Bubble Babble?

IndustryWeek's Michael Evans recently penned a column titled Ignore the Bubble Babble, in which he argues that the runup in housing prices will not 'pop' like a bubble, but will still increase in price, albeit much slower and much more in line with inflation. Evans pulls no punches, starting out the article with:

U.S. housing prices, on average will rise 2% to 3% next year, the same as the rate of inflation. In 2007, they will rise 4% to 5%. These projections are obviously well below the average rise in housing prices of the past four years. But they don't constitute the bubble-bursting scenario being put forth by many alarmists.

His assertions stem from two observations:

1. Interest rates drive home prices - Evans concedes that, yes, interest rates will increase over time, but it will be several years before they balloon to a point that will hamper house price appreciation.
2. There is a large contingency of buyers - rising prices have pushed people out of the city and into ex-urbs, requiring long commutes. As prices start to stagnate and come down a bit, Evans argues, those out in the ex-urbs will snatch up the depreciating homes in the 'hot' real estate areas, thereby keeping the prices from a bubble-like bursting.

I think Evans's first observation is valid. Interest rates do, in a large part, drive home prices, because they dictate how much house one can buy. Personally, I don't think interest rates should matter, since in an ideal world people would buy what they could afford in the grand scheme of things, not buy what monthly payment they can stomach. This attitude is what led people to the interest-only and option ARMs that are going to cause grief as their fixed terms end and interest rates continue to climb. Regardless of my personal feelings, though, interest rates do, obviously, serve as a barometer for house prices. The large runup in house prices over the past half-decade has been due in large part to the vast liquidity in the marketplace thanks to the lowest interest rates in history.

While the first observation is notable, I find the second one laughable. The only people that could move from the ex-urbs into the more expensive city areas would be those who are renting in the ex-urbs and have saved large amounts of money. If these ex-urbians are home owners, who's going to buy their house? If the city areas start depressing in price, why wouldn't the same effect be seen in the ex-urbs? And wouldn't the effect be exascerbated?

Considering that Americans are saving 0% of their income and many people who moved out to the ex-urbs moved there because they wanted to own a home, I don't think that there will be a flock of ex-urbians into the city to help prop up city prices. Even if, somehow, ex-urb home prices stay high admist falling city prices, wouldn't that scare the home owning population out in ex-urbia to hang onto their house? Our society views a house as one's greatest financial asset, so why would someone sell their appreciating house to buy a depreciating dwelling back in the previously 'hot' market?

Evans's argument basically ignores elementary economics: renewable resources move in cycles and what goes up always comes back down eventually. All one has to do is look at a graph that shows the ratio of mortgages to income and realize that such a long, upward progression is bound to reverse itself. Those that think otherwise are just delaying their own personal day of reckoning. (Some good graphs are available at Speculation in San Diego and You'd Be Smarter to Rent.)

Condo-Tels in San Diego

Condo-Tels, which are essentially condos/hotel rooms owned by a particular person who can rent out the unit on a nightly basis through the hotel, are popular options in Las Vegas and Orlando, two very touristy cities. Now, it appears, they're coming to San Diego. The Diegan is being built in the historic Gaslamp district with studios starting at $450,000 and the penthouses clocking in at over two million. Diegan president Jim Trammell describes the condo-tel as thus: "It's a hybrid vacation home ownership product where you enjoy the amenities of your hotel room that you purchased as a buyer and when you are not using it you share in the revenues with the hotel operator." (Source)

Do such units make sense as an investment? The numbers don't seem to add up to me. Imagine that you purchase one of the studios for $450,000 with $50,000 down on a 30-year fixed mortgage at 6%. (Yes, I know most "investors" in real estate would rather go with the option ARM or I/O loan, but let's be real - the attractiveness of these loans are quickly losing their luster as the Fed continues its interest rate hikes and the effects of inflation set in...) That would be a mortgage payment of just under $2,400 per month on the $400k balance. Now, the units are cleaned nightly by maids, and from my understanding the hotel does the bookings. So what's that got to cost, maybe a few hundred per month? Throw in property taxes and condo insurance and we're quickly going north of $3,000 per month.

