The following is an excerpt from the article appearing on the Thinking Outside the Boxe website www.thinkingoutsidetheboxe.com. Click here to download the full article.
Throughout history there have been many speculative bubbles in various markets—tulip bulbs, peanut oil, railroads, tech stocks, and now, perhaps, real estate. There has been much speculation in recent months amongst the media, investors, policymakers and analysts that the United States real estate market is in a dangerously expanding, speculative bubble. The bursting of this speculative bubble could have significant damaging repercussions for the economy, much like the internet bubble in which tech stocks inflated and collapsed, sending the economy into a tailspin. But is the real estate market really in a bubble or are there merely isolated areas of speculative fervor throughout the U.S.?
Thinking Outside the Boxe examined this issue extensively and concluded that there are substantial risks to the real estate market and the broader economy stemming from the current speculation in certain markets throughout the country. In addition, Thinking Outside the Boxe believes that the preponderance of evidence is towards a severe speculative bubble surrounding select real estate markets rather than a systemic misalignment between real estate prices and fundamental value.
To begin, it is important to understand a basic financial concept. The fundamental value of any asset is the sum of the present value of the cash flows expected to accrue to the owner of that asset, discounted at the appropriate rate to reflect investor preferences and risk. Financial assets, such as stocks that may pay dividends or bonds with a coupon payment, may be valued by discounting the future cash flow (dividends or interest) to a present value. A privately-held business may be valued by discounting the future cash flows to the owners to a present value. Likewise, real estate may be valued, in theory, by discounting the future rental income or the owner’s equivalent rent to a present value to yield the fundamental or intrinsic value.
A speculative asset bubble could be characterized by a significantly large and lengthy positive deviation of market prices from the fundamental value of the asset. Unfortunately, there is no model or set of guidelines that quantifies what magnitude of deviation constitutes a bubble. Typically, a substantial deviation from the long-run average (a deviation which is not supported by any underlying financial or economic fundamentals or is contrary to fundamentals) is a useful measure in assessing the potential for an asset price bubble.
For example, the real estate market has experienced price appreciation at a rate that far outpaces the growth in implied rental values with the price-rent ratio roughly 18% higher than the long-run average. As John Krainer indicates in “House Prices and Fundamental Value” from the October 1, 2004 FRBSF Economic Letter, the U.S. price-rent ratio (the existing home sales price index published by the Office of Federal Housing Enterprise Oversight divided by the owner’s equivalent rent index published by the Bureau of Labor Statistics) has increased dramatically over the last three years from roughly 1.1 to nearly 1.3. Mr. Krainer concludes the following with respect to the current level of the price-rent ratio:
The price-rent ratio for the U.S. and many regional markets is now much higher than its historical average value…We found that most of the variance in the price-rent ratio is due to changes in future returns and not to changes in rents. This is relevant because it suggests the likely future path of the ratio. If the ratio is to return to its average level, it will probably do so through slower house price appreciation.
To be sure, the U.S. real estate markets have experienced a significant increase in prices, particularly over the last year. According to the Office of Federal Housing Enterprise Oversight (OFHEO), the real estate market has appreciated by 5.4% annually on average over the last ten years. Since the bursting of the speculative bubble surrounding technology stocks in 2000, however, house prices have appreciated by an average annual rate of 7.4%. Since the beginning of the recession during the first quarter of 2001, house price appreciation has averaged 7.1% annually.
The strength of real estate appreciation has been confirmed by the National Association of Realtors, whose data indicates that home sales have experienced significant gains in 2005. During the first half of 2005, total existing home sales have experienced consistent year-over-year growth in the range of 4-5% each month. In fact, the second and third highest levels of homes sales ever recorded occurred in April and July of this year.
The median national existing-home price has increased by double digits on a year-over-year basis and stands at roughly $218,000 as of July 2005 (up 14% from $191,000 in July 2004). The prices of condominiums have also experienced phenomenal growth, increasing at double digit rates between 11-18% throughout the first half of the year on a year-over-year basis to roughly $219,000. For 2003 and 2004, the median sales price of existing single-family homes increased by 7.5% and 8.3%, respectively. Though total existing home sales have been strong, perhaps suggesting a natural increase in demand as opposed to a speculative bubble, price appreciation has increased at a much more rapid rate during the period, perhaps indicating a shortage of supply for the level of demand. However, there has been no indication of an imbalance between supply and demand in the real estate markets which would account for the rapid increase in real estate prices.
The rapid price appreciation that has characterized U.S. real estate markets and suggested the development of a speculative bubble has been more pronounced in many local markets. In the Myrtle Beach (Horry County), South Carolina area, sales of new condominiums increased by 400% in the first quarter of 2005 on a year-over-year basis, according to Market Opportunity Research Enterprises as quoted in Realtor Magazine. The number of resale condos doubled during the first quarter on a year-over-year basis with the median price for resale condo units increasing by 25% to $138,900 from $111,000. The median price for new condos increased 35% to $164,900 from $122,040 during the first quarter on a year-over-year basis.
