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A Real Estate Market Crash: 7 Reasons Why The Impending Housing Bust Will Be So Severe
by Mark Skousen, Chairman, Investment U
Friday, September 1, 2006: Issue #577
Recent data on real estate is depressing…
New home sales in July are 22% below last year. In the previously hot northeast market, new homes sales plunged 43%. The inventory of unsold new homes hit a new record high at nearly 4 million, up 22%. And existing home sales are down to 6.33 million in July (from 7 million last year).
Lower or stagnant selling prices are another indication of a weaker market. The median price of a home last month was up less than 1% compared to the same time a year ago, to $230,000. It’s the smallest increase since 1995. That’s a sharp contrast from recent years when the median price of a home shot up by nearly 60% since 2000.
Real estate’s woes are manifesting themselves in the stock market, too, with a sharp falloff in prices for mortgage REITs and, more recently, homebuilder stocks such as Toll Brothers (NYSE: TOL) and Centex (NYSE: CTX).
The real estate cycle is well known, and typically lasts 10-15 years. Real estate market crashes have happened before, but there are seven reasons why this particular boom-bust cycle is severe on both the upside and the downside.
The Real Estate Market Represents 56% of Financial Wealth
In the second edition of Irrational Exuberance, Yale professor Robert Shiller published a dramatic chart showing the unprecedented and unsustainable price chart of real estate in the United States. And it appeared in The New York Times Sunday, August 27, in “Read Between All Those For-Sale Signs.” (Shiller is to be commended for pinpointing the top of two giant markets – the Nasdaq in 2000, and the real estate market in 2006. Who says economists can’t predict?)
Take a look…
Over the past 10 years, real estate assets have increased dramatically, from $8 trillion to $21.6 trillion, representing 56% of financial wealth.
There are seven unusual reasons why:
1. The stock market boom: The “irrational exuberance” on Wall Street caused many investors to diversify into other real assets.
2. Favorable demographics: The baby boomers have a special taste for real estate.
3. Tax advantages: Real estate investors are taking advantage of the fall in long-term capital gains taxes to 15%, and special tax-free benefits ($500,000 exemption and tax-free exchanges).
4. Terrorist attacks since 2001: Many scared investors switched out of the stock market into real estate.
5. Cheap financing: Banks and mortgage companies invented two borrow-friendly underwriting techniques, including adjustable-rate and interest-only loans.
6. Foreign demand: Because the U.S. dollar is so cheap, American real estate is “on sale.” It is estimated that foreign buyers purchase more than 20% of real estate in Manhattan.
7. Last but most importantly, the Fed’s irresponsible low interest rate environment in 2001-2004, pushing short-term rates down to 1%: This allowed mortgage lenders and bankers to play the spread and virtually print money.
How Bad Will the Real Estate Market Crash Be?
Austrian economics teaches us that easy money and artificially low interest rates create an unsustainable boom – and the higher the boom, the greater the bust. If the housing market were like the bond or stock market, with instant liquidity and low transaction costs, today we would see a real estate crash of unprecedented proportions.
But this is an “invisible crash” because the real estate market is inherently illiquid, largely due to high closing costs. Instead of falling prices, owners try to keep prices as high as possible and wait for a buyer to come along. Thus, the waiting period expands to months. In addition, many sellers give up and take their property off the market, waiting for a better environment.
Fortunately, there are several factors mitigating against disaster:
- Continued foreign buying of U.S. real estate: The dollar is still cheap, and so is property from the viewpoint of foreigners.
- Low mortgage rates: Despite the Fed’s aggressive rate hikes, the long-term mortgage rates have increased less than one percentage point to around 6.7%. However, if mortgage rates rise steeply, the depression in real estate will be disastrous.
- The tax benefits are still in place, and given the uncertainty of the stock market, investors may choose real estate as an alternative “real asset.”
These factors should cushion the fall, but there’s no question that the real estate boom is over for now and will take years to recover.
Good trading,
Mark
Today’s Investment U Crib Sheet
- You can find a copy of Robert Shiller’s second edition of Irrational Exuberance at Amazon.
- Why Housing Prices Will Keep Dropping in Value
- Housing Prices: Why Greenspan Is Right About Real Estate Investments
- The Housing Market: The Disappointment Of The Decade
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