Is There a Real Estate Bubble?

Suggesting that real estate is or is not currently a good investment is fools errand.

Much has been written already about a possible real estate bubble yet clients are asking about the White Oaks view on the issuer and what should be done and therein lies the purpose of this paper. Suggesting that real estate is or is not currently a good investment is fools errand, however, with all investments whether they be real estate, bonds or stocks there may be times when the holding periods may be excessively long due to an excessive price being paid. Time indeed does heal all wounds yet experience has taught us that many investors assertions that they are long term investors does not live up to the multi- year test of buying at high prices. When prices are clearly high a prudent action would be to exercise caution.

Clearly the media has caught on to the concept that residential real estate may be reaching unsustainable pricing levels particularly in some markets. The significant appreciation in real estate since 2000 has been attention grabbing to say the least. Some might argue that this is a result of the baby boomers reaching and nearing retirement age and the trend will likely continue for some time. Others are warning that the trend is unsustainable and a crash would likely cause havoc economically on a global basis.

We should start out by stating we have a strong bias for investing for the long-term and believe that under-valued asset classes have the highest probability of delivering returns above historical averages. The longterm historical average for real estate is slightly more than the inflation rate. With a long-term inflation rate expectation of 3%-4% this would suggest an appreciation of real estate of 3.25% to 5%. Of course, to have an average you would have returns above the range and below the range. Therein lies the next big question. Are the above average returns going to continue and for how long? Are these above average returns due to long-term investment/ demographic trends or speculative activity like the internet craze of the late 1990's? How long will it take to work out a bubble if in fact there is one?

Sir Isaac Newton (we believe a very smart guy in his time) who was one of the investors in the South Sea bubble remarked ? I can calculate the movement of the heavens but not the madness of people?. So what is a bubble and what does it look like? There have been several instances in history of investment bubbles. The Tulip Bulb Craze in 1593, the South Sea Bubble (mentioned above), The Great Depression, The Crash On 1987, and the more recent Asian Crash and Dot Com Bubble. The Florida Real Estate Bubble of 1926 might be instructive.

Hot Topic for the Hot Investment Idea at the cocktail party:
It's not unusual for the conversation at social events to turn to investing. The conversation goes something like this. Wow! We?ve really done well on this property (stock/fund etc,) and it was sooooo easy! This serves to bring in others to increase demand. It is easy to feel you ?getting ahead? of the curve but current purchasers may find the curve was well formed before you arrived on the scene or they are the curve.

Lots of media coverage
Don't buy what's on the cover of Money Magazine is a common phrase in the financial advisor community. Case after case can be found that investment advice reported is historical information and that those seeking an easy ride are likely too late. Another take on this is the notion that a golf pro like Tiger Woods does not read Golf Magazine to find ways to improve his game.

Cash flow and relative value is ignored
One way to examine whether property is a good long-term value is to compare the proposed purchase with renting the property. At the highest phase of a speculative boom renting may be much more attractive than owning. The ongoing expenses of a real estate property are significant and need to be considered when calculating your return on investment. If designed for rental and you determine developing adequate cash flow is a stretch how would a passive investor view this purchase and what would they pay?

It's different now:
Probably the best sign that a bubble is forming is the phrase ?It's different this time?. Somehow the rules of valuation and investing were turned upside down and what previously was a bad investment is now a great one. Careful historical perspective is critical to understanding what real value is. The most money in real estate is made after a period of over-valuation and prices again make sense. Of course, one must also recognize it may not be different this time and a good investment opportunity is indeed before you.

Careful analysis will bear this out and by filtering out anecdotal information.

Is all real estate valued at crazy levels? No, for example, commercial properties in general are not over-valued at the time of this writing. Adequate cash flows are frequently being generated in commercial industrial properties (5-7%) and there is little or no (none in Minneapolis according to a recent JP Morgan analysis) speculative building activity. Lenders are requiring a new building be 30-50% leased before releasing funds for new construction.

