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Here’s Danny’s question: “It seems that conversations regarding the real estate industry, how much people are making off of real estate transactions, etc. have replaced the daytrader, stock-market conversations of the late ’90’s. Back then, everyone suddenly became a stock market guru, and now everyone thinks they are a real estate mogul. We all know how it turned out with the stock market. What do you think about real estate? The discussion should be somewhat general, but for my sake, a specific section addressing real estate in Southern California would be helpful.”

What is going on with the residential real estate market? Will it crash like the market for tulip bulbs (1637), the South Sea Company shares (1720), the Klondike gold rush (1899), railroad stock (1900s), Australian mining shares (1970), Japanese assets (1980s), and dot com stocks (2000)? Or is it a fundamentally sound increase in value?

What is a bubble?

According to Econ 101, a bubble occurs when speculation in a commodity causes price to increase, and the increase attracts more speculation, until the price rises far above the real intrinsic value. The definition is rather unhelpful until a bubble has burst, since it’s not clear what distinguishes speculation from smart investment, or how to judge the intrinsic value of real estate.

Many people say confidently there is no bubble. Upon their last visit to a Sunday open house, lots of people showed up wanting to make a purchase. The few houses for sale go quickly. However, looking at how things are doing now doesn’t help you discover a bubble. Every bubble, until it collapses, has plenty of current demand and a very limited current supply. If that weren’t true, the price wouldn’t be increasing rapidly for such goods on the upslope of the bubble. Yet rapid increases in prices aren’t automatic signs of a bubble. They may just be the market recognizing a good investment. If current reality is no help in defining a bubble, what can help us describe a bubble?

Looking to the Future

Whether a bubble exists today is based entirely on what the supply and demand will be in the future. When the supply in the future will be plentiful, and the demand in the future will not keep up, prices are going to crash. When the supply in the future will stay restricted, and the demand in the future will stay strong, prices will stay high or keep increasing, and there is no bubble.

How do we predict what the supply and demand will be in the future? The first thing to realize is that since we can’t know the future with certainty all we can do is talk about what the probable future will be and the amount of risk that people are taking currently to reach the future they think will happen. To do that, we have to look at what people are buying today, how supply works today, how demand works today, how the past changed into today, and how today might change into the future.

What’s really being sold?

When people buy real estate it is a very personal decision. No two properties are exactly alike, but there are roughly similar alternatives. There are always two components to every choice: the raw land (the size of the plot, its location, the zoning rights attached to the land) and the structures built on the land (such as a house, condo building, etc.). Is the increase in real estate prices due primarily to the raw land or the improvements on the raw land?

Here are a few clues: Identical houses in different markets, like Los Angeles versus Omaha, sell for very different prices. Even in Los Angeles, where a property sells for $800,000, the cost of constructing the house from scratch is perhaps $250,000. Warren Buffett recently pointed out that he sold a house that might cost about $500,000 to replace, built on 2,000 square feet of land in Laguna, California, for $3.5 million. That values the land at $60 million an acre. As construction technology continues to improve, the dollars paid for the quality of construction received has likely trended downwards. It therefore seems pretty clear it is the value of the raw land that has increased significantly, not the value of the improvements.

All land is not equal. Many people desire to live in or near a city despite the disadvantages (crime, pollution, larger schools, etc.) in return for the advantages (variety of activities and people, economic opportunities, nightlife, etc.). As population density increases in cities, traffic becomes worse, creating a desire in people to live closer to where they work. The latest trend in city development is therefore mixed use, where the lower parts of a building are commercial, and the upper part is residential. Some cities, such as San Francisco, and the interior portions of Los Angeles, are significantly built out. New development would require tearing down existing structures, which costs significant capital since the land and old improvements must be paid for. Once the horizontal expansion has built out all available raw land, construction upwards becomes economically preferable, giving rise to high rise condominium or mixed use projects.

Demand.

