Sunday, January 16, 2005

Yes, a real-estate bubble now exists

By Mark Schniepp, Ventura County Star

Between 2003 and 2004, the price of a home in Ventura County leaped 28 percent. A home selling for $325,000 in 2001 is now selling for $600,000.

Walk around your home in Ventura County. Your house looks pretty much the same as it did three years ago. Why do you think it is worth twice as much? Exactly what has added value to your home? The answer is: buyers, and lots of them. The intrinsic value of your home has not increased. The perceived value that someone is willing to pay for it has. Now, what happens when the collection of buyers that drove prices up in your neighborhood stops coming? What happens when perceptions of value change?

What happened to the Nasdaq in 2000 when buyers stopped buying Lucent, Cisco, and Pets.com?

Bubbles occur when fundamental economic criteria associated with the demand for any asset fade or disappear, leaving anticipation of price appreciation as the principal reason for purchasing the asset. There is a growing evidence that this type of behavior has largely pervaded the housing market in California and other parts of the country.

A credible survey of nearly 700 homeowners in Boston, Milwaukee, San Francisco and Orange County finds that the average person is counting on double-digit price appreciation each year for the next 10 years.

The existence of a bubble takes back burner to the more pressing question: Will it burst? Real-estate bubbles don't usually burst; but they do deflate, and usually slowly over an extended period of time. The probability of deflation increases when a number of conditions are met. What are those conditions?

Increased vulnerability

The fundamental relationship between income and home value has deteriorated. Low interest rates have made this possible, but more adjustable rate mortgages are being embraced by buyers. They will constitute 32 percent of all mortgages this year in the United States, versus 19 percent in 2003.

Rising interest rates (like we've seen since June) can ultimately lead to an increase in the cost of housing by existing homeowners, and will generally lead to higher-cost mortgages by future home buyers. Consequently, higher rates reduce the demand for home-buying.

Sluggish employment growth (like we've seen in Ventura County this past year) will also slow down demand. Though the weak labor market in the county has not slowed demand to date, the linkage between job growth and home sales must ultimately be restored. If job growth does not accelerate, the demand for homes will abate.

There is more anecdotal evidence of flipping, and speculatory behavior appears to be growing. Speculation up to now has not been problematic, but more evidence of second-home purchasing for investment or recreational purposes is starting to pile up.

There is not much producer speculation at this time and probably won't be in the coastal environments of California, but limits on housing supply are not enough to keep the bubble from deflating.

Supply limitations not reason enough

Price appreciation is caused by the growth in demand exceeding the growth in supply. It is not enough to say that as long as supply is limited, there is no bubble, and prices will not fall. We can still have limited supply, and even a decline in supply (negative growth), and a bubble can still exist when the fundamental structures associated with the demand for housing are breached.

When the growth in demand falls below the growth rate in supply, the bubble begins to deflate.

Defenders of the "no-housing bubble" position often cite supply as the overriding factor. But with regard to a bubble, demand is always the overriding factor.

What drives the growth in demand?

Demand for housing is driven by new job opportunities, demographics, and lifestyle changes. It is also driven by speculation. There is more speculation today than at any time in the last five years because there is more buyer enthusiasm based on anticipated price appreciation.

When job growth subsides, so does part of the demand for homes. When the growth in the home-buying age group of the population begins to slow, so will the demand for homes. And if there is a surge in marriage rates, or cohabitation rates, two people can occupy a single housing unit instead of one, and the demand for housing slows.

Finally, when the economy slows down, unemployment rates rise, the growth of income plateaus or even declines, consumers accumulate fewer assets, like second homes, and demand for homes falls.

Demand growth is therefore quite fragile, dependent on the economy and other factors that are cyclical and some of which can change quickly.

We believe we are in a bubble because a component of the current growth in demand includes speculation and second-home purchasing. When this type of behavior goes away, the current level of demand will fall back to that associated with economic or demographic fundamentals. Demand based on fundamentals may still be enough to match the growth in supply, but it may not.

When the regional economic growth begins to slow or even reverses, employment opportunities will decline and the growth in demand will fall further. When demand falls below supply, prices begin to fall and the bubble begins to deflate. The situation is exacerbated by the subsequent fall-off in demand from speculation and/or investment. A spiral downward in prices is the inevitable consequence.

When does the bubble deflate?

While job and income growth are not forecast to subside in 2005, the following year is much more uncertain. However, expect a material slowdown in price appreciation.

Productivity growth cannot keep up the same pace as it has the last three years. It already is showing signs of tiring out. As it does, so will the growth of income.

Consumers cannot continue to lead Gross Domestic Product growth and regional growth with their insatiable spending. At some point, consumers begin to tire, on both retail goods and housing. This may occur in 2006 or 2007. Either way, unless income growth rises to elevate the fundamentals associated with demand for housing, there will not be enough buyers to keep housing prices at current levels.

We believe demand will weaken before incomes can grow high enough to warrant current housing valuations. Prices will undoubtedly fall if consumers tire, the economy softens, and income growth weakens. Prices in some regional markets are falling now.

Appreciation rates of 20 percent or even 10 percent cannot go on forever. And if something can't go on forever, it won't.

-- Mark Schniepp is director of the California Economic Forecast.