One Bubble of a Ride

[Randolph Harrison]

A typical house, in typical suburban San Francisco neighborhood. You could call it "upper middle class". A good grade school, a not so good high school, friendly neighbors, beautiful parks, and everyone seems to forever labor to keep their picket fences white and flowerbeds planted.

This is the tale of a home, purchased in 1996, sold in 2002, and now for sale again in 2007. This is a true story of the real estate bubble, with a real house, real data, real people, and real fortunes to be won and lost.

Redwood City

Redwood City is as typical as any large American suburb, save for the fact that it sits on the San Francisco Bay peninsula, on the northern border of the Silicon Valley. There are large corporate office parks, major thoroughfares, numerous commercial shopping districts, and lots of neighborhoods. From the outright poor and rundown to the upper edge of "middle class", Redwood City is as typical as one finds on the peninsula. Perhaps the weather is a tad nicer than competing suburbs.

One of these neighborhoods surrounds a picturesque little park. And, among the tree lined streets, barking dogs and laughing children, sits one little stucco ranch house.

1996

In late 1996 this little house was purchased for $365,000, relatively expensive when compared to other similar neighborhoods elsewhere in America.  It had three bedrooms -- one of which had been converted into a professional home office. It had one and "three-quarters" bathrooms; meaning one normal full bath and a master "suite" closet-turned-bathroom with a tiny shower. Built in the early 1940s, this little 1300sqft home complete with freshly planted flower beds, was just perfect for younger, first time buyers.

Northern California had just started emerging from a sharp real estate slump, so this was indeed the proverbial "time to buy".

2002

Over the years from until this little house sold again dot-coms came and went, along with sock puppets, 23 year old CEOs, and DOW 36,000. The "jobless recovery" passed through the Valley and beyond. And 9/11 was still echoing loudly.

The little house, not much changed from 1996, was sold. It was sold for $675,000. Adjusting for inflation back to 1996, the real price was $588,702, meaning the owners netted a gain of 61% on house price appreciation alone.

2007

After another five years, the little house built in the early 1940s and updated in the 1980s was still not much changed. The other little houses all around, mostly built around the same time, were also much the same as they had been for some 30 years.

The owners put the little house up for sale again, for $1,099,000. Adjusting back to 1996 again (using 2006 CPI data), that was $854,899, an increase of 134% from the price a mere 10 years earlier.

The now popular Zillow real-estate price web site predicted a price of $947,563, ($737,098 in 1996 dollars), still an increase of over 100% over the ten years.

2007~2012

One of the problems with bubbles is that it is impossible to predict exactly how and when they will deflate. The best method for estimation currently available, the Case-Shiller Index, indicates the little house will eventually return to roughly its linear regression. This just means that, after smoothing out all the big ups and downs, the price tends to increase at a slow, constant rate over the years.

And that prediction tells us the little house, now on the market for an asking price of $1,099,000, is really only worth around $625,000 in 2007 dollars. Taking that estimate back to 1996 by removing inflation, that's $486,180, about a 33% appreciation over the 10-15 years.

And a 33% of real price appreciation per decade isn't too bad, considering in many parts of the country anything more than 10%-12% is considered fortunate.

Buyer Beware!

Assume for the moment that the little house sells this spring; not for the asking price of over one million dollars, but for $947,563 --the Zillow estimate. Here's the scenario our buyer will very likely face. You decide if he or she is the greatest fool:

• Buy the little house in 2007 for $947,563.
• Invest $189,527 down payment (20%) into the little house.
• Take out a loan for $758,106.
• Drink wine or champagne with the realtor(sm) in title company office during close.
• As spring gives way to summer, prices of other homes in the area start slipping a bit in price.
• Fall gives way to early winter.  While raking the leaves from under the Japanese Maple tree the neighbors load their moving van. Like many others, they've been forced to cut their price sharply so they could quickly sell because they had to escape their resetting adjustable mortgage payments, which they were unable to refinance out of because they couldn't afford payments on a fixed rate mortgage. But our buyer is content, almost snug, in the knowledge they've secured a fixed rate mortgage, and at a historically low rate to boot.
• It's now spring 2008, over a year since our buyer bought, and prices have collapsed in "non prime" locations. Unfortunately, for all of the appeal of this quaint little neighborhood, Redwood City is decidedly non prime.
• One of the many nearly identical little homes sells for $750,000, perilously close to our buyer's loan amount. But our buyer hasn't yet internalized that they've lost all the equity they had in the little house. Our buyer isn't even thinking about moving anytime soon, so all's still well in their mind.
• Fast forward a couple more years and now our buyer is very worried. It's 2010, prices have continued bouncing their way down rapidly, and fate has it they've got to move. They haven't run out of money, or lost their job, or had identical quintuplets. Instead, our young buyer has an incredible, can't-turn-it-down new job opportunity. Problem is, it's on the other side of the country. Not selling is not an option, at least not at first blush.
• Our buyer starts up Windows Vista SP37, launches Excel 2010, and starts figuring.
• The best price our buyer, now a seller, can hope for is $625,000 (unadjusted). Ouch!
• That means buyer-now-seller has lost $133,106 in real cash. Not funny-money. Not some nebulous book value. But a real whopping $133,106. Of course, there's zero equity in the little house; the bank owns all of it plus an extra bill for the remaining $133K our buyer-now-seller owes on the loan.
• Our buyer-now-seller has lost just around 34%, over one third of their "prices-only-go-up" investment.
• Ultimately our buyer-now-seller is one of the luckier in this position. They borrow some money from the folks and leave the little house, glad to be rid of California real estate.

