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Real Estate Bubble Revisited

Last update on: Oct 17 2017
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Residential home prices in many areas have skyrocketed. One estimate is that average prices nationally rose 40% over the last five years. In a number of areas, however, home prices increased 75% and more, especially on the coasts. In my area some neighborhoods have waiting lists for homes, and brokers say they have more buyers than sellers.

That price action ignites fresh discussions of the possibility that we are in a housing price bubble. It is easy to find analysts who say housing prices today are much like technology stock prices in 2000, and that you should sell real estate and rent for a few years.

We last discussed the prospects of a housing bubble in the October 2002 issue. My conclusion then was that we were not in a housing bubble and homeowners did not have much to fear. Let’s re-assess those arguments in light of the price appreciation that has occurred since then.

The home market is different from the stock market. The typical person does not buy a home with the prime goal of earning capital gains. Generally, a person needs a place to live and prefers to own his home. He’ll search for a home that meets his needs, is affordable, and is in a good neighborhood.

Likewise, few people sell homes because they think prices have peaked. Housing is not a liquid market like stocks. It takes time to sell a home, and there are costs involved in selling and moving.

In addition, the consequences of selling a home are different from those of selling a stock. When a stock is sold, the issue is what to do with the cash proceeds. They can be invested in another asset, spent, or given away. When a home is sold, the former owner needs to find a new place to live and must move all the family’s possessions. Most people need a great deal of motivation to sell their homes.

Because of the liquidity issue and the disincentives to sell, a housing crash resembling the Nasdaq crash is highly unlikely. Without an economic decline in an area, a lot of people aren’t likely to put their homes on the market at once.

Most people tend to look at the wrong factors when analyzing the outlook for housing prices.

Residential housing prices tend to parallel incomes. Nationally home prices rose about 136% from 1980-2001. Likewise, median incomes rose 138% during the period. People tend to buy the homes they can afford, and they buy homes when they believe their incomes are secure. So, home prices track income.

But housing prices don’t always match income growth over shorter periods. From 1996 to 2003, incomes nationally increased 22% while the average home price rose 47%. In Boston during that same period, incomes increased 40% while local home prices increased 120%. Similar disparities occurred in other areas, especially on the east and west coasts and in high-income resort areas.

Falling interest rates were one factor helping home prices increase faster than incomes. Lower interest rates made higher-priced homes more affordable for the many people who borrow to buy their homes.

Yet, housing price growth cannot exceed income growth for long. At some point, home prices reach a level that few people can afford. Rising interest rates also will slow the growth of housing prices in time. Over the last year, the prospect of rising rates actually boosted home prices as buyers sought to buy and lock in their mortgages before rates rose. But higher rates make homes unaffordable for more people and hold down the prices other buyers will offer.

Don’t expect interest rates, however, to cause a housing crash. Inflation generally is under control. Rates aren’t going to rise enough to make houses unaffordable for most people. Also, the markets priced in significant rate increases for long-term debt such as mortgages long before the Federal Reserve took action. Long-term rates probably will rise a relatively small amount from current levels.

There is one major difference between the current market and most prior real estate cycles. Mortgage lenders have gotten very creative in devising new types of mortgages. They also are aggressively structuring loans to make payments affordable to buyers. More lenders now write mortgages for buyers who have zero equity in the homes.

Rising short-term interest rates could make these mortgages unaffordable to some unknown number of homeowners. With zero equity in their properties, they might be more interested in turning the properties to the lenders instead of trying to restructure the mortgages. The consequences of higher interest rates on these new financing vehicles, such as the effect on overall home prices, are uncharted territory.

Some analysts believe that an aging population will cause a long-term downward spiral in home prices. I believe that fear is unwarranted. Immigration plus the large generation of the Baby Boomers’ children will keep the home market active.

Even so, housing prices cannot increase at the same pace they have over the last five years. Home prices can rise faster than incomes for only so long. Residential real estate prices, in fact, have exhibited regular periods of rapid appreciation followed by periods of low appreciation or stagnation. We’re nearing the end of a rapid growth period.

My advice is not to sell a home to avoid a crash. Unless your local economy goes into a tailspin, home prices are unlikely to crash. But be careful about buying now, especially if you plan to be in the home only a few years. Unless incomes in your area are rising rapidly and will continue to do so, home price appreciation is likely to slow. In a period of little or no price growth, the costs incurred in buying and selling could equal one to three years of appreciation or be even higher.

The second home market is a different story, because second home prices respond to other factors.

A significant percentage of Baby Boomers are entering the years during which they will want second homes. They are in their peak earning years and are looking to buy either retirement homes or vacation homes.

Second homes generally are not purchased from current income or at least do not stretch current income the way first homes do. Second homes often are purchased by tapping equity from the primary residence or by using either an inheritance or investment or business gains. Many buyers pay cash for a second home, especially at the high end of the market. It appears that a meaningful percentage of Baby Boomers are downsizing by selling their long-time principal residences and buying smaller principal residences plus second homes.

The prices of homes in desirable vacation and second home spots have paced the housing market the last few years. Higher interest rates will reduce, but not eliminate, appreciation for second homes selling for less than $1 million. Upper-end homes are unlikely to be affected by interest rate changes.

Vacation home hotspots often help boost prices with zoning laws that limit development. Demand for second homes is almost guaranteed to outpace the supply in many of the desirable second home areas.

Since second homes are a discretionary purchase, their prices are more volatile than those for primary homes. Second home prices actually can decline during economic downturns, but they have faster appreciation in strong markets. Long-term, demographics and other factors favor continued strong appreciation in second homes.

If you are interested in a second home, look for one convenient to a large population center. Most people buy second homes about 185 miles (a three-hour drive) or less from their first homes. That’s why West Virginia is a big second home market.

Those who cannot afford a second home in a traditional market should consider now-obscure places that might be up-and-comers. Developers are always trying to turn sleepy areas into new, hot markets. EscapeHomes.com names as emerging second home markets places such as Burnside, Ky. and Caribou, Me.

Whether it is a first or second home, you always can assess a market’s valuation level by calculating the cap rate of a home. Determine what the home would rent for annually and subtract property taxes and insurance. Then, divide that into the current value of the property. A cap rate between 5% and 10% generally is average and probably a reasonably valued property. A cap rate above 10% often is a bargain. A cap rate under 5% looks like an overheated market.

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