More Proof of a Housing Bubble

Kids are graduating college and immediately buying houses. Rent an apartment? What are you, crazy? Extra cash is being invested, not in stocks (by far the best performing asset class since the beginning of time), but rather in real estate.

When people reflect on the Internet stock bubble of the late 1990’s, they often recall shares of Yahoo! and Amazon.com being the most common topics of conversations at dinner parties. Nowadays I find myself at poker games where investing in real estate is the main topic of conversation.

A few months ago, I got an email from a University of Missouri student who had been present for one of my guest lectures during his senior year. He had moved back to St. Louis after graduation and, along with a buddy of his, wanted to meet with me to discuss investment opportunities. Maybe they wanted to take my advice and open a Roth IRA, I thought. I was thrilled to sit down with them and offer some advice.

Turns out Roth IRAs were the farthest thing from their minds. Instead, they had assembled a group of 20 or so friends, most in their early 20’s. Their plan was to pool money together and invest in real estate. They figured 20 people contributing $200 a month would net them $10,000 within three months; enough for a down payment on a $50,000 house, which they would then fix and resell for a profit.

This is the type of behavior the current real estate market has induced. Amazing really, given what we all experienced just five short years ago. The logic seems to be that stocks were just pieces of paper, but houses are a much safer asset. Houses might be more tangible, but regardless of what you are investing in, the only thing that really matters is how much you pay for it and how much it will ultimately be worth.

Below is a link to an article from Sunday’s L.A. Times (free registration required). If you don’t think there is a real estate bubble in this country after reading it, I’d be surprised. The author may be highlighting California-specific instances, but something tells me it’s happening in a lot of other states as well.



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21 Thoughts on “More Proof of a Housing Bubble

  1. Jason Youngquist on March 29, 2005 at 7:17 AM said:

    Chad,

    Funny you should mention the University of Missouri, Roth IRAs, and home purchasing. So far, I’ve avoided the home buying craze after graduating from college, but I currently have a contract on a house in Columbia in the Benton-Stephens area. Wanted something in central Columbia, in a decent neighborhood, for less than 100k. My goal is to purchase the house by putting 20% down, live in it for a few years, fix the lots of minor things, and either resell it or rent it out.

    I’ve been doing quite a bit of research in the Columbia housing market, and it seems real estate and home construction is booming in Columbia. There’s a new neighborhood going in north east of town where I live and there’s at least 50-75 single family homes….and this is just one new subdivision.

    My question is how can I determine if indeed there is a bubble in Columbia, because from what I know of Columbia, it seems to be virtually resession proof.

  2. Jason Youngquist on March 29, 2005 at 7:24 AM said:

    So if you were going to be a contrarian and not invest in real estate because it’s over-priced, what other types of investments look under-priced at the moment?

    Couldn’t have the recently graduated students killed two birds with one stone? Open up a ROTH IRA and use it to invest in real estate?

  3. Chad Brand on March 29, 2005 at 8:47 AM said:

    Jason,

    I think the easiest way to determine if prices have gotten too rich in a specific area is to look at the appreciation over the last 3 to 5 years. If annual gains have been meaningfully higher than housing typical sees, say 15, 20, or 25% per year, that should be a signal that things may be too hot. There are some areas that haven’t seen more than 5-6% annual appreciation. That would be nothing to worry about. If you’re paying under $100K for a house, chances are you’re not getting into a speculative area, unless of course the house was only $50K a year or two ago.

    If you want to see how the investment might take shape, assume the price of the home remains constant and interest rates rise. If you still think you’ll be able to break-even on the mortgage by renting it out in those conditions, then you’re not taking on too much risk.

    As a contrarian, the new trend that you mentioned (investing IRA money in real estate) strikes me as symbolizing exactly what kind of mentality there is right now. Historically, stocks have been the best performing asset class by far. Home prices only rise about 3%-4% per year over the long term. Stocks have done 3x that. The fact that people are choosing to sell their stocks and buy real estate with their retirement money, because they see it as a better investment, will be wrong long term. To a contrarian, it signals the time is right to consider stocks.

  4. Jason Youngquist on March 29, 2005 at 9:47 AM said:

    Chad,

    Thanks for the info. Have a listing of quite a number of selling prices, so going to try to take a look at pre-2000 appreciation rates compared to 2000 and greater apprecation rates.

