The Investment U e-Letter: Issue # 423
Monday, March 28, 2005 The Real Estate Bubble End Result: Is a Bust Headed This Way?
By Dr. Steve Sjuggerud, Advisory Panelist, Investment U "When the (real estate) bubble burst, property prices plummeted more than 80%… wiping out many families' wealth and helping plunge the economy into 13 years of stagnation." ~ Financial Times, March 24, 2005, referring to Japan in the late 1980s. Our house sold! My wife and I went by yesterday to clean out the last few things, and our old neighbor stopped by to tell us the plans for his house. "We're moving too - an hour north of here," he said. He then shared his seemingly sensible plan…"You can't go wrong with investing in real estate on our island," he said. This, of course, is said in every real estate conversation here nowadays, and probably everywhere else on the Florida coast. My friend continued: "We're up a few hundred thousand dollars on this house. So we're going to buy a house an hour north of here AND buy a condo here, so we can keep a place here." Why two places? "The way prices are going on this island these days, if we don't buy it now, we won't ever be able to afford to buy here again." My old neighbor sums up the prevailing thinking - buy good real estate now, while you still can afford it… But sinking tons of money into real estate investing right now might be a bad idea… Here's why… A Real Estate Bubble Danger Sign: The Crowd Believes "Prices Can't Fall" in the End Prices have been soaring for seven years now on the coast. Just when you think prices on the coast can't go any higher, they double again - in just two to three years! Most people only see the last seven years, and they don't know the big picture and the end truth… that for the last quarter of the 20th century (1975-2000), Florida home prices were flat, when you adjust for inflation. It's not hard to see how a regular home in a regular neighborhood where I live has doubled from $200,000 to $400,000 - as incomes have risen, the population here has risen, and mortgage rates have fallen. But is that zero-lot line home in the cookie-cutter neighborhood really going to double to $800,000? I realize that anything in real estate investing is possible. But two things concern me: The first thing that concerns me is the basic economics. It's reaching a point where most people can't afford the median home. The second thing that concerns me is the strong belief that prices can't fall. The Japanese thought the same thing in the late 1980s when their real estate bubble burst, and they're still suffering terribly… Similarities to Japan's 17-Year Bust Last week, the Financial Times reported that residential real estate prices in central Tokyo rose by 0.9% in 2004. That rise is nothing to write home about… except that it is the first time in 17 years that residential real estate prices in central Tokyo actually went up! Back in the late 1980s, the Japanese felt the same way about real estate investing as people on the Florida coast do now. I checked the results of data on Japanese real estate going back to the 1950s (as far back as data in English exists), and I found that, with the exception of 1975, Japan home prices never had a losing year… Never that is, until the bubble burst and the bust followed. And with it, 17 straight years of pain. At the height of the bubble, "it was a matter of pride that the land around the Imperial Palace in Tokyo was at one point worth more than California," the Financial Times said. Those days are long gone… "When the bubble burst, property prices plummeted more than 80%, undermining company balance sheets, wiping out many families' wealth and helping plunge the economy into 13 years of stagnation." What You Can Do Now to Protect Yourself from a Bubble and Get your Desired End Result: Sock Away Equity! First of all, I don't think we're in for a Japan-style real estate crash nationwide in the States. The main reason we won't have a Japan-style bust is that we didn't have a Japan-style nationwide real estate bubble in the first place. But there is reason to play it safe, and to protect yourself from risk by not getting overextended in real estate investing. Let's use an example from Japan… A guy in central Tokyo who borrowed $500,000 to buy an apartment still owes the full mortgage today, but his apartment has lost 80% of its value. A $500,000 mortgage on a $100,000 apartment… now that's a bad place to end up. My old neighbor can easily avoid the risk of ending up like this Japanese guy. Put simply, he doesn't need the two places. He needs the home. He doesn't need the speculative condo and the new pile of debt. "But if the rent can cover my mortgage and costs…" he says. Stop right there… It won't. You're dreaming. (I couldn't tell him that as a result…) The safe way to do it is for him to plow profits on his old house into EQUITY in his new home. This way, if the bubble bursts a little and property prices here near the coast fall by 20%, for example, it wouldn't affect him one bit. He probably won't do that. He'll probably do what everyone else is doing here: taking their profits in real estate here and plowing them back into real estate. It's the late 1980s in Tokyo once again. There's a chance you'll be thinking about buying or selling real estate in the next few years (if not few months) because "in the long run, real estate always goes up." But if you're heavily leveraged, or you're plowing real estate profits back into bigger real estate deals right now, remember: These are not normal times in real estate, particularly on the coasts. And normal times will undoubtedly return, whether it's via a real estate bubble bursting, or a long, drawn-out period of no price change. And don't forget, even a period of no price change costs you a lot of money in real estate, with taxes and maintenance. A Final Warning on the 'Real Estate Bubble' I'm glad my other house on the island is selling now. And I wish my old neighbor the best. As for you, if you've got too much exposure to coastal real estate, or your own "hot" local market, I'd suggest paring back now. Beat the rush… as getting out of real estate is not as easy as selling a stock. Yes, there could be another year or two of good times, and I'll miss 'em. But I'm okay with that. Good investing, Steve Today's Investment U Cribsheet Related Articles Investment U Archives | 