The East and West coasts seem to have the most extremes in financing and explosive prices. Low interest rates and creative financing have had the impact of allowing more marginal buyers into the housing marketplace. More home ownership is a worthy objective from a social policy standpoint, however, the supply and demand equation may be impacted if marginal buyers who qualified with low interest rates and/or marginal credit buy increased sales/foreclosures or more ?doubling up? by taking in renters in order to make ends meet. Banks traditionally pull back during tough times and the new credit standards may disqualify many who might have been qualified under current guidelines. The resulting reduction in demand would likely soften the real estate process.

What are the catalysts that could pop a real estate bubble?

Rising Interest Rates:
Interest rates on mortgages are a major cost for most real estate purchases and is a prime consideration for affordability. If interest rates rise less people can afford to purchase or upgrade their home or vacation residence. Mortgage lenders have been very creative in offering adjustable rate mortgages that allow for the possibility (or probability in the current environment) of increasing interest rates (costs). In some markets interest only or negative amortization (designed to pay less than the interest charged causing the remaining interest to add to the mortgage balance) serve to increase the affordability to purchase the home but place the purchaser at risk for higher costs when interest rates rise. If interest rates were to rise overstretched owners may be forced to sell or worse yet to face foreclosure.

Overbuilding:
It has been very common for real estate developers to over-estimate demand at the end of a real estate cycle. Faced with the reality not being able to put product on the marketplace fast enough the developer decides to build a couple of properties (known as 'spec? houses) ?in advance? of a purchase agreement. Of course, the first few go well and then being convinced he/she was right builds a few more. Of course, over time all developers decide this is the way to go and eventually over-supply kicks in. The consumer is faced with an abundance of choices and prices stall and in some cases decline.

Over-confidence:
There are two aspects of overconfidence, the developer and the consumer. The dynamics for the developer are outlined in the overbuilding section above. The purchaser also participates due to their fear of missing out on a great opportunity. The emotions of fear AND greed play a big role here. Investing without emotion is the prescription for rational investing.

What will be the first signs of a bubble pop?

First, will the time on average to sell a property increase due to sellers being not willing to price their home to the market. Sellers use their neighbors who sold as guidelines for what they should receive. If the market softens the average listing times will increase. Upper bracket homes are in this stage now in many areas. Second, impact is that the appreciation rate will likely stall. Third, over stretched property owners are forced to sell or face foreclosure, then prices will either fall or be in a multi-year holding pattern.

While this may be seem to give the property holder a long time to take action the realities of real estate and the time and expense to sell will not likely provide any cushion.

Potential Scenarios:

Crash In Prices:
Clearly, this has happened before and could happen again. Examples of the Florida Crash of 1926 above show that Real Estate also experiences volatility but it is usually a local event rather than a broad based national one. Other examples of this are the Texas and Colorado real estate crashes during the 80's. A devastating time in those areas and a few others left many other areas impacted on a much lower or nonexistent level.

One clear difference is that a Real Estate property is not valued daily and therefore is subject to LESS emotional selling than the stock market is. It is not possible (at least very unlikely) to sell your real estate tomorrow and have a check in three days like in the more liquid stock and bond markets. Since your choices are limited an investor is more likely to hold and not sell into an emotional blowout. If a ?crash? were to occur in real estate our opinion is that it would be in pockets where the market has been the most speculative and in other areas the appreciation would flatten out.

Extended Period of Low or No Appreciation:
This scenario has played itself out several times including the 70's and 80's where the value of real estate holds its own but appreciation is small or nonexistent. As mentioned in the section above the lack of a daily valuation mechanism and the fact that most of the property is question is owner used and occupied that those with equity in their properties will simply continue to live in/use the property and wait it out. Again the long time horizon is the investor's friend. We think based on the history of asset classes and the current environment this is the most like scenario.

