Is Real Estate The Latest Bubble?

Is housing next? One of the few bright spots through the bear market, recession, and war on terrorism is the housing market. New home construction and sale prices of existing homes continue to surge. As home prices rise, people can refinance their mortgages, take some equity in cash, and spend that cash.

Many people now fear that residential real estate prices also are a bubble due to burst, just as technology stocks were. The appreciation in some markets is impressive. Over the last year, Nassau-Suffolk, NY housing prices surged 29.6%. Some other parts of the New York City area had one-year appreciation over 20%, while in San Diego prices increased 21.3%. The National Association of Realtors reported over 25 markets had one-year appreciation of over 11% in the year ending July 2002.

To be sure, housing prices are not uniformly surging around the country. Some areas that were especially dependent on the technology industry have had modest price increases or even declines. Yet, areas that normally don’t see strong price increases experienced them over the last year.

Some observers say they see the first signs of the bubble deflating. There are some studies indicating that home price increases accelerate before their peak, and that housing prices normally peak two to three years after the stock market peaks. Realtors in at least some areas report softness in prices for homes costing $1 million and above. They also say it is taking a bit longer to sell homes and that sellers are reducing asking prices.

Other observers offer more anecdotal evidence to warn about housing prices. They point out that investors apparently are selling stocks to buy real estate. Also, new books are appearing to explain how people can get rich in real estate instead of stocks. In many areas, people apparently talk about home prices instead of stocks at parties and around the office.

With all the talk about a bubble, people are wondering if they should delay buying that retirement home or second home. Some even are considering selling their homes and renting for a few years when they expect to buy similar housing for a lower price.

Housing prices normally grow in line with inflation, income growth, and population growth. Over the long term, housing prices nationwide rise at the inflation rate plus one or two percentage points. Clearly, it is unlikely that housing prices increases of the last couple of years can be maintained. That isn’t the same as saying that housing prices are a bubble that is about to deflate.

A housing price bubble is not corrected the same way as a stock market bubble. Houses cannot be traded steadily during the day, and houses are purchased to live in. The transaction costs in selling, selecting a new home, and moving can equal about 10% of a home’s value. Homeowners won’t all sell their homes because the prices seem to high or have declined the last few months. That is why home prices won’t suffer a collapse similar to the Nasdaq’s. Usually a housing bubble is deflated by years of lower price growth or even stagnant prices.

Actual declines in housing prices are rare and usually tied to severe local economic problems. There was a national decline in prices briefly in the late 1980s and early 1990s. That was tied to a recession, very high interest rates, and the Gulf War. Most importantly the savings and loan industry, the main source of home mortgages, collapsed.

Today we have low interest rates and low inflation. The recession apparently ended, and the mortgage market is healthy. Personal income keeps rising, as it did even during the recession. In addition, homebuilders have not engaged in the overbuilding that commonly contributes to a peak in housing price growth. In fact, several areas report that there isn’t enough new housing to meet demand.

In most areas, the important middle sector of the housing market is supported by a solid balance between supply and demand. There is not a lot of new apartment building in many areas, and that increases the demand for residential real estate.

Also, raw numbers on housing price increases do not take into account the fact that new homes are larger and have more expensive features than in the past.

Real estate prices almost always are a local phenomenon. While I do not believe there is a national housing market bubble, local bubbles always are a possibility and you must determine if a local bubble exists before making a decision. The key factors in determining whether or not there is a bubble are income, prices, and interest rates. These combine to determine the affordability of housing in the area.

Several studies in recent months argue that there are bubble in some localities. One study says the most overvalued markets are Boston, San Diego, Fort Lauderdale, San Francisco, Miami, Denver, San Jose, Orange County, Calif., Charleston, S.C., and New York City. Another study by Economy.com drew similar conclusions. The Milken Institute also reports affordability is near a record low in those hot markets. Another source that monitors affordability and possible local housing bubbles is Housingzone.com’s Housing Cycle Barometer.

I’ve always recommended that you analyze a housing market by determining a form of price-earnings ratio for the area.

First, determine both the purchase price and the potential annual rental value of the home. From the annual rental income subtract taxes and the other costs of ownership, which not counting the mortgage are about 30% on average. You now have the net operating income of the property. Divide this by the purchase price.

The result is known in real estate as the capitalization rate or cap rate and is somewhat similar to the inverse of the p-e ratio for stocks. The higher the cap rate, the better the value of the property. The lower the cap rate, the more highly valued the property is.

Cap rates in a normal real estate market generally are between 5% and 10%. If you compute a cap rate in that range, then the property probably is reasonably valued. A cap rate of over 10% sounds like a good buy. A cap rate under 5% looks like an overheated real estate market in which purchase prices have outpaced rents.

Here’s an example. Suppose you determine the annual rent on a property would be $24,000, expenses would be 30% of that, and the property would cost $500,000. That is a capitalization rate of just over 3% ($24,000 – $7,200/$500,000). That’s clearly a market with high real estate valuations.

This is an imprecise way of getting a relative value for real estate. You also should look at the rate of housing appreciation over the last few years and determine whether or no rents have increased at a rate similar to home prices. I also would avoid buying real estate in an area in which homes are selling within a few days for more than the seller’s asking price.

Finally, and perhaps most importantly, take a look at the local economy. Incomes in the area are ultimately what will support real estate prices, and housing prices will be healthy as long as the economy is healthy.

External factors always can upset any local or the national real estate market. An escalation of the war on terrorism might stall the economy and housing prices for a while. Also, if economic growth picks up interest rates rise. That could make housing less affordable. My final advice is always to view a first or second home as a consumer good that might appreciate. Do not purchase a home with the goal of increasing your wealth through the home’s appreciation, and be cautious when considering home that has appreciated rapidly in recent years.