    I’ve actually become interested in the market over the past few years. Been reading a lot of different books on trend, swing, contrarian, value, position and technical analysis trading/investing.

    According to IBD, It seems that the market doesn’t know which way to go. The S&P 600 is barely hanging on, and the other markets such as the NASDAQ have fallen below their 200-day moving average. Guess you could start shorting stocks, but don’t have that expertise yet.

    –Jason

  5. Chad Brand on March 29, 2005 at 10:00 AM said:

    It’s good you’ve become interested. Can only help you greatly over time. The market probably won’t be too exciting while the Fed is raising rates. The cost of doing business will be on the rise, leaving share price appreciation potential limited. Hopefully Greenspan will get to the end of the tightening cycle later this year, at which point I think stocks will movely nicely higher.

  6. Tommy Milf on March 29, 2005 at 10:14 AM said:

    Chad, thanks for linking to that story. The story was surprisingly insightful and equally hilarious. It reminded me of why smart people usually make money and idiots do not.

    Although interest rates have risen sharply, one can still get 6.25% which is historically low. It seems that the bubble is going to burst in the areas mentioned in the article, but I can’t imagine the same will occur for growth areas under 5%. Although not as lucrative as stocks, real estate investment right now still looks good as interest rates continue to climb.

    5 years from now, when bubbles have bursted and interest rates hover around 8% or 9%, today’s investment at 6.25% in a 3-4% growth area will look really good. I imagine there will be a growing amount of renters as interest rates climb, and investors who can ride out the bursting bubble will have plenty of people to pay their mortgage for them. Disagree?

  7. Chad Brand on March 29, 2005 at 10:38 AM said:

    Tom,

    You make good points. I have been questioning in my mind the trend of 22 year olds buying houses. Obviously if you are getting married and starting a family, a house is up there on your priority list, and for good reason.

    I just think a single guy or gal buying a house just out of school in the scenario you highlight (6.25% fixed interest rate and 3%-4% annual price appreciation) will be disappointed if they think they are going to make a lot of money on that type of investment.

    After factoring in interest payments on the loan, property taxes, as well as upkeep costs associated with a house, I am curious how much this “investment” will return. What should the average person expect in these terms? What are your expectations, for example?

    Perhaps I’m wrong, but I don’t see double digit annual returns. I don’t even see high single digit returns. As a result, I would think a Roth IRA would return far more than buying a house, on average. Clearly there will be exceptions, but I would not be so confident that I would be one of them.

    It should be interesting to see how it all plays out. As we all know, bull markets in any asset typically go longer than most expect, so we could see another few years of this real estate environment. Remember, Greenspan warned of stock market “irrational exuberance” in 1996. He was right, but stock prices soared for 3 more years before they collapsed.

  8. Tommy Milf on March 29, 2005 at 11:01 AM said:

    Chad-
    You are correct in not seeing double digit returns, but I am a different type of investor than those in the article. Those mentioned in the article are middle-aged and close to retirement, trying to get rich quick.

    I believe that a select few get rich quick, and the rest of us have to get rich the hard way. My expectations, or any young person’s expectations, when buying a home is to satisfy two needs: 1) having a place to live and 2) not blowing all your money on fast cars and fast women (aka saving for the future). To me, buying a home is an almost zero risk investment that will have returns better than a savings account with an added bonus of providing a roof over my head. Sure, a Roth IRA will have greater return, but you still have to fulfill that other need. Right now, I’m not so sure that renting and putting money in a Roth IRA is better than owning your own house.

    Another added bonus would be to have renters paying my mortgage, so in 5-10 years, I have an asset that I did next to nothing to acquire. And if I am lucky enought to have renters for the next 30 years, those rents will be pure profit just as my kids are going to college.

    The goal would be to have real estate investments that take care of themselves (i.e. breaking even) and having a place to live at the same time, with the disposable income created by not paying my own mortgage being sent to Peridot Capital Management! That way, my portfolio is spread over tangible assets that will pay out in the long term and more lucrative stocks.

    The key is to lock in now at these interest rates so if we ever get back to the 18% interest rate days, one renter in a three bedroom house could take care of the entire mortgage. Cha-ching.

  9. Chad Brand on March 29, 2005 at 11:33 AM said:

    Good points, Tom. I wish everyone didn’t look at buying a house as a get rich quick scheme. I agree that the need to have somewhere to live is a big motivator. It is funny though that five or ten years ago, when real estate largely was being ignored, the same types of people didn’t “see the light” but today they do.