And the final buyer of the little house after the bubble party is finally over? Well, they rented for the past few years, earning about 8% return on money they saved because renting cost about a third as much as taking out a mortgage to buy a massively overpriced house would have. And when they do buy the little house they pay $625,000, just about 33% over the original price all the way back when this story began.

And our final renter-now-buyer lived happily ever after, not even stopping to worry about the value of the little house while raking away the autumn leaves under the Japanese Maple.

 

Comments

[ausman]

The main problem with your reasoning, is that you are taking "trough to peak" measurements, rather than "
peak to peak".

Over a long time (since WWII) home prices have appreciated at about 8% nominally.

Putting in $365k and inflating it at 8% for 11 years give me $851k, not $625k, like your valuation.

Also, you should remember what happened the last time after a big run up in CA home prices (the late 70's): home prices stagnated for about 5 years, went up a bit, then stagnated for another 10 years, ending up with 17 years of nominal gain (and a real loss that I have not calculated).

Why is it "different this time"?

I believe that we are in for a decade or longer of sub-par performance, but no collapse, like you predict.

[randolfe]

Those are good points, so I decided to test them against some real data. Specifically, HomePulse HSBC, using the San Francisco-San Mateo-Redwood City, CA (MSAD) 1975 through Q3 2005.

Considering that I was talking only about real prices, not nominal prices, which I don't know exactly why you bring up (CSI is purely a real-price index methodology):

Real House Price Declines occurred 1980-1982, 1984, and 1990-1996.

Just out of curiosity, I set the model to produce nominal prices. Nominal prices were indeed flat, with just about 0% gain, from 1980-1985. Nominal prices did decline numerous times, specifically: 1989-1990, 1990-1991, 1993-1995.

Now, let's return to reality and put inflation back into the equation (set prices back to real). Let's also measure only excess return on housing, which is what you're alluding to with your statements of 8% nominal peak-to-peak appreciation.

Well, unfortunately, excess returns are very volatile. About 23% in 1977, -8% by 1982. Almost -10% in 1991, and a negative real return excess of risk free returns all the way from 1989-1996. Also, 1 in 3 years from 1975-2005 produced negative excess real returns.

The real kicker is where these numbers are now, and why it's a mega-bubble of unprecedented proportions. Real excess returns of over 100%?

So I ask you, why *is* it different this time? Every single piece of data I'm looking at in front of me at this very moment insists that prices will correct quite significantly in real terms, and almost surely a good amount in nominal terms unless there is a whole lotta inflation coming up over the next decade. I'm talking about rents increasing 2.5x in a few years kind of inflation.

How long will it take? As I said in my intro, that's anyone's guess. My wild-ass guess is somewhere about 2010-2012, but I can be convinced otherwise. Show me the data.

[ausman]

Yes, home prices in CA are volatile, I hope no one seriously disputes that.

But you are predicting a downturn equivalent to the largest downturn in the lest 50 years, *three years in a row*.

You predict that in three years real home prices are going to drop 34%. It has never happened before and (I predict) that it won't this time either.

I with I had real numbers to play with, but here are the best I could find:

http://www.realestateabc.com/graphs/calmedian.htm

As you can see, we had an even bigger "bubble" in the late 70s and early 80s and there was no severe price correction afterward. And in the early 80s CA suffered a severe recession.

So tell me, what is different this time? Why aren't we just going to suffer a decade or longer of subpar (3% or so) nominal price gains? Yes, this is a real price decline. I agree that prices are out of whack, I just don't see any real reason for a "Big Bang" correction.

Rising interest rates would change everything, of course.