Let’s consider the demand for raw land. For any particular price what matters is not how many people want to own the property, but what the purchasing power of the people who are actually willing to be in competition for the property is. There are three ways in which purchasing power has increased in recent history:

As salaries of Americans have risen over the last few decades, their purchasing power has increased. The income of the very rich has outpaced the income growth of lower income levels. The effect of this income disparity is most visible in the stratospheric increases in the costs of very high end real estate properties.

The second change is that long term interest rates lowered significantly in the late 90s, reaching and then stabilizing at rates that by historical measures are very low. Interest rates to an extent depend on the actions of the central banks of many countries. The Federal Reserve in the United States, for example, can affect interest rates by requiring loan generating banks to hold more of their cash in-house, rather than lending it out.

Why would central banks ever raise interest rates? Raising interest rates can stave off inflation (the weakening of the purchasing power of the money in your pocket). Because of impressive productivity gains in the early part of this decade, probably partly due to just in time workflow techniques and partly due to globalization of worldwide supply chains, the Federal Reserve determined it could allow lower interest rates without inflation becoming a problem. The lower interest rates made it less expensive for banks to loan consumers, like you and me.

The most significant and far reaching change in purchasing power, however, is the result of another change, the revolution in the structure of the mortgage loan financing industry that has taken place over the last 25 years.

The transformation in lending.

Once upon a time a bank would loan money to its customers for a house. The bank would bear the risk that the customer would not pay their loans in a timely fashion, and thus it was pretty stingy with its lending.

Now there is a reseller market for mortgages. A bank lends its customer the money for a mortgage. Some very large companies, Fannie Mae and Freddie Mac among them, package together the rights the bank possesses to be paid for a number of mortgages, and sells the bundle of rights to foreign countries, pension funds, and other large institutional investors. Although such bundles of mortgage rights are more risky then government bonds, they carry a slightly higher return, and are felt to be safer than many other investments because they are backed by people’s houses. China has been a particularly large buyer of such mortgage backed investments, which it uses to currency pressures.

Notice how the incentives have changed. Before it was the incentive of the bank making the mortgage loan to be stingy with its money. The bank held the risk that the loans would turn out bad. But now the bank is no longer in the business of bearing most of that risk. It is in the business of marketing and selling mortgages. It collects information that is analyzed by the mortgage reseller’s computer algorithms for likelihood of default. It is the incentive of the bank to come up with ever more clever ways to lend money, because it can turn around and sell mortgages through Fannie Mae or Freddie Mac to the Bank of China or pension funds. It is to the advantage of Fannie Mae or Freddie Mac to slice up the data on creditworthiness in as many ways as possible, so that the widest array of mortgages can be sold and resold.

There are many mortgage lending banks, and they are in intense competition with each other. A home or condo buyer uses a mortgage broker, a person familiar with the products of different mortgage lending banks. There are standardized forms and information, making the process of applying to multiple mortgage lending banks much easier.

To generate a profit, the mortgage lending banks come up with new products that can divide up the customer base into finer and finer slices. Can’t afford a loan for a fixed rate, they’ll offer an adjustable rate with a fixed 7 year term. Or a three year term. Or if you can’t afford an adjustable rate, they can offer a negative amortization loan, which starts with low payments, then increases the amount of principal you owe early in the life of the loan. Or instead of a 30 year term for the loan, you repay the loan over 40 years. All of these products require less cash to make a home purchase in the near term but can devour cash flow at higher rates later on and for longer.

Although the new mechanism of providing loans creates significant ethical risks, particularly between the mortgage brokers and the mortgage banks, it is much more efficient than the old system at meeting the expressed desires of loan customers. The process of selling loans, creating a bundle of loans, and reselling the loans has also greatly expanded the pool of capital that is being used to supply loans to real estate buyers. It has also sped up the innovation of new loan products.

The shifting of risk has increased purchasing power.

Notice as well that the more risk someone is willing to take on with their loan terms, the greater their purchasing power. This is similar to the college girl who decides to buy a luxury purse although she can not really afford it. She can just buy it now and take the consequences later. No longer are the goods completely out of reach. With the real estate industry the situation is exacerbated, because many years of low interest rates have given people the confidence to give up fixed rate mortgages in favor of hybrid adjustable rate mortgages, or pure adjustable rate mortgages, or even negative amortization loans. They can pay less out of pocket now, but still pay a higher price.