    30 years seems like a long time to get a return on one’s investment, albeit if it coincides with college expenses, it would be well timed. I do think profit before the mortgage is paid off will be fairly limited.

    A $150,000 mortgage at 6% costs about $900 a month. If rates go to 8%, that mortgage will run $1100 per month. Renters will only be willing to pay less than $1100, so your profit margin after all home-related expenses (taxes, repairs, etc) won’t be too high.

    Regardless, there is not a lot of risk as long as you are smart about it and don’t get caught up in the speculation. I just tend to think of things in terms of percentage return on investment, given the business that I’m in and what other investment options I am comparing real estate with.

  10. Jason Youngquist on March 29, 2005 at 4:02 PM said:

    Chad & Tommy,

    I’ve been in the working world now for 5 years. First two years was spent getting my school loan paid off. The third and fourth year were spent maxing out my 403(b) which I just recently converted to a ROTH IRA. During my fourth year started saving for a downpayment on a house, but took a hit because my car died, so bought a used 1998 JEEP Cherokee for cash. Then decided it was time to leave a job that I had had for 4.5 years…Was time to move on. Didn’t have anything lined up, but had some money saved up. Had a 2 month mini-retirement and then found a job late October which is very enjoyable. One of the reasons buying rather than renting is because I can see myself at my current position for several years, near 3 collages/universities so more of premium for rents when/if I decide to rent it out, will live 1 mile away from work, so plan on going home for lunch. This alone, if I do this for 4x a week will probably save me at minimum of 100 bucks a month. Being a mile away from work will save me at least 30 bucks a month on gas. Plan on biking to work. By putting 20% down on the house will avoid PMI which is roughly 50 bucks a month. So by buying a house closer to work (If I stick to my lunch plan) I can save approximately 180 bucks a month which 42% of my estimated monthly mortgage payment of 421 which includes principle, interest, tax, and insurance.

    Will be spending a bit of money to fix up the house, but this is something I can do over time….Would love to refinish the hardwood floors, but they aren’t bad, and don’t mind the ~60 year old character they have accumulated.

    The house I’m looking at is 2 bedroom, so could potentially get a roomate and charge 300 bucks a month for rent and 1/2 utilities.

    Since I will be taking several thousand out of my ROTH IRA for the home downpayment, after the monthy mortgage payments, then next thing is to start maxing out the ROTH IRA again.

    Also, apparently Schiller, who wrote a book called “Irrational Exuberance” at the height of the dot.com market in 2000, is releasing an updated version April 1st which is supposed to include information about the “housing bubble”

    Schiller has a paper called “Is there a bubble in the housing market an analysis” which is quite interesting. You should be able to do a google search and find it.

    Nice conversation we have going on.
    –Jason

  11. Tommy Milf on March 29, 2005 at 7:11 PM said:

    I spent about half an hour at work today coming up with a model to defend my position (which I hold literally since I am a young homeowner). Here is what I came up with:

    Chad and Tom both have $900 to spend on housing and investing for the future. Chad chooses to rent for $300 a month and invest $600 a month at a rate of 8%. After 5 years, Chad has about $44,000 in assets. In essence, Chad spent $54,000 (60 months @ $900 a month) in acquiring assests while providing a roof over his head.

    Tom chose to use the entire $900 a month on buying a house for $150,000 (less 15% down) at 6.25%. If the house appreciates 4% a year, in 5 years Tom has a $182,000 home. Add that appreciation to the principal paid on the loan, and Tom has almost exactly $40,000 in assets to show for his $54,000.

    Clearly Chad is the victor, but not by a whole lot. Tom’s assets will catch up to Chad’s as time goes by because the principal will be paid down quicker as time goes on. The independent factors have to be the ability of Chad to maintain an 8% return while finding comparable housing for only $300 a month for 5 years. Tom must also choose an area where 4% appreciation is realistic. I also haven’t factored in closing costs or the upside of Tom’s ability to collect rents from roomates. Either way, I am just trying to convince myself that I shouldn’t just sell my house right now and give all of my money to Chad. Obviously he is going to better than 8%, so I guess the point is moot.

  12. Chad Brand on March 29, 2005 at 11:00 PM said:

    Tom,

    You’re such a bad influence… now I find myself making an Excel spreadsheet to figure out exact returns to see if my thesis works out the way I think it would.

