Is the Real Estate Market a House of Cards?

Is the Real Estate Market a House of Cards?

The upswing in housing prices may increase consumer spending by homeowners who believe increases in the prices of their homes has made them richer.

In 2005, prices for homes climbed to dizzying new heights. Does this trend in prices represent a bubble? Will the bubble burst? Are these higher prices sustainable? What will be the economic impact?

During 2005, the housing market has been a frequent news topic. Why all the interest? First, the price of housing, particularly in some "hot" areas of the country, has seen annual double digit growth over the last five years--up to 50 percent per year in Las Vegas! Second, the housing affordability index has been dropping. This index is a measurement of those who can qualify for a mortgage on a median priced house given current interest rates, a 20 percent down payment, and the median income in the area. For example, the average cost of a house in California as of November 2005 was $545,910, and the median salary was $54,140--less than half the salary needed to qualify for a mortgage. In Southern California the gap was even bigger. The median salary of $52,580 was $74,240 below the salary needed to qualify for the median priced house.[1] These figures indicate that less than 14 percent of households can purchase the median priced house--down from 18 percent a year earlier. As housing prices increased and the affordability index fell, market participants began to question whether the high prices could be sustained or if a housing price bubble existed.

Why Should Businesses Care?

If there is a housing price bubble and it does burst, why should business people care--other than be concerned about a drop in the value of their own homes? The economy is driven by consumer spending, which makes up approximately two-thirds of all spending. Consumers who have seen the price of their houses double in the last few years feel "rich" even if they do not plan to sell. If consumers feel rich, they spend. In addition, homeowners have taken advantage of the low interest rates and high real estate prices. They have converted their real estate investment into cash either by refinancing and pulling cash out or borrowing with a home equity loan against the higher value. If consumers see the price of their houses stagnate or fall, they may cut spending and thereby impact economic growth.

This article explains an asset bubble, analyzes the causes of a possible bubble, and examines the implications of a bubble.

What is an Asset Bubble?

An asset bubble exists if prices are high today because investors believe they will be higher tomorrow--not because fundamental factors justify the rise in prices. History provides several examples of asset bubbles--and the big pop.

On March 10, 2000, the NASDAQ stock index, which lists many technology firms, hit 5,049, followed by the pop heard round the world. The market plunged downward, reaching its bottom of 1,114 on October 9, 2002. The "experts" cite many causes of the technology bubble, including the belief of many market participants that a "new economy" had emerged in which technology ensured that recessions were a thing of the past and productivity gains would continue at levels that formerly had seemed unattainable. Though many technology companies had yet to produce a profit, overconfident investors felt that this was a temporary condition and that the inevitable profits would ensure that technology stock prices would continue to rise. By January 2006, the NASDAQ index had regained less than half its peak value.[2]

On December 29th, 1989, the Nikkei 225 Index, which reflects the value of Japanese stocks, hit its all time high of 38,916, and then, "pop!" The Nikkei slid downward for more than a decade, reaching its bottom of 12,698 on June 18, 2001. Again, the experts cite many causes for the Nikkei bubble, including financial institutions exhibiting aggressive behavior and inadequate risk management, monetary easing and low interest rates, regulations encouraging increases in real estate prices, and investor overconfidence and euphoria.[3] After a decade of deflation and banking reform, the Nikkei hit a five-year high in January 2006, about 33 percent of its peak value.

Photo: Fleur Suijten

However, asset bubbles are not a recent phenomenon, nor are they limited to stock markets. The Dutch Tulip bubble of the 17th century was one of the most dramatic examples. After tulip bulbs were introduced into Europe, they became the prized possessions of the rich. As the price of tulip bulbs increased, speculators began buying the bulbs from sailors and selling them to the wealthy. By 1634, bulbs could be bought and resold within a few days for a significant profit. In 1636, the Amsterdam Stock Exchange began trading interests in bulbs, and notaries began specializing in recording tulip transactions. It is estimated that a bulb at the peak of the bubble sold for $34,584 in today's dollars. Eventually, some investors began to liquidate their interests in tulips, supply increased dramatically, and during a six week period in 1636, tulip prices fell by 90 percent. To limit the chaos that followed, the government nullified all tulip contracts and declared tulip speculation a form of gambling. Tulip prices never recovered after the bubble burst, and today rare tulip bulbs sell for $0.30 to $0.40 apiece.[4]

A House of Cards?

Are we experiencing an asset bubble in the U.S. real estate market? There are some interesting parallels to previous asset bubbles--particularly low interest rates, aggressive behavior by financial institutions, and high short-term profit potential, which encourages speculation.

The U.S. economy entered a recession in 2001, and the Federal Reserve (Fed) lowered interest rates--monetary easing--to spur the economy. As mortgage rates fell to 40-year lows, more households qualified for mortgages, and the demand for houses increased. Increased demand helped to inflate housing prices.

Increasing prices eliminated some potential buyers from the market even with low mortgage rates. Financial institutions stepped in by pushing adjustable rate mortgages (which lower salary requirements with lower initial payments) and by offering creative mortgage financing featuring such things as no down payment, zero percent interest for the first year, negative amortization (the monthly payment is less than the repayment