Bubble or not?

So, the world is obsessed with real estate and thus there can be no going back. Or, it’s a bubble, and it’s bound to end soon. Which is it? Of course, no one knows. After years of obsessive fascination with booms and busts, depressions and recessions and crashes- I think the one thing that can be said is that although the bubble itself is often perceptible, no one can predict exactly how—or when—it will all come crashing down.
So, with that in mind boys and girls, I thought it would be more valuable to speculate on what might happen if it is indeed a bubble. First of all, you won’t know when the end comes. It will most likely sneak up on you. As the wall street journal said in an article yesterday, people don’t all of a sudden sell the house like they might sell their stock portfolio. Even if they are margined to the hilt, they don’t get the infamous margin call: the house does not go on the market the next day.
But I thought I’d use the experience of the crash of 1988 in the oil belt: Houston, Oklahoma City, Anchorage and all of Alaska. Here’s what happened in Alaska. First was the oil pipeline boom. As construction ramped up, the state was flooded with new workers, and everyone needed housing. Lenders loosened up on the rules to get houses built fast. And they were bought as fast as they could be built. Then came the oil royalty boom: the state allocated money for new construction projects faster than you could spit. Another construction boom, and houses did not loose value, so they must gain value, right? Then came the precipitous drop in oil prices- the state, having eliminated all forms of taxation was wholly dependent on the oil companies, and had to cut the budget not only for construction projects but for services. The cuts radiated down through local governments and the universities and then the schools. And on and on. People who had moved to Anchorage in the previous few years had bought houses at the top of the market, in 1986. They were also the people who lost their jobs first. So they put their homes on the market, and when they did not, could not, sell for what they owed, they walked away….. gave the keys to the bank. [Do the math: you bought the house for $150,000, 10% down, you owe $135,000, and it might sell for 115,000. You owe more than its worth.] And these were not only state workers: companies posted new managers to Alaska to get in on the boom, and pulled them out just as fast when it crashed. Condo buyers were in even worse shape, as potential buyers could buy a single family house for the same price.
Now, the boom in the 1980s still required borrowers to put down 10 or 20%. There were no interest only mortgages. And few units were sold to real estate speculators. In the most worrisome development of the recent boom is that in some markets, like Tucson, as many as one third of the buyers are investors. So, around Tucson, you see “For Rent” signs cropping up like weeds. What is going to happen is that first, the investors who cannot afford to hold the property without the rent income are going to cash in. Then the percentage of owners who have to sell because of a move, transfer or divorce are going to have to put their homes on the market. These homes will compete with those of the investors. The prices will go down, a significant portion will go into foreclosure as the owners walk away, just as they did in the eighties. Prices will fall. But it won’t be widespread, at first. Maybe there will still be investors willing to make the bet on the lower priced housing stock and the foreclosures. But, soon after, the investors will spook. One third of the buyers will exit the market probably all at once, pulling the floor out from under house prices.
This is what will happen in Tucson, Alaska and peripheral markets. But what will happen in the center of the bubble: Washington DC, California, New York, and Florida. This is where the talking heads and prognosticators keep saying the demand is driving the prices. Each may be a unique situation. Switch over to PBS for the documentary about the middle-income couples from the mid-west buying not one, but three yet-to-be-built condos in Florida. When your grandmother’s Hispanic hairdresser’s uncle is buying real estate for an investment, this is a bubble. So, same thing as Tucson, only faster. Developers with highly leveraged and unsold stock will dump it on the market at rock bottom prices, as will the banks that are left holding the bag.
Californai is always a special situation. “San Francisco and Bay area real estate will always go up.” Is this a law of god? The bay area golden egg will crack from the outside in. Many people are going further and further from the core to buy cheaper houses. These people will be the first to bail. The prices will crash first on the outer rim. This will soften prices on the next close concentric ring of communities. This will soften prices in the core areas of san Francisco, Silicon Valley and Berkeley. But, if the house you bought ten years ago for $300,000 is valued now at $500,000 instead of $650,000 have you lost money? The answer to this question is “no” unless you have borrowed on the home equity above the new lower value of the home.
So the stble homeowners will probably not be hurt. Those hurt will be the last in. And of those, only those who borrowed more than the house’s new value. And those who have to sell because of circumstances. Even people who have to sell will not be devastated unless they borrowed more than the hosue was worth. The worrisome trend here is the vast number of people who have been convinced that they can and, thus should, buy a $450,000 condo in downtown Los Altos with nothing down and an interest only mortgage. And this is the trend that probably describes overheated markets like Washington, Boston and New York as well.
So, what should you do? Is there anything worth buying? My next edition will tackle that problem.




Real Estate, the Global Obsession - New York Times