Let's assume that it does run exactly $3,000 per month, which I think is a bit low. To break even on your "investment" you'd need to book it EVERY night of the ENTIRE year for an average of $100 per night. I'm guessing that while the studio itself might run north of $100 per night, the hotel's taking off a percentage for the booking, cleaning, etc. In other words, it looks as if a condo-tel is anything but a wise investment.

Sure, if you're going to be using the unit often, it might make sense. A ~$100/night unit is cheaper than any decent downtown hotel room, plus you can rent it out on the off nights or loan it out to friends and family. Hrm, sounds an awful lot like a time share, which are pretty horrid investments to enter.

A condo-tel might make sense in more reasonably priced real estate markets, but at today's overinflated costs, dropping the money for a glorified time share seems like a losing proposition to me.

How Deep Does This Bubble Cut?

One thing I've often wondered about is just how profound this housing bubble's effects will be. When this bubble bursts, what will happen to the US economy? What will happen to the world economy? Will we be able to effectively shrug it off, much like we did when the dot com bubble popped? Granted, there were a couple hard years, some layoffs, some start ups shutting down, but nothing on the magnitude of hard times this country has seen before.

Many argue that we rebounded from the dot com crash because of the boom in the housing sector, made possible in large part due to the Fed dumping money into the markets. But now the Fed is tightening up their money policy at the same time the housing market is beginning its decline.

One person who sees trouble when the housing bubble bursts is Roger Bootle, economic adviser to accountants Deloitte & Touche LLP and a former adviser to the U.K. Treasury, who wrote: "Like the earlier bubble in shares, the extent of overvaluation is different in different countries, but this is a global phenomenon. In the end, this bubble may be more serious than the primary bubble in shares. When it bursts, the world will tremble." (Source)

Not all people are so pessemistic. Edmund Seifried, professor of economics from Pennsylvania's Lafayette College had the following to say: "We can keep the economy moving and deflate this housing bubble, and not pop it, if interest rates stay low. ... Even if we have a slip-up in the economy, we still live in the best economy in the world. If we have a recession, your lifestyle will barely change a bit." (Source) That last line sounds a bit pompous - try telling that to the guy who just lost his job and now can't afford his overpriced, overfinanced home.

Median House Price in SoCal at All Time High

Even with rising rates, inflationary fears, and increased inventory, home prices in Southern California hit an all-time high in August 2005. From Median Price Of San Diego Home Over Half-Million:

"The median price of an existing home in the San Diego region last month was $616,870, 6.5 percent higher than the same period a year ago, according to a Realtors group. Sales in the region last month were up 5.4 percent when compared to July, and 3.1 percent higher than in August 2004, when the median home price was $579,040."

Is this figure - $616k and change - going to be the all-time high for the far forseeable future, or do we have more appreciation ahead of us? It's hard to imagine that the bubble will continue, that September's median price will eclipse August's, but stranger things have happened. What's especially telling is the poll on the article, which queries readers for the amount of home they can afford to buy. 80% of the readers indicate that they can only afford a home between $0 to $300,000.

A South of the Border Bubble

The San Diego Union Tribune recently had an interesting article on the housing boom that's happening to San Diego's southern neighbor, Baja California, Mexico. The article - Baja's Building Boom - looks at the latest real estate boom in coastal Mexico and, thankfully, takes a fairly balanced looked at the pros and cons. (It's nice that media outlets have gotten over the "OMG! Real Estate roxs, it is da bomb! Buy and be rich!!!!!11!!!!!1!!")