How do Demand and Supply create a Market Price?

How much of the increase in home prices is because of the lack of a supply of optimal land to build on, and how much is due to the increase in purchasing power made possible by these new forms of loans, continued low interest rates that encourage more risky borrowing, or rising salaries?

The critical idea to keep in mind is that a decrease in supply will not raise prices significantly unless the buyers in the market place have both sufficient desire and sufficient purchasing power. Similarly, an excess of purchasing power won’t matter if there is a significant increase in the amount of goods being supplied. The question is not whether supply is insufficient or whether demand is strong currently. If either supply will be increased significantly in the future or purchasing power will weaken significantly in the future, there is a bubble.

Will supply remain insufficient?

The high pricing of real estate has encouraged the building of housing, where it can be built. Where horizontal development is possible, like in Ventura County, tracts of homes have sprung up. Where horizontal development is not possible, apartment buildings are converted into condos, industrial buildings are being converted into lofts, houses are being replaced by four story wood frame condo complexes, and where possible (like in the Wilshire corridor) multistory steel frame condo towers are being built. Despite these measures, in cities, particularly in hard to develop regions of cities, there is likely to be restraints on supply.

Notice that new condos are much easier to create than new houses in an urban environment. Therefore, we can expect that if the bubble pops due to an increase in supply, the bubble will pop more strongly in the condo market than in the house market.

Will purchasing power strengthen?

The real problem with real estate prices increasing indefinitely is that purchasing power can not keep increasing indefinitely. Indeed, it is likely that purchasing power will diminish within three years, particularly in big cities.

In most of the country, the ratio of home prices to annual income is modest, 2.4:1 in Wisconsin, 2.2:1 in Kentucky, 2.9:1 in Illinois. In 20 metro areas the ratio is out of balance. In California, the price of a home stands at 8.3 times the annual family income of its occupants. Although salaries have risen faster in cities than in the nation as a whole, the gap is too big to sustain. In California, a middle-class family with two earners each making $50,000 a year now owns, on average, an $830,000 home. In the late 80s, the last time these eight states saw price-to-income ratios this high, the real estate market collapsed. You can’t cover the gap with rents. While real estate prices have soared, rents have stayed flat, suggesting that new landlords are buying homes without a reasonable expectation of covering the cost of such homes with rental income. They may instead be betting on price appreciation.

The movement of buyers into more risky types of mortgages, from fixed rate, to hybrid adjustable rate, to purely adjustable rate, to negative amortization loans, also has a limit. In the Los Angeles market over 50% of buyers are using an adjustable rate mortgage of some variety. According to the Federal Reserve, on a national basis homeowners now have equity of 55% of their housing value, down from 72% in 1986.

Mortgage rates are closely tied to the market for long-term government bonds, which are benefiting from purchases by foreign governments, particularly in Asia, that continue to buy Treasury bonds, as well as from investors looking for a haven from risky corporate securities.

The Federal Reserve has stated it has a policy of gradually increasing rates to fight inflation. The Chinese can’t keep buying US currency forever; at some point it’s in their best interests to let their currency float, and when they do the Chinese central bank’s buying of US currency denominated treasury securities and mortgage bonds will diminish. And at some point lenders in cutthroat competition with each other, offering more and more enticingly structured transactions to lure in customers, will find that those loans in different economic conditions will be defaulted upon. Some lenders will go bankrupt, and others will find themselves tightening their lending policies, further decreasing the purchasing power available in the market.

So, is there a bubble?

I don’t think one can positively say there is or isn’t a bubble. It’s something that’s decided in the fullness of time, once you can see what the future held.

However, it seems to me the purchasing power of consumers can’t keep increasing indefinitely. The substantial structural shifts in the competitiveness of the lender market have encouraged lenders to create new loan products that shift more risk to consumers. Interest rates have remained low for a very long time. This has allowed purchasing power to keep increasing, stretching what the incomes of consumers justify. It doesn’t seem to me that this structural shift and low interest rate environment can keep generating higher and higher amounts of purchasing power. Growth in purchasing power will slow, and likely drop.

