Friday, July 30, 2004

Freddie Mac: No Housing Bubble

By Salim Haji

Motley Fool

As sales of existing homes hit an all-time high in June, concern is increasing among investors that the U.S. real estate market may be teetering on the edge of a cliff.

On the front page of last Sunday's New York Times business section was a column entitled "Housing Bust: It Won't Be Pretty," citing a Goldman Sachs (NYSE: GS) study that indicates that U.S. home prices are significantly overvalued. As I first wrote back in April, I believe the evidence is strong that a bubble is building in residential real estate, and that like all bubbles, it will eventually burst.

Not everyone agrees with this view. In a presentation at UCLA a few weeks ago and in a subsequent telephone conversation with me, Amy Crews Cutts, the deputy chief economist at Freddie Mac (NYSE: FRE), argued that there is no housing bubble in the U.S. today.

According to Cutts, the term "bubble" is a situation in which the price of an asset or an asset class is not driven by fundamentals. The Internet Bubble of the late 1990s is a classic example. The prices of stocks were driven by speculators who bought stocks based primarily on the expectation of being able to resell them at a higher price. As Fed Chairman Alan Greenspan famously said, the market was driven by "irrational exuberance."

Bubbles are based on a herd mentality -- as long as the herd believes that prices will continue to rise, bubbles survive. Bursting is difficult to predict, because identifying what makes the herd all of a sudden change its view about future prices is nearly impossible. (Greenspan was about three years early with his comments on the dot-com bubble in 1996.)

According to Freddie Mac, the housing market remains rational. While Cutts cautioned that rational markets can fall based on underlying economic conditions, they don't exhibit the boom and bust characteristics of bubbles. She offered six reasons why Freddie Mac doesn't believe that a housing bubble exists:

1. Supply of housing for sale is low. The current inventory of new and existing homes for sale is lower today than it has been in the last 20 years. For new homes, as the homebuilding industry has consolidated, such homebuilders as KB Homes (NYSE: KBH), D.R. Horton (NYSE: DHI), Lennar (NYSE: LEN), or Centex (NYSE: CTX) have increased their share of the market over small, local players. These larger, more sophisticated homebuilders use options and other tools to minimize the capital they put at risk in particular housing markets. As a result, Cutts argues, the supply side of the housing market can adjust to changes in demand much more quickly than it could in the past. If demand drops off, supply can be quickly cut back, which basic microeconomics tells us will mitigate any steep drop-off in price.

2. Housing doesn't resemble the typical bubble asset. According to Freddie Mac, the purpose of a typical bubble asset is investment, not consumption. In addition, typical bubble assets have low transaction costs and are held for short periods of time -- speculators can buy and resell the asset rapidly to make a quick profit. Housing is different. The transaction costs are high, holding time is typically quite long, and most people buy homes primarily for consumption, not investment.

3. Mortgage rates are low. Freddie Mac argues that even with the recent increase in mortgage rates, we are still very far away from the 30-year mortgage rates above 10% that existed in the early 1990s. Even if rates were to rise 100 basis points, rates would still be below the 1971-2004 average of 8.5%. With sustained lower mortgage rates, people can -- and will continue to be able to -- buy more expensive homes.

4. User costs are negative. Related to the previous point, as long as mortgages are low and home prices continue to rise, net user costs are negative. Freddie Mac argues that interest (after tax), maintenance, and taxes approximate 6.5% of the price of a house. If the home price rises at 6.5% per year, the owner gets to live in the house "for free."

5. Household incomes and house prices in balance in the long term. Freddie Mac's presentation includes data that illustrates that between 1991 and 2001 the growth in home prices and average household income has been about the same. Cutts does concede that if these data were extended to 2004, a gap would exist. (According to The Economist, the ratio of home prices to average household income is now at a record high: 14% above its long-run average.) But she argues that the ratio needs to be compared to similar points in the business cycle -- she now expects wage growth to accelerate as the economy recovers and "catch up" with home prices.

6. Rent vs. price growth is aligned. The equivalent of the P/E ratio in the real estate market is the ratio of home prices to rents. In the U.S., again 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. Freddie Mac argues that this data is misleading, because it does not take quality of housing into account. Cutts claims that quality in rental housing has not kept up with the increasing quality of homes that are owned. As a result, the widening ratio is explained not a by a bubble in home prices, but rather by a widening spread in the quality of homes for rent vs. those for sale.

My opinion
While I believe that many of the points that Freddie Mac raises do make the real estate markets less susceptible to bubbles than markets where the asset traded is more speculative (such as Internet stocks), I don't agree that one can conclude that bubbles in real estate can never happen.

Data indicates that real estate bubbles, while less frequent than in other types of markets, such as equity markets, do indeed occur: A recent study by the International Monetary Fund looked at 14 countries between 1970 and 2002 and found 20 instances of real estate bubbles bursting (as well as 25 examples of equity prices crashes).

I also don't believe that the real estate market is fundamentally rational. Changes in underlying economic conditions simply cannot explain the fact that in the last year home prices soared 18% in Los Angeles or 14% in Miami. In my opinion, like all markets where a subjective view of the future plays a key part in what people are willing to pay for the asset being traded, the residential real estate market is driven in large part by group psychology.

In my mind, Berkshire Hathaway (NYSE: BRK.A)(NYSE: BRK.B) CEO Warren Buffett's famous allegory of the manic-depressive Mr. Market (first articulated by his mentor, Benjamin Graham, and recently explained in a commentary on value investing by Zeke Ashton) also holds true for the real estate market.

Perhaps Mr. Real Estate Market is a bit more emotionally stable than his brother Mr. Equity Market, but fundamentally the family's mental health is not terribly sound.

In the same way that adherents of the efficient market theory believe that stock prices accurately reflect everything that is known about a stock and its prospects, Freddie Mac believes that current prices in the U.S. real estate market are rational and reflect underlying economic conditions. While prices may change as economic conditions change, investors should rest assured that there is no psychological bubble in the housing market that is going to burst anytime soon.

I respectfully disagree.

Fool contributor Salim Haji owns shares of Berkshire Hathaway, but no other stocks mentioned in this article. The Motley Fool is investors writing for investors.

3 Comments:

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