In Miami, Florida, where there are more than 11,000 residential units under construction in the downtown area alone, 23,000 additional units approved, and 27,000 units planned , investors have witnessed an increase in the median sales price from $189,800 in 2002 to nearly $316,000 in the first quarter of 2005. The median sales price in Miami increased by 19.4% in 2003 and 22.2% in 2004. For the first quarter of 2005, the median sales price had increased by 13.9% from the 2004 level.
Orlando, Florida has also experienced a rapid price appreciation for existing homes with the median increasing 6.22% in 2003, 16.9% in 2004, and 14.6% for the first quarter 2005 to $194,400.
Overseas investors have been attracted to Florida real estate for second homes as a result of the comparative pricing differentials between property there and other vacation destinations throughout the world. Vacation properties on the French Riviera average, for instance, about $1,500 per square foot as compared to $500 per square foot in South Florida. In addition, foreigners perceive American real estate markets as a safe investment climate, insulated from the risks associated with their domestic economies.
In the mid-west, prices of downtown condos in Chicago have increased 34% over the last five years to $349,000. Chicago is third in the number of new units being added this year, behind Miami and San Diego...
...It is also interesting to note that the real estate markets may suffer from significant inefficiencies. Based on the fundamental value of the rental properties, the condos that are being sold at preconstruction discounts are significantly below the appropriate implied prices (much like the IPOs of many tech stocks during the internet investment frenzy), allowing for significant gains to those who invest early (often times the realtors selling the condos acquire units personally, giving rise to accusations of a form of insider trading). It would seem that the developers could easily increase the preconstruction prices (offer less of a discount) to a level that is nearer the estimated fundamental values. This could eliminate some of the inefficiencies. Second, the real estate markets are influenced by the appraised value of properties. In a period of investment speculation where prices increase dramatically, an appraiser may rely on properties that have been sold at an inflated price. This may artificially inflate the price of other condos being appraised. The process feeds upon itself, prompting further increases in prices and allowing for financing at much higher prices as well.
In addition, the speculation on condominiums that has occurred in many resort areas such as Orlando, Myrtle Beach, and Miami has been fueled by real estate investors attempting to “flip” properties. The practice involves buying a condo and selling it as soon as possible for a capital gain. In the case of preconstruction properties, the condo is acquired at a preconstruction discount and held until the construction of the property is completed (which may take up to two years). Once completed, the condo is then sold for a considerable gain with very little of the investors’ money actually invested. In many cases, the buyer is ready to acquire the property simultaneously as the investor closes, and sometimes the investor never actually takes possession of the property.
This “flipping” scheme operates on the greater fool theory (I may be a fool for paying this price, but there is a bigger fool to whom I can sell for an even higher price) and is reminiscent of the investment frenzy in dotcom stocks in the late 1990s. With the internet stocks, investors ignored the fact that many of those companies had no income, no prospect of generating any meaningful profits or cash flow, and lacked adequate cash reserves or operating cash flow to sustain operations into the future. Some investors only seemed interested in the potential capital gains that could be obtained from investing in these stocks (particularly IPOs) that were trading at levels that clearly defied financial and economic fundamentals. Just as the income of these tech companies did not support the valuations placed upon them in the market, the rents of many investment properties currently do not support their lofty valuations. When investors realize that the valuations are far too unreasonable, the real estate market for condominium rental properties is likely to experience substantial price deflation. Since investors are more likely to sell real estate than are owner-occupiers, the real estate markets in areas such as Orlando or Myrtle Beach may be particularly susceptible to a downturn as investors seek more profitable opportunities elsewhere.
Thinking Outside the Boxe believes that there is certainly a speculative bubble in select real estate markets—particularly those related to investment properties such as vacation homes and rental condominiums.
As a result of accommodative monetary policy initiated by the Federal Reserve following the recession of 2001, low interest rates prompted many homeowners to borrow against the equity in their homes. This was one factor that fueled the aggressive consumer spending during the last few years, which enabled the economy to rebound strongly following the terrorist attacks of September 11, 2001. However, the low interest rate environment and prevalence of interest only mortgages or exotic mortgages (reverse amortization) also prompted many consumers to make purchases of real estate that they could not afford under normal circumstances. Many of these investors may be forced out of the market by an adverse increase in interest rates, resulting in an elevated level of bank foreclosures and distressed sales of properties. Should the market be forced to absorb this increase in supply under reduced demand requirements, prices would adjust through depreciation in value to a level where demand would once again be aligned with supply.
Indeed, it should be clear that those individuals investing large amounts of money into real estate may suffer a financial setback if the real estate bubble were to burst, resulting in a correction of prices or deflating to reflect the fundamental value. As potentially dangerous would be a prolonged period of stagnant prices, prohibiting investors from securing capital gains through a sale of the property. Investors acquiring property through the use of significant leverage or exotic debt financing and seeking to make a quick profit may also be forced to sell the property at distressed prices merely to satisfy the debt associated with the real estate.
As many investors painfully learned as a result of the bursting of the speculative bubble surrounding dotcom stocks in 2000-2001, the value of assets cannot rise indefinitely with disregard to underlying fundamentals in the mistaken belief that speculative fervor will produce continued capital gains. The greater fool theory finally came to an end when investors realized the folly of investing in many of the now defunct internet companies. If the speculative bubble surrounding some real estate markets does burst, as we suspect it will, there will be quite a few fools left holding the bag this time around as well.
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