Thursday, December 09, 2004

Get Real About Real Estate

By Lisa Scherzer, Smart Money

THE HOUSING MARKET HAS shown Herculean strength in the past few years. New home sales increased 0.2% in October, to the third-highest level ever, according to a recent Commerce Department report. That same month saw new home construction rise 6.4%, to the highest level of the year. But the furious rise in property prices during the past few years leaves some experts scratching their heads in befuddlement and others dropping the "b" word.

In his new book, "Bubbles and How to Survive Them," John Calverley analyzes some of the major market bubbles of the 20th century, and says that the U.S. is now in the early to middle stages of a housing bubble. Calverley, chief economist and strategist at American Express Bank, writes that there are clear signs of an already inflated housing bubble in the U.K., Australia and Spain. Modern economies, he argues, are increasingly dominated by bubbles in asset prices, be they tech shares circa 1999 or single-family homes today.

So what's driving home prices ever higher? On the demand side, it's low interest rates, relatively low unemployment, rising incomes and increased migration; on the supply side, new building is constrained by planning and zoning restrictions. Calverley also cites a crucial factor that plays into all bubbles — an expectation of future price increases. "In any asset market, whenever price appreciation becomes the main reason for people buying, the market is in danger of becoming a bubble," he writes. "We must suspect a bubble if homeowners are regarding housing primarily as an investment, rather than as a place to live." recently talked about bubbles with Calverley and asked him why he thinks that, just as with stocks in 1999, now is the time to reduce exposure to the housing market. According to your book, the U.S. is looking at the early to middle stages of a housing bubble. Have people not learned from the tech bubble of a few years ago?

John Calverley: The construction of new housing is at a very high level, and has been at a high level for the last few years, which is unusual in a recession. As a percentage of GDP [gross domestic product], residential housing investment is just about at its highest [on record]. Obviously, it's driven by low interest rates and strong demand. The Office for Federal Housing Enterprise and Oversight provides a price index for houses, which came out last Wednesday. It was up 10.3% over the last year... one of the fastest rates in history.

One of the main drivers is low interest rates. When people look at a house, they see how much they can afford, the biggest mortgage they can afford. What that means is that they end up paying for expensive housing. Interest rates are low in nominal terms. Mortgage rates are 5.8%. But when they rise against rents and [people's] incomes, housing is actually not a good investment.

SM: In your book you say that bubbles make the economy highly vulnerable to shocks or policy mistakes. With the danger of a housing bubble looming in the U.S., how careful does the Federal Reserve have to be in its attempts to prevent something comparable to the Internet stock bubble of the late 1990s?

JC: At the moment, the Fed wants to raise interest rates. I think that's correct; it makes sense to raise rates. The danger is if they raise rates to a point where the economy slows. Predicting how the economy will respond is hard. I think it would take a major mistake to cause any real damage.

SM: Part of your book compares the U.S. bubble of the 1920s with the Japanese bubble of the 1980s. Given similar experiences, why did Japan's bubble not lead to a depression like the U.S.'s did?

JC: The big mistake the U.S. made was in 1931-2. The U.S. had a normal recession, and the stock market was showing signs recovery. Because of the gold standard, the Fed raised interest rates to defend that standard; it raised interest rates when the economy was still weak. It was a particular mistake linked to a fixed exchange rate system. Since we don't have the gold standard system anymore, the risk of major depression now is pretty low.

SM: You suggest that buyers in recent years seem not to appreciate that interest rates have been held at unusually low levels. Are people now overly optimistic? Do they have poor short-term memories?

JC: It does depend on people having enough confidence... In the U.K., in the early 90s, house prices fell in London. People don't remember the last time interest rates were this low. In the U.S., you have to go back 40 years. The mortgage market has liberalized; it's a lot easier now to get a mortgage.

With the tech bubble, everybody could see how good this technology was, that it could transform the economy. People thought that any company using that technology would see a rise in profits, and there's no way you could lose money. With housing, people look back at the price index of the nation as a whole, and they see that prices haven't fallen. Which is true. They think the economy is good and house prices are rising. Houses look like a good investment. The problem is that prices didn't fall in the past because the underlying consumer price inflation was rising. The last time house prices fell [in several regions] was around 1990 to 1995. But house prices fell [during other periods] if you adjust for inflation. The worst thing is the view that people have that housing is a no-lose investment. And we were there four years ago with stocks.

SM: In your book, you talk about the psychological factor in bubbles and how investors sometimes behave irrationally when it comes to assessing risk. You cite "mental framing," the tendency of individuals to organize their world into separate mental accounts. So they might borrow at a high interest rate to finance buying a car while saving at lower rates. What are some other examples?

JC: Another is called "anchoring," which is believing that the current price is somehow justified and likely to continue. People regard a two-bedroom apartment in New York City costing hundreds of thousands of dollars as justified because that's just the way it's been in Manhattan. Obviously there is demand, genuine underlying demand, but to what extent do people want to live there for all the real reasons — like it's a cultural center, it's close to work — vs. because it's a great investment? People are partly motivated by feeling that it doesn't matter how much I pay for my apartment because it's an investment.

SM: Real-estate prices in Manhattan are outrageous. Is it a big bubble waiting to burst?

I wouldn't say it's a big bubble. More people now want to live in cities rather than in the suburbs. There is an underlying demand for Manhattan specifically. I think it's definitely bubbly. It's clear a lot of people are treating property as a great investment.

SM: How much does immigration factor into the rise in housing prices?

JC: Clearly, there is some demand for housing from immigrants. The argument that immigration is driving much of the demand for new housing is more relevant in the U.K. than in the U.S. In London, they're not building as many houses as in the U.S. because they have more planning controls and restrictions there.

SM: One of the ironic points you make in the book is that, as a response to the bursting of the tech bubble in 2000, Federal Reserve Chairman Alan Greenspan cut interest rates, which led to stronger demand for housing. And now we may be facing overvaluations in housing.

JC: In the last year or so, we've seen an acceleration in house prices. Now the Fed is trying to raise interest rates, though the most important rates for housing are long-term interest rates, which the Fed doesn't control. Bond yields are so low. Why? Maybe because Asian banks are buying Treasurys... The mortgage rates are linked to the bond yield. The 10-year yield is 4.15% now. If mortgage rates go up a quarter of a percent, that might slow housing prices. I argue in the book that to stop the housing bubble, you probably need the mortgage rate to be 7% or more. (The average rate on a 30-year fixed-rate mortgage was 5.71% this week, according to Freddie Mac.)

SM: How should investors approach the prospect of a bubble?

JC: The most important thing is to recognize that it is a bubble, because then you can be careful not to be drawn into it. People see a rise in prices, they see the gains their friends make, they read about it in newspapers, and everybody wants to buy. A late-stage investor should be very cautious, generally, about buying housing. That doesn't mean it isn't going to be a good investment for some people in some places. Where yields are higher, it might be a good income. People should be careful of having massive amounts of property in their portfolio... They can lose a lot of money.

SM: How do you think Fed officials should deal with it?

JC: It's quite difficult for monetary policy to do anything about bubbles. The Fed is right to raise interest rates. With other policies, there are not many options. One is to publicly warn about bubbles. Greenspan has warned in specific areas; he hasn't made a general warning. Another way to go is to try to see if there are ways to restrain bank lending.

Another issue in the U.S. is the role of Freddie [Mac] and Fannie [Mae]. They are the source of a great deal of mortgage lending. Greenspan suggested they be broken up — and instead have a number of private sector institutions. That might help.


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