Real Estate Bubble

by Investment U

Real Estate Bubble

The Investment U E-Letter: Issue # 449

Friday, July 1, 2005

The Real Estate Bubble: What's Really Happening

By Dr. Steve Sjuggerud, Chairman, Investment U

I'm getting tired of hearing about the real estate bubble… So today, I did what I always do when I get tired of hearing about an investment…

No, I don't go play golf and forget about it. I go back to the raw numbers. I want to forget the hype, and see what's really happening.

So today, let's take a quick stroll through the raw numbers, not the hype and stories you've undoubtedly read about the bubble bursting or the bubble expanding. The outcomes will probably surprise you. To spare you the suspense:

  • Believe it or not, when you size up real estate home prices nationwide, "insane" is not the correct description. "Prices are much higher than they had been in recent years, nationwide," is about all you can really say.

  • The supply of new homes is still very low, which has been a great leading indicator of higher home prices ahead. Additionally, even at today's higher prices, thanks to low mortgage rates, real estate is still much more affordable today than it was in 1980.

  • A major risk ahead to housing prices is recession, brought on by the Fed hiking rates too aggressively. Recessions follow boom times. And the Fed hiking interest rates is often a trigger of recessions. Recessions are killers for new real estate home prices. I'll explain this below.

In sum, with low supply and low interest rates, home prices can continue higher in the short run. But looking ahead, a double-digit percentage drop in home prices (after inflation) is extremely likely, based on history.

Let's take a look...

New Home Prices Nationwide

New home prices are up nationwide, but it's hardly "insane," based on history.

Real Estate Bubble, Chart 1: New Home Prices Nationwide

The Real Estate Bubble Today: Gasoline on the Fire?

Part of the "gasoline" on the real estate fire is the sheer lack of supply of new homes. As the chart here shows, whenever the supply of new homes drops (see the green circles), the price of new homes soars. It's Economics 101... and we're still here, without enough homes - at least according to the current statistics.

Real Estate Bubble, Chart 2: New Homes Supply and Prices

Homes Are Still More Affordable Today Than They Were in 1980

Even with the rise, houses are still much more affordable than they were 25 years ago. Mortgage rates 25 years ago rose to darn near 20%. It took everything you had to buy a modest home. Now, we're deep into 2005 and mortgage rates are under 6%. The reality now is, homes are still much more affordable (based on % of income needed to pay your mortgage payment) than they were in 1980.

Real Estate Bubble, Chart 3: Housing Affordability Index

So the supply of new homes is still low these days... and homes are affordable nationwide (at least according to the national statistics-the real estate bubble areas of course are an exception). Based on this, surprisingly, home prices nationwide can climb higher.

The Big Threat: Alan Greenspan

Alan Greenspan seems bent on hiking short-term interest rates. The problem is, long-term interest rates haven't been rising with his hikes in short rates. So that actually puts the economy in a dangerous position...

The financial markets expect Greenspan to raise short-term interest rates to 3.75% by the end of this year. Meanwhile, long-term interest rates right now (as measured by the 10-year Treasury bond) are below 4%. So if Greenspan goes through with raising rates as promised, then the spread between long-term and short-term interest rates will obviously be very tight.

The lesson from history is: whenever short-term interest rates rise above long-term interest rates, the economy goes into recession. Here's a chart going back to the early 1960s. As you can see, for the last 40 years, whenever short-term rates rose above long-term rates (whenever the blue-line crosses below zero), the economy has dipped into recession.

In 1990 and in 2000, short-rates just briefly crossed below zero, triggering a recession. Could Alan Greenspan trigger another recession? Absolutely...

Real Estate Bubble, Chart 4: Yield Curve vs. Recessions

(A note about this chart: I carried this chart out to the end of 2005, and I assumed (as the markets do) that Greenspan will hike rates in September and November, bringing short-term interest rates up to 3.75%.)

Recessions Have a Huge Impact on Real Estate and New Home Prices

The chart below tells the story. Every bar in grey is a recession. And as you can see, recessions are very bad for new home prices. Really, over the last 40 years, the only times that new home prices have fallen are in or around recessions.

Real Estate Bubble, Chart 5: New Home Prices, Adjusted for Inflation

New home prices have taken it on the chin in most of the past recessions. After a big rise in home prices in recent years, a fall in home prices in inflation-adjusted terms seems pretty certain. And a double-digit percentage fall isn't out of the question at all.

To sum it up again, we know for a fact that home prices have risen, but the storm clouds don't really seem to be gathering, based on the nationwide data as shown above. (The anecdotal evidence, however - the cocktail party chatter over the real estate bubble - really spooks me, as I know there's no free lunch, but everyone wants to believe differently.)

Based on the data, the big threat is probably Alan Greenspan hiking rates too quickly, which could inadvertently cause a recession.

Recessions follow booms. There's no way around it. And as the last chart shows, new home prices (adjusted for inflation) have a hard time avoiding the wrath of recession.

New real estate home prices could keep going up in the short term. But a return to "normal," where the median family can afford the median home, will no doubt return, ending the bubble's run. To get to normal, either household incomes have to rise significantly or home prices have to fall. Which do you think is more likely?

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Today's IU Cribsheet

  • To read more on the real estate bubble situation in 2006, including movements in home prices recently, see the National Association of Realtors Housing Affordability Index (you need to have Adobe Acrobat Reader installed to view this chart). The NAR has a great website: http://www.realtor.org

Good investing,

Steve

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