Renting is More Economical Than Owning:
More investors getting into the rental business creates more supply and renters can negotiate better deals whether for rental property or permanent living arrangements. This serves to reduce demand on two fronts. First, people seeking to reduce costs are selling homes to do so and second the renters have more bargaining power. This can lead to poor or negative cash flow forcing highly leveraged landlords to sell their properties in a soft market.

So what's a person to do in this environment? Should one buy a house now? The answer for me is yes. My primary motivation for buying the home is a place to live and be able to mold it to fit my personal style. This is a personal lifestyle decision not a longterm investment decision. How about a vacation home? Somewhat the same answer, however, it may be very cheap to rent if your personal use time is short term. (again see paper mentioned above) What about property for investment? Careful due diligence needs to be done on each property. It would be prudent to plan for higher vacancies because supply of properties is likely to go up. It would also likely lead to less appreciation than has been experienced in the last several years.

Real Estate like all asset classes demonstrates normal cyclical patterns. Buying high will lead to longer holding periods to achieve average results. It usually takes 5-10 years for a bubble to deflate itself and the asset class to get back to ?normal?. Our most recent example to technology stocks continues to validate this rule of thumb. While it takes the ?bubble asset? five years to recover a well-diversified portfolio should be able to whether the storm quite well.

How will it affect other asset classes?

The pressing question is will a real estate crash affect other asset classes? Another way to look at this question is to ask ?Where will the money flow if a crash occurs??. In the last bubble of technology stocks the money flowed into cash, bonds, and real estate. Real estate because there was a perception a.) At least I can use it and b.) this ( real estate) won't go down in (or always goes up) value. As we can see from above, item b.) is a false assumption. This does not change the fact that the dollars flowing into real estate now will likely go in a different direction once the market stabilizes or values decline.

With interest rates so low the likelihood that more flows there will be based on how bad the losses might be. The fixed income market is the safe harbor and more money flowing there would mean interest rates would likely decline or at least remain stable for some time from already low levels. If interest rates were to decline or the expectation that they will remaim stable the equity market could be a beneficiary, particularly if valuations are attractive. Based on current interest rates the equity markets are 20% undervalued. Even if we assume interest rates rise to 5% the markets are fairly to slightly undervalued. One could assume that the investment markets will all go down due to the lessened ?wealth effect? or due to shocks to the economic system. This would likely be a short-term issue if in fact it were to occur.

Summary:
Economist John Maynard Keynes once opined ? In the long run we are all dead?. Real estate as an asset class is always a long-term investment. The rapid appreciation and speculative behavior of these markets suggest additional caution be used when committing funds to this area. History has proven repeatedly that when asset classes exceed historical norms for an extended period of time, there will be a correction or regression to the mean. History has also shown that real estate has not been an exception. Assuming there is in fact a bubble (probable but not guaranteed) and that above average appreciation is not sustainable, investors in real estate need to increase the due diligence to ascertain their risks in the marketplace.

Real estate always has and will continue to be based on very narrow local influences. Attempting to translate what happened in one area to another will likely have adverse consequences. Not all segments or locations of the real estate market are over-valued. There are likely still good opportunities where the crowd is not looking. Comparative value (purchasing vs. renting or cash flow analysis) can give an investor in real estate a sense of whether or not an investment will produce the results desired. We believe on of the reasons that the perception of real estate remains positive is that many faced with the difficulty of selling in a soft market forced themselves to stay as long-term investors. Of course, this could be true with all investment asset classes but choices can be more freely made in stocks or bonds that increases the emotion of an investor's decision making.

Alan Greenspan warned of ?irrational exuberance? in the stock market in 1997. It took nearly 4 years before many investors really understood what the consequences were to their pocketbooks. Well-diversified portfolios offer the highest probability of success in meeting financial goals and speculative activity often has severe consequences. While no one can predict the prices or when or if a reversal in an asset classes fortunes may reverse valuations do count and reversion to a more realistic value can be painful. Careful selection is always important but when an asset class is ?frothy? or ?irrationally exuberant? wise investors will take a cautious route.