[randolfe]

ausman,

Thanks for the comments, and I hope I don't sound too much like I'm beating you up, but a couple of things:

* You need to work off of real data. There is some on this blog, including the data I just referred to above (click the bubblizer thread link upper left).

* This time is much worse than previous bubbles on most every metric. Including:
- Home owner cost as portion of income
- House price to income ratio
- House price to rent ratio (this is the worst)
- real value of future debt service costs versus income
- median real house prices to regression
- inverse of net rental yield
- required real price growth to justify buying using 20 year avg ex-post risk premiums
- the same using 20 year avg ex-ante risk premiums
- the same using zero risk premiums (assuming buying a house has zero risk)
- monthly TCO
...I'm not even going into related tax trends and holding cost proportions.

* I'm _not_ predicting "predicting a downturn equivalent to the largest downturn in the lest 50 years, *three years in a row*". I'm guessing. I am predicting the largest downturn in the past 50 years sometime in the near future, over at least 3-5 years, but maybe longer.

* Real home prices certainly have dropped by 34% before, just not since WWII. The entire first half of the 20th century was marked by progressive cycles of real-home price losses, mostly as a product of industrialization and mass-production undercutting the supply side of housing.

[ausman]

No, I don't feel like you are beating me up at all, just pointing out flaws in my reasoning, which I appreciate it.

Especially since I have "skin in the game" in the form of one of those $1M Noe Valley duplexes.

I will try and look at the real data you pointed out to me. I have tried in vein to get it before.

Have you looked at Jonathan Laing's work (Sizzle Inc). He went from a bubble believer to someone who feels the opposite after examining the data some more.

There are some very good reasons why home prices should outpace inflation for a while: the Fed has a mandate to keep inflation in the 2-3% range and since almost anything that can be made in China is deflating there has to be excess inflation in other assets to make up for it.

Now, the flip side is to ask why rent has not inflated at a similar pace, since that is the most equivalent to home prices.

I am not sure, but the easy money policies of the Fed over the last 5 years have to be the main culprit. This combined with exotic loans, which has pushed home ownership up and helped keep rents down.

We both basically agree that homes are at the peak of a valuation cycle, we just disagree on the magnitude and pace of the fall. I find it extremely unlikely that we are going to see a pre WWII style "panic" in the financial and home price markets. I think we really do understand economics better these days, which is why volatiility has been steadily going down.

The other main thing that props up Bay Area home prices is the fact that national home prices have gone up so much. The Bay Area has traditionally commanded a 3X premium to the nationwide average. Right now we are at 3.5X. So I expect the Bay Area to depreciate a little bit faster than the rest of the country, but not extremely so.

[randolfe]

ausman

I agree there will almost surely be no Depression-like crash. In fact, I've long argued that a longer, softer landing is equally likely. There are good arguments both ways. But even a severe, fast, harder landing in housing doesn't automatically spell deflation and Depression. Like you said, globalization and modern economics have helped to diversify risk.

I see it as a game of pushing up the tipping-points. In other words, because everything is now so diversified and so interconnected, there is a much higher threshold to reach a cascading failure ala The Great Depression. However, it also means that if one were to start, it likely couldn't be stopped. My money is on no-Depression.

I also think home prices *should* and *do* outpace inflation. Earlier blog entries here involved some of us creating a conceptual model for home-prices over the long-run.

Roughly, they should increase at Inflation + net_demand_growth + intangibles_premium + location_premium - market_return + 1%.

The problem is, all that doesn't add up to much more than 1% over real-price excess returns, about 2.5% in the boomiest of boom areas; and boom areas tend to smooth out after a couple of generations.

[palo alto renter]

I think the big question mark is the unwinding of affordabilty. I know so many people in the BA who purchased homes with easy money because there was no other way. An interest only loan got you into the ball game. If you got into trouble, you never really got into trouble because you built equity just by treading water.

That mentality has become baked into the market. Somewhere north of 75% of all homes purchased here in 05-06 were non-traditional loans. People now assume you just can't lose. Since 1997, that's pretty much been accurate.

But there are lots of people holding the bag near the top now. What happens to them when their ARM resets or they can't refinance their way out of the problem?

People have paid gigantic premiums on houses because (1) they expected to earn 20% YOY and (2) you had to outbid the competition, who entered the game with easy money.

That's why I think it could be more dire. We are in unchartered territory. Inventory and interest rates are major uncertainties. Inventory can change easily because all you have to do is put a sign in the yard.

It will be slow, but I think painful.

[Boston]

Randy,

This is off-topic, but do you know if HSBC is going to produce the "Froth Finding Mission" document again for 2006? I know you did a significant analysis using their 2005 document and have been eagerly waiting for the updated version. Especially as their 2005 document seemed so prescient.

