Is Bubble Talk Just Hot Air?

Dictionary.com defines “bubble” as: “A price level that is much higher than warranted by the fundamentals. Bubbles occur when prices continue to rise simply because enough investors believe investments bought at the current price can subsequently be sold at even higher prices.” So the question is, are we on the threshold of a housing bubble, or are we already in one?

Bubbles have been a fairly constant feature of global investment markets since human beings first began to trade. In modern history, they are identified with irrational investment activity in a stock market, followed by some type of crash in prices. The 1929 crash was obviously the result of a bursting investment bubble. More recently, the dot com “correction” (remember irrational exuberance?) has been viewed in retrospect as a wide-ranging bubble.

Sometimes, bubbles are not restricted to stock markets—or recent times. In 1624, Holland fell victim to a tulip bubble, the result of investors bidding up the price of single bulbs producing unusually vibrant color patterns. For a short time, the price of individual bulbs exceeded the price of gold. As fate would have it, investors imported such huge quantities of bulbs from Turkey that supply soon far outstripped reasonable demand and the market crashed.

The Dutch economy had only just recovered from the aftermath of the tulip crash when the South Sea Bubble exploded in 1711, almost bringing down the British economy and giving us the financial term. Clearly, it is reasonable to ask if a bubble can occur in the brick-and-mortar world of residential housing, and, more important, if there is a bubble, is it ready to burst?

On the face of it, the answer to both questions would seem to be no. Even in potentially overheated markets such as California, demand seems to be outpacing supply, and there is little likelihood that supply could easily outpace demand. Also, in terms of feeding unfettered development, the capital markets appear to be more disciplined today than in the mid-1970s.

Some observers have argued that, because of the particular dynamics currently at play in other regional housing markets, even a burst bubble in California wouldn’t have a marked impact on housing values in, say, Buffalo. Housing, they say, is the purest of all real estate markets, subject only to local demand. Supply is relatively easy to regulate, and new development follows demographic and income patterns very closely.

However, the recent release of data by the National Association of Realtors reveals some disturbing trends that bring question to those assumptions. Some 13% of all home sales last year were second or third (vacation) homes, up 20% over 2003. How were these homes purchased? The report indicates that 83% were financed through new mortgages, with an average down payment of 22%. This suggests that much of the equity for these purchases is coming from tapping equity built up in buyers’ first homes. In fact, some are even tapping this resource further, using freed-up equity to buy third homes.

The other disturbing piece of data unearthed by NAR is that 23% of all homes purchased last year were bought as investments--not as homes to live in, or even as secondary residences, but purely for rental or re-sale purposes. Again, many of these purchases used equity from the more highly-mortgaged primary residence. It’s a good enough strategy in a market where values never fall and interest rates are low, but we all know that values can decline and rates do rise.

The purchase of investment homes last year was up 14% over the prior year, representing the purchase of about 1.8 million homes. Add this to the sales of second homes, mix in the investment/vacation home market, and that activity amounts to more than a third of the total current home-sales market. So, who is buying what, and for what purpose?

There’s also anecdotal information that points to the potential for a bursting bubble. A recent news report suggests that flipping low-priced homes is on the increase in that city. Property values in Buffalo are among the lowest in the country, and the report indicates most of the flipping is done by out-of-town investors, including some from as far away as California.

How are they able to buy and sell so easily and quickly from so far away? Answer: the Internet, which adds an entirely new dimension to potential bubble development. The report even suggests some homes have been bought and sold on eBay.

Also pushing pricing up is a significant increase in the number of homes purchased by foreigners who find their housing dollar stretches far further here, thanks to the strength of their money against the US currency. This buying power has sent European buyers to popular markets like Florida in droves. In the Sunshine State, some new high-end condo developments are being marketed almost exclusively to foreign buyers. This demand is driving prices higher, often squeezing out local buyers. What happens when the currency arbitrage play ends and foreign buying reverts to normal patterns?

I have begun to ask myself some blasphemous questions on the bubble issue. Is a precipitous increase in purchases of investment homes (combined with highly active buyers going beyond familiar markets--especially in what are rumored to be lower priced markets), seducing a more fluid investment system that allows trades quickly and efficiently? In short, are we talking about a duck yet?

After all, I’ve been here before. In the mid-1970s, one of the main subjects of conversation at cocktail parties was how many homes the young, upwardly mobile buyers had purchased for investment purposes. Interestingly, many of those younger investors are the same group purportedly driving much of the activity today--the baby boomers. They may be older, but they might not necessarily be wiser. As the poet, critic and philosopher George Santayana warned: “Those who do not remember the past are condemned to repeat it.”

This is not to say that today’s 20- and 30-somethings aren’t also dabbling in the speculative housing market. Beyond asking simple questions (like, who’s going to rent all of these investment homes?), those who remember the huge run-up in interest rates between 1980 and 1982 (which still holds the record as one of the worst economic recessions of the post-war period) know all too well that adjustable-rate mortgages (worse yet, interest-only mortgages) have their own special risks.

Roughly a third of all mortgage applications are now made for adjustable-rate loans with payments that increase on a monthly basis as overall interest rates rise. Forget about even the slightest equity build here. So, my next question is this: Can a new generation that has not experienced a down market resist the temptation to walk on mortgages it can no longer afford?

How far and how fast rates rise will play a big part in whether any housing bubble simply breaks or deflates slowly. I should note here that interest rates are rising, albeit very slowly, once again.

One thing we do know: There would be interesting new complications if a 21st Century bubble bursts. For example, unlike past housing bubbles, many more homes today are occupied by renters, not the folks who own the property. If owner/speculator equity is wiped out by rapidly moving interest rates, absent any real price appreciation, those owners are far more likely to cut their losses and walk away. So, the renter’s new landlord becomes the bank, or whatever entity owns the mortgage. What a wonderful thought for the CMBS markets, or the entire residential lending industry, for that matter.

It all comes down to this: Shelter will always be an essential part of human life and, as much today as in any time in our history, home ownership is still the most sought-after of the American dreams. But even a stable, rational need can be derailed by a run-up in prices, especially one driven by questionable investment trends.

A residence is a highly specialized commodity, but, as with any commodity, accelerated trading opens up the potential for rampant speculation, and a bubble, which is inevitably followed by a burst and then a crash. Is anybody in the market for a third home?