Housing Bubble Revisited

The headlines about housing certainly changed over the last year. Talk of unending years of double digit appreciation have been replaced by stories of unsold homes, sharp price declines, and forecasts of how long and how steep the decline might be.

Throughout the housing boom we maintained that there was not a national housing bubble. As with other assets, there is a normal cycle in residential real estate. For five years or so, prices boom. They rise at a rate that exceeds local growth in incomes, the economy, and inflation. Homeowners stop negotiating and bid up prices. At the peak, homes sell in a matter of days for more than their listing prices. A large number of investors are drawn into real estate expecting quick gains (from property “flips”).

Suddenly, the boom stops. Often a credit crunch or sharp rise in interest rates stops the boom. Sometimes the halt is caused by an oversupply of property. The current boom seems to have stopped simply because people realized it had to and that they weren’t going to pay higher and higher prices. Also, the rise in short-term interest rates reduced use of some of the more aggressive mortgages.

Real estate boosters point out that there never has been a one calendar year decline in national housing prices. But there have been post-boom periods with actual price declines in particular areas and in certain types of properties. The declines are most likely to occur in areas where prices boomed the most and speculation was the strongest.

The chart nearby shows the actual and forecast prices in my home county of Fairfax, Virginia over more than a full cycle. There were actual price declines for three years in the early 1990s, followed by several years of modest gains or falling prices. This period followed a long-term boom in the 1970s and 1980s. The 2007 price gain is a forecast; the actual could be much different and could be a decline.

Price declines also can be disguised. Builders and sellers offer incentives to keep from reducing the indicated sale price. I even have heard of some homeowners including expensive cars with the sale of their homes.

Throughout the boom, we were suspicious of the housing bubble theory and also doubtful that high price gains would continue indefinitely. We urged two strategies for home buyers. One strategy is to view a home to be a long-term consumer good. Buy the home if you like it at the price and plan to stay there for a number of years. The second strategy is to determine the capitalization rate of the property by estimating its rental value. In boom times, home prices rise faster than rents. A low capitalization rate indicates that homes are becoming overpriced, because rents are a fraction of the cost of owning the homes. Details about capitalization rates were last given in our July 2005 visit and are in the Archive of the web site.

The post-2000 boom is over. The post-boom period is unlikely to be short. The boom pushed up home prices far faster than the incomes that are needed to pay the mortgages. The boom ended though long-term mortgages rates did not rise much. Only short-term rates, which were used on the more speculative mortgages rose, and they are unlikely to decline to their 2002 and 2003 levels.

The valuation cycle occurs in houses just as it occurs in stocks. Buyers move from periods of extreme pessimism to extreme optimism and back. The period of extreme optimism is over. While housing prices won’t crash in most areas, do not expect the boom to return any time soon.