Thanks,

[randolfe_]

Boston,

I've also been waiting for an '06 update to the HSBC research. I'll email the authors and ask if they will be releasing anything.

Do note that HSBC has had a bit of a run-in with subprime mortgage issues recently, so they may not wish to continue producing bad news of this sort.

[Boston]

If you get a hold of the update or find anything out from the authors, will you post a link here (or run a separate blog entry on it)?

thanks!

[randolfe_]

Boston,

I will post a new thread if I hear or get anything from HSBC.

[GK]

Randolphe,

I am sure you have a reasoning behind prices are sticky now, and why some people who believed that there was a bubble a year ago now have begun to question whether their belief in the bubble was a form of irrational exuberance itself.

How may percentage points above 'fair value' is the SFBA today?

What do you think of BusinessWeek's article on rates being permanently lower (or at least for a very long time)?

What is the chance that the correction will merely be 3 years of flatness, and then a resumption of a moderate 4-5% annual trend?

[GK]

Randolphe - any thoughts?

[randolfe_]

GK,

I still firmly believe there was (and still is) a bubble in real estate. The SFBA is very diverse, and the percentage by which properties are overpriced here will vary wildly between neighborhoods and school districts.

Measuring from current prices, I would say that many areas are due to see at least 15% price reductions (in nominal terms). Some will see much more than that, perhaps 40% or more. Remember that there was a 100% run up over a period of 18-24 months in many areas, based on no fundamental changes to the underlying economy other than easy credit and cheap money.

I do not think BW has it right. The "new paradigm" thinking on interest rates is wishful thinking. What has changed most probably is that interest rates, inflation and unemployment as related to one another have become much less immediate. This is probably due to globalization and derivatives markets.

That doesn't mean that inflation won't eventually come back around. It most certainly will. It's just being dampened by globalization. We haven't had a real recession in 15 years now, so we have to see what happens when one does hit. If low unemployment doesn't cause inflation, then what happens when slowing growth causes rising unemployment? It could well be that some processes that are keeping rates down now reverse during a recession. And that would be very bad.

I can't make predictions any better than anyone else when it comes to specifics. But, I'll clearly say that I don't see a permanent new plateau for housing prices. And I certainly don't see long-lived resumption in price increases. The forces aligned to push prices down are simply overwhelming at this point. Eventually, after all the stickiness is worked out, prices will resume downwards.

[Birdman]

Largest sales gain in two years; prices down for sixth straight month

"Sales of existing homes rose in January by the largest amount in two years, but prices fell for a sixth straight month, leaving a mixed message on the state of the housing market.

The National Association of Realtors reported Tuesday that sales of previously owned homes rose by 3 percent last month, the biggest one-month increase since a 3.3 percent increase in January 2005, a time when housing was roaring toward the peak of its five-year boom.

The median price of an existing home sold in January dropped to $210,600, a decline of 3.1 percent from a year ago. It marked the sixth straight month that the median price has been down compared with a year ago. The January decline was the third-biggest drop in history."

Personally I think it still has a good ways to drop in prices but if people are willing to drop those prices we might not see a bubble bursting (in the bad way).

-Birdman

[randolfe_]

I think prices are still largely *stuck* in the Bay Area. Other areas are seeing more smooth price adjustments. The problem here is there is a vibrant and growing job market, and even a bit of labor shortage right now.

The bottom line is people are both willing to buy and willing to hold their selling prices (even if their house languishes on the market for months), so long as they have a job and aren't too worried about their employment.

If we get a recession, then I expect prices will come unhinged pretty quickly.

The important thing to always keep in mind is that fundamentals always win in the end. And there has been nothing, and I mean nothing, which has changed so as to support current bubble-high prices. Unless we all see rents & salaries triple sometime soon, these prices are disequilibrium, and the pressure downwards will remain.

The *only* thing that caused all this mayhem was weak credit+easy money. That is changing before our very eyes now.

[RankBull]

It's interesting watching people take world wide economic data trends going back over a hundred years in order to draw micro-local, short term conclusions upon which to guide their personal lives.

They always seem to include a lengthy and detailed fantasy of future vanquishment and "happily ever after" ending.

Psychologically interesting.

[randolfe_]

Similar to your other comment, this will be removed unless you provide guidance for the discussion. It is often a good idea to actually read the blog author's work before making asinine and incorrect assumptions about his goals, fantasies, or situation.

Just for reference, I've owned many homes in my life and I will own more in the future.

[RankBull]

[deleted]

Discussion rules.