I’m less convinced that supply will grow. In some urban markets there does seem to be limited supply, which can be alleviated for condos much more easily than houses. However, if there is a significant enough drop in purchasing power, it could cause foreclosures that increase supply, and cause investors to try to sell investment properties because they can not rely on gains in asset prices, and must instead rely on cash flows that have turned negative. Therefore a significant enough drop in purchasing power may also cause supply to grow as foreclosures rise, investment properties are sold at a loss, and lenders tighten their standards creating fewer eligible buyers.

If the bubble does pop, when will it happen and where will it hit hardest?

Largely it depends on where you live, what kind of real estate you are talking about (condos vs houses), how much of the real estate out there is bought by people who are stretching their purchasing power and taking risks, and whether the popping is due to a decrease in purchasing power, an increase in supply, or both.

The highest risk and the fastest pop would therefore be in neighborhoods where people recently purchased condos that they bought at the limits of their purchasing power, particularly as a second or third property, particularly where there are still new condos being built. Purchasing a condo in a new condominium tower next to another condominium tower that is half way built would therefore seem the worst investment to me, and the most susceptible to the 2-4% rise in rates the Federal Reserve will likely cause within the next 2-3 years. The lowest risk and the slowest pop would be in neighborhoods where houses were purchased to be lived in, were purchased some time ago (or by people whom are well capable of affording the homes), and new development is difficult. In some such situations, prices may not decline, although they may remain stagnant.

Update, 9-22-05: Here’s an interesting idea: New homeowners can now buy a home, but not the land underlying it, which is instead held by a nonprofit trust. Kind of like renting, but you actually are acquiring ownership of the improvements on the land. For more on the concept, click here.

Update, 12-8-05: According to the Wall Street Journal, the real estate market is weakening. Click for more here.

Update, 9-1-06: Here’s an excellent post by Fabrice Grinda on the economic analysis of residential real estate: http://www.fabricegrinda.com/?p=105

I remember a year ago listening on NPR to a man explain exactly how and why New Orleans was vulnerable to a direct hit or near direct hit from a hurricane. He explained the importance of the levees, their weaknesses, the likelihood of devastating floods. He painted a bleak picture with impeccable logic. That man on NPR talked about what could be done, what had to be done, to avoid the risk.

Alot of people are pointing out the Bush administration, rather than expand the funding for such protection, cut it (see Newsweek; compare with FactCheck.org). Those with the knowledge, but not the resources, were unable to convince the gatekeepers of the resources.

New Orleans officials are saying FEMA isn’t present. FEMA says it doesn’t move in when people are shooting at them. The military wasn’t set to go in immediately. You could say that this disaster was unprecedented, and thus hard to plan for.

But we already had 9-11. What is the Department of Homeland Security for, if not to prevent and if necessary coordinate responses to disasters? If the disaster was completely unforeseen, then the question would be how to foresee better. But with both 9-11 and Katrina, the risk was foreseen by someone. A novelist, a French investigator, an FBI agent, knew terrorists might crash planes into buildings. That man on NPR and the Army Corps of Engineers pointed out the risk of a powerful hurricane to New Orleans.

There are people with the knowledge in both instances. But they can’t get the attention and dedication of those with the resources. And it’s happened in two major crises now. That points not to a problem of knowledge, or of resources, but of the system by which the resources are attached to the knowledge. It’s a problem in the system, not just the planning for one crisis.

Update, 9/6/05: “Governments at all levels failed,” Sen. Susan Collins, R-Maine, said at the Capitol. She announced that the Senate Governmental Affairs Committee would hold hearings, adding, “It is difficult to understand the lack of preparedness and the ineffective initial response to a disaster that had been predicted for years, and for which specific, dire warnings had been given for days.”

Update, 9/13/05: Newsweek has a good preliminary review of the federal, state and local lack of response to Katrina.