Monday, January 03, 2005

Has Greenspan Over-Pumped the Real Estate Bubble?

by Noel Sheppard

The residential real estate market is beginning to behave in an irrational fashion that could be portending an imminent peak.

Like most people with even a passing interest in matters relating to business, I have been reading articles in financial periodicals and have heard the prognostications of many economists concerning a looming “Real Estate Bubble” for at least the past three years. Regardless of the logical and empirical approach to much of the research that has been shared on this subject, my own analysis has been quite contrary to these bearish assertions. However, some recent events have begun to weaken my resolve, and lead me to believe that the residential real estate market is indeed beginning to behave in an irrational fashion that could be portending an imminent peak.

The first cautionary signal was raised when a good friend of mine told me about what has happened to the house that he bought in Sarasota, Florida this April. As he will be retiring in two years, he purchased a lot with construction plans for a lovely model in a fine, gated golf community a bit inland from the Gulf. His base price before his personal add-ons was $399,000. They have barely broken ground to lay the foundation, and a similar floor plan in this community’s next development is now going for $699,000. That is a 75% appreciation in eight months -- an annualized increase of 112.5%. Now that’s what I call a bubble.

Granted, there may be mitigating circumstances in Florida related to the hurricanes, very strong economic growth in the region, retirement home purchases by baby boomers just like my friend, etc. However, when assets begin to appreciate at this kind of a pace -- not just the ten and twenty percent annual rates that we have been seeing in many parts of the nation including Florida for the past five years or so -- one must start paying heed.

The next shoe dropped a few days later when another friend of mine who owns a mortgage company told me about his average client the past three months or so -- mid-40’s to mid-50’s couple that is tired of their recent paltry gains in the stock market, and is, for the first time, purchasing a home or condominium as a rental/investment property. In doing so, they are not only leveraging themselves to the hilt, but also are negatively amortizing with total payments -- including taxes, insurance, homeowners’ association dues, and equity reduction -- that give them a monthly negative cash-flow of $1000 AFTER rent collection. But, they’re not concerned about this guaranteed recurring loss of capital because they believe they’ll make it all up when they sell the house for a huge profit somewhere down the road. That’s also what I would call a bubble.

To try and put this kind of speculative borrowing and investment behavior in perspective, in the stock market, this would be akin to buying on margin -- purchasing stocks with money that you had borrowed off of the value of other stocks you owned -- to such an extent that your interest costs were eating into the principle of the equities that you held. Now, to be sure, this is not an uncommon practice for investment professionals and experienced traders. However, analysts are always keeping track of the total retail margin debt that exists as a percentage of retail stock accounts to gauge speculative excesses in the market. To be sure, one of the real warning signs in the first quarter of 2000 when stocks were peaking was the level of this very debt. Now, it is quite conceivable that this same degree of speculation is emerging in the real estate market.

Finally, my other concern about this behavior is that these are first-time real estate “investors,” or what stock traders would refer to as “weak hands.” Strong hands are professionals and seasoned investors. Weak hands are neophytes who have no experience with equities that always get sucked in as buyers at or close to the peak. Certainly, this is what happened in the first quarter of 2000, when you couldn’t swing a dead cat in this country without accidentally hitting someone who had never invested in stocks in their lives, but now owned either dot-com shares, or an aggressive growth mutual fund that was largely investing in such worthless assets.

Today, the weak hands -- people who have never purchased investment property before -- are actually willing to lose money every month because they believe that real estate will keep going up. It’s dot-coms all over again, folks, but with much larger sums of money, much greater degrees of leverage, and, as a result, much more ominous portent. When people were speculating this way in the stock market five years ago, for the most part, all they lost was their savings and their retirement plans. This time, if the cards begin to implode, people could end up quite literally losing not just their investment properties, but also the homes that they live in.

What potentially is the cause of this speculative excess this time? Well, to a certain extent, the same as one of the root causes of the recent stock bubble -- overly aggressive monetary policy. If you recall, in the fourth quarter of 1999, in order to ward off the possible banking illiquidity that was feared to transpire as a result of money hoarding prior to Y2K, the Federal Reserve left interest rates unchanged at its December meeting. At the same time, they executed a variety of procedures to make sure banks were quite flush with cash just in case Y2K problems arose. Many economists after the fact believed that this “looser” than required monetary policy precipitated the upward movement in stocks at the end of the millennium.

As one can plainly see from a NASDAQ chart, this index went from roughly 2500 to 4000 during the fourth quarter of 1999 -- a 60% rise -- with some of the catalyst clearly being an overly aggressive monetary policy. Moreover, Mr. Greenspan was certainly too slow in altering said policy. For instance, at the time, there were many economists like myself who expected that once Y2K had passed without the dire consequences that had been presaged, the Fed would immediately -- meaning as soon as the first or second business day of the New Year -- raise rates. Why? Because the economy was very strong throughout 1999, and clearly warranted a tighter monetary policy than was necessary to avoid Y2K related liquidity problems. Unfortunately, by leaving rates unchanged, Mr. Greenspan encouraged the final rally in stocks that quarter that ended with the eventual financial bloodbath. By contrast, if Mr. Greenspan would have immediately raised rates early in January 2000 -- rather than waiting until February -- the final push from NASDAQ 4000 to 5000 in roughly ten weeks might not have occurred.

Subsequently, as far as real estate is concerned, Mr. Greenspan might be making the very same mistake, for without question, much of this extended real estate boom is largely interest rate driven. However, part of today’s aggressive monetary strategy is clearly also intended to deflate the value of the dollar to help our multinational companies export products and reduce American appetites for foreign goods. Unfortunately, even at the current 2.25% federal funds rate, our monetary policy is still on the easing side, given that a neutral posture would attempt to mimic the current rate of GDP growth. For example, as GDP grew by 3.7% in the third quarter, and will end up likely somewhere between 3.5% and 4% this year, with projections of roughly the same next year, a neutral policy would be a funds rate somewhere between 3.5% and 4%. Obviously, as we are nowhere near that yet, even though our economy has been expanding since the fourth quarter of 2001, our central bank for all intents and purposes still has its foot on the gas pedal with much of the fuel going right into the real estate speculation engine.

Given this, one has to wonder if Mr. Greenspan isn’t making the same mistake that he made in 1999 and 2000, when he left rates too low for too long. In fact, of Mr. Greenspan’s policy errors during his fabulous tenure, it has usually been either this kind of a situation where he doesn’t raise interest rates in a timely and aggressive enough fashion to prevent an asset-bust, or an overreaction to a financial crisis (1987 stock market crash) with excessive easing that results in a rekindling of inflation.

Irrespective of these cautionary signs, there are economic realities that exist today that are quite different than what was transpiring just before our last two real estate busts in the early 80’s and early 90’s. For instance, both of those collapses were preceded by exogenous economic events that led to huge employment dislocations in entire industries. In the 80’s, it was the implosion of the oil patch. In the 90’s, it was the fall of the defense complex as well as the savings and loan industry. By contrast, as our economy looks quite healthy at this stage compared to what was occurring during both of those periods, there is currently no apparent similar dissolution of an entire employment sector that appears to be presently looming on the horizon.

As a result, my concerns -- much as they were in January 1999 when I first started worrying about equity valuations -- might be very early. Moreover, if Dollar Diplomacy works, the population models moving forward could suggest that any correction in real estate valuations regardless of severity might just be a short-term deflating of present aberrations. However, as an exploding stock bubble was largely responsible for our last recession, and a real estate collapse acted to significantly exacerbate the previous one, this matter warrants continued scrutiny.