What attracts real estate investors south of the border is, simply, the low prices. For example, one can land a beautiful ocean-side single family home in Mexico for around $200,000 US dollars. Such a home in coastal California would easily surpass the million dollar threshold. Of course, in California US citizens can own coastal property and there's much less chance that the government can seize your land, which might explain the price differences. Some other reasons might be that in the US the economy is stronger, the government less corrupt, and the real estate laws more favorable to US citizens. But what do I know - I only own one piece of property, after all (my primary residence).

The article does a good job of highlighting the "issues" with a US citizen buying property in Mexico. From the article:

The Mexican Constitution bans foreigners from owning coastal residential property, so most oceanfront buyers hold title as beneficiaries of long-term trusts through a Mexican bank. Financing is more difficult and expensive, and required down payments can be as large as 50 percent of the purchase price. Real estate agents are not licensed as they are in the United States, and they have no legal obligation to disclose potential problems with a property.

Scary. But these conditions aren't scaring off everyone. As the article notes, "More and more are drawing equity from their primary homes in the United States to finance second homes in Mexico."

In addition to the Union Tribune article, there was also a good episode on the KPBS radio show These Days - How secure is buying land in Mexico? (Don't know how long this MP3 file will be available, but you can listen to the show at http://stream.publicbroadcasting.net/production/mp3/kpbs/local-kpbs-484927.mp3.) Host Tom Fudge had on three guests:

• Adrian Martinez, Mexican Attorney licensed to practice both in Mexico and California
• Nicolas Renard, independent real estate agent specializing in the Rosarito/Ensenada corridor
• Serge Dedina, Ph.D. Executive Director of Wildcoast

The first two guests talked about real estate law, title insurance, and the process of a US citizen buying property south of the border. The third guest, Serge Dedina, talked about the environmental impact of the increasing building along the pristine Baja California coastline. Overall, a very interesting half hour discussion - check it out!

My end opinion, which is, of course, bearish - when the US property bubble bursts, prices will plumit in Mexico. What's keeping these prices afloat other than foreign investors? (Interesting factoid from the These Days show: prices in Rosarita have increased nearly 100% in the last three years, due solely to US investors.) When the burst occurs, expect investors with Mexico holdings to attempt to sell those first, before having to liquidate their US-based assets. And who's going to buy in Mexico when the picture is so dire stateside?

We've Crested the Peak

After years of run-ups and double-digit appreciation in the real estate market, I think it is safe to say now that we've crossed over the peak of the mountain and are ready to begin our trek down. Anecdotally, I've been noticing this here in San Diego for several months now, with homes staying much longer on the market, with prices being reduced, with the sharp increase in the number of 'For Sale' and 'Open House' signs. 18 months ago you could just slap up a 'For Sale By Owner' sign in your front yard and have he place sold within a week. These days, though, I see dozens of 'Open House' signs on the corner each weekend... one condo conversion project down the street has even employed sign flippers to stand out on a corner and toss the 'Condos For Sale!' sign up into the air, in a lame attempt to sell.

My sentiment and observations appear not to be just a SoCal thing. From
Slowing Is Seen in Housing Prices in Hot Markets, authors David Leonhardt and Motoko Rich note:

A real estate slowdown that began in a handful of cities this summer has spread to almost every hot housing market in the country ... More sellers are putting their homes on the market, houses are selling less quickly and prices are no longer increasing as rapidly as they were in the spring... Brokers said that some houses seemed to be on the market longer because sellers priced them too high, assuming that their value was still rising sharply. In other cases, people who otherwise would have waited a year or two to sell their homes - like empty nesters ready to move into smaller quarters - had listed them now out of fear that prices would soon fall.

Too many sellers asking too much money and not enough buyers. In addition to this fact, lenders are tighening their credit standards, making the "easy money" of past years harder to come by. Couple that with the rise in interest rates, and it's no surprise that home prices are facing a decline.

One of the best ways to guage the fiscal health of a sector or business is to examine what the top brass are doing - how are the CEOs and board members positioning themselves? For real estate, the picture is dire, as "executives at big home builders have sold almost $1 billion worth of company stock this year." Eep. I pity the suckers investors that bought those shares.