannot be one landlord in one location, REIT employees are armed with tablets and laptops, helping communicate current information from the field. From the inspection and construction teams inspecting potential homes for purchase, to the project managers checking in on homes they are rehabilitating, to the agents showing homes to potential renters, to the handy-men answering renter complaints, all the information is transmitted back to the main office from wherever they are.

Other than DFW, the large REIT’s have not been as active in single family in Texas. The inability to buy large numbers of discounted properties due to the limited supply of homes has prevented the large equity groups from making significant plays in Texas. It doesn’t mean it couldn’t happen, this analyst just believes that that opportunity passed a couple of years ago in this state.

Low Inventory

Meanwhile, here in Texas, there is a shortage of existing homes and new homes for sale. Nationally, there were only 1.68 million previously owned properties on the market in March 2013, down from 1.93 million the prior year, according to the National Association of Realtors. That’s the fewest since March 2000. Here in Austin there is only a 2.7 month supply of resales available, 25 percent fewer than April 2012. In San Antonio housing inventory has held steady at 5.2 months since February. Houston is at a 3.4 month supply, a thirteen year low. And in DFW there is currently a 3.3 month supply of homes— the lowest inventory in almost 20 years. In a healthy balanced market, there’s roughly a six month supply. This March, nationally the number had fallen to a 4.7 month supply — a market favorable to sellers. Limited inventory pushes prices up. The median value of an existing home rose 11.8 per cent, the most since November 2005, to $184,300 last month from $164,800 in March 2012. Many listings are seeing multiple offers. Does this indicate a coming real estate bubble? Not quite.

The same, but different

One of the reasons we are hearing murmurs of a bubble are the stories of frenzy – homes in Austin are selling as fast as they are being listed, and those in desirable areas are receiving multiple offers, sometimes above list price. However, this isn’t a speculative bubble. It’s driven by the lowest inventory levels we’ve seen in years. As stated above, nationally, regionally and locally the inventories are low; home inventories are at 1.9+ million units, which is equivalent to about 4.7 months of supply, based on the current sales rates. And inventories keep dwindling on a year-over-year basis with little to limited replacement. Nationally inventories continue to decline, with 135 out of 146 markets tracked by NAR experiencing year-over-year inventory declines, with about 25% of the markets seeing declines of 20% or more. New home construction has been held on a tight leash, with limited speculative construction due to previous lower demand. Considering that, there’s no way we’re getting to six months worth of supply any time soon locally or nationally – not unless home construction activity picks up in a major way. New home construction remains over 65% below the peak, which also flies in the face of any bubble talk.

What about foreclosures?

Yes, they continue to happen, but they have slowed down dramatically from the top of the bust. Foreclosures fell 27% from where they were a year ago, to the lowest level since 2006. Yes, they continue to happen in Texas, but because of demand remain less than 1.5% of all sales. They are basically a non-factor in this region and they have slowed down dramatically nationally.

Values improving

As more buyers bid on fewer properties, prices are being forced up. Home prices are rising even as homeownership drops. Prices in the top twenty cities have risen 9.3 percent in the past year, according to the Case-Shiller Home Price Indices that track home prices in twenty major metropolitan markets.

Inventory will continue to be challenged as long as interest rates remain low. The tight supply isn’t the only factor slowing the housing market. Homebuyers are facing fierce competition because of record low rates. It is hard to argue with purchasing when rates are so low. Who could refuse the Federal Reserve’s cheap credit? So yes, the claim that the housing rebound is closely tied to the Fed’s campaign to lower interest rates is true. The Fed Rate which has pushed down mortgage interest rates to historic lows has made housing an attractive (and affordable) investment. The low interest rates have lured investors of all stripes to buy homes, a large factor in the diminished inventory we discussed.

So, when you couple this scarcity of listings – particularly high-quality ones – with historically low interest rates, what do you get? Competition for properties, of course. It’s the basic economic principles of supply and demand at work. But as we have stated before, we don’t have to fret about this situation leading to another bubble.

First, increasing record low mortgage rates will slowly erode record affordability. Borrowing costs for a 30-year fixed mortgage just hit 3.51%, the highest level in six weeks, yet are still tremendously affordable compared to the boom. As rates creep higher, it should help contain demand and slow purchases. Second, most mortgage applicants now boast FICO scores above 740, over a 100 points higher than during the boom. Yes, the industry wants to improve and increase lending. There is more capital available than ever before at the banks and equity groups, but they are still concerned about down payments and lending standards. Lending standards remain tight. Insisting on higher credit scores ensures that the real estate market doesn’t get (way) ahead of itself again.

To have a bubble of any type, you need speculation and financing. There may be some speculation happening locally, but it isn’t the short term house-flipping type speculation seen in the boom years in CA, FL, etc. Lenders and appraisals continue to be cautious, taking a lot of the wind out of potential bubble concerns. What we are seeing locally is genuine demand, driven by job creation and inmigration, and low supply due to the slowdown in home construction in the last five years. Increasing values are because of need, and not the speculation we saw in the boom. Any speculation is tempered by the large capital needed to be an investor, typically at least 25% down.

High Demand

Whether it is local, regional or national, we have had a record low number of home sales the last five years. Household buying slowed, while household formation did not. With little to no inventory being produced the last five years that demand is finally catching up to us. Austin needs 23,000 to 25,000 to meet demand, San Antonio 18,000 to 22,000. Another way to look at it, is for every two jobs, you historically have one housing start. That hasn’t happened in any of the Texas metros over the last five years. So, we are playing catch up as well as facing future demand, leading to a healthy local and regional markets for a while.

The continued strength of national, regional and local employment will continue to push the demand for housing, whether rental or purchase. There is always a need for ‘shelter’, both new and used.

The bottom line is that we don’t appear to be in another real estate bubble. Not yet, at least. Is the potential there? Always. But again there is a difference between demand and speculation, and what the Texas metros are experiencing is a strong demand, not speculation. So, forget talks of a bubble and continue to look for ways to profit from the current recovery.

Is there a danger of a housing bubble in Texas?

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?