    Here are my assumptions:

    I used the same specifics you mention, $150,000 house, 15% down, 4% annual price appreciation, and a $900 monthly mortgage payment on a 30-year fixed loan. I also used a property tax rate of 1.5% because it is meaningful in the calculation.

    I also assumed that you would live in the house yourself for 5 years. Starting in year 6 you would rent it out. You would charge $1000/month rent in year 6 and you would increase that rent 4% per year. Obviously, starting in year 31, the house would be paid off completely. Finally, I assume that you continue to rent it for 20 years after the mortgage is paid off, bringing the total time period for the calculation to 50 years.

    Here is what the spreadsheet tells me in this scenario.

    *You would break even after year 19, meaning at that point, the total amount of money you paid (down payment, mortgage payments, and property taxes) would be eclipsed by your equity in the house plus the cumulative rental income you collected.

    *During the 30 years you were paying the mortgage, your total investment would be $477,739 and your return would be $986,261. This equates to a 106.4% return over 30 years, or a 3.5% return per year.

    *Since the house is paid off after year 30, your returns would increase in years 31-50. Looking at the entire 50 year period, you will have invested $703,741 and made $2,518,356. This comes out to a 257.9% return over 50 years, or 5.2% per year.

    These are the types of numbers I am considering when I look at real estate. Breakeven after 19 years, 3.5% per year over 30 years, and 5.2% per year over 50 years.

    Inflation runs about 3.0% per year on average. From 1925-2000, money market funds averaged 3.8% per year, U.S. Government Bonds returned 5.3% per year, and the S&P 500 returned 11.0% per year.

    Everything that I have read has said real estate beats money market funds but trails stocks and bonds. This model I created with your assumptions supports this thesis. That is why I am surprised that real estate as an investment has become so popular.

    Granted, buying a house to live in is a completely different thing, but for long term investment purposes, I really don’t see the logic. Many seem to be using unrealistic assumptions to justify their actions. I’m glad your expectations are not that high, because you are being more honest with yourself and won’t be surprised when historical averages play out over time.

  13. Jason Youngquist on March 30, 2005 at 6:56 AM said:

    The key with real estate is to find property that is undervalued compared to the going rate, and then to use sweat equity to fix it up and re-sell it.

  14. Jason Youngquist on March 30, 2005 at 6:58 AM said:

    Notes from Schiller’s write-up about the housing bubble
    ========================================
    –bubble—situation in which excessive public expectations for future price increase cause prices to be temporarily elevated.
    –people think that home prices are very unlikely to fall, and certainly not fall for long, so there is little perceived risk associated with an investment in homes.
    –Economist Intelligence service – rapid surge in home prices after 2000 infected almost all advanced countries except Germany and Japan.
    –price-rental ratios and price-average income ratios have hit highs that are record since their data begin in 1975
    –the term “boom” is much more neutral than “bubble”
    –the term “boom” suggest an opportunity for investors
    –the period of the 1980’s and the price declines in many cities in the early 1990’s is now widely looked back upon as the example, or middle, of a boom cycle that led to a bust. A pattern of sharp price increases, a peak around 1990 and then a decline in many world cities…
    –During the 1980’s spectacular home price booms in California and Northeast helped stimulate the underlying economy on the way up, but ultimately encountered a substantial drop in demand in the late 1980’s and contributed significantly to severe regional recessions in the early 1990’s.
    –Since 1995, U.S. housing prices have been rising faster than incomes and faster than other prices in virtually ever metropolitan area.
    –The Office of Federal Housing Enterprise Oversight (OFHEO) makes state level repeat value indexes produced by Fannie Mae and Freddie Mac available for all states.
    –when excess supply occurs, prices do not immediately fall to clear the market. This tendency not to accept price declines is connected with a believe that prices never do decline and with some of the parameters of thinking that underlie a housing bubble.
    –home buyers do not perceive themselves as in a bubble.
    –a rate of only 11.6% per year in home price means a tripling of value in ten years.
    –the results of the last question in table 9 show that people generally do not believe that markets are driven primarily by psychology, even in a booming real estate market.
    –but while interest rates may explain movements through time, they cannot explain differences in appreciation rates across cities.
    –an amazing 45% of respondents reported in the 2003 survey selling at above asking prices in San Francisco in 202, well after the sharp decline in employment following the NASDAQ collapse which began in 2000.
    –it is a stylized fact about the housing market that the “bid-ask” spreads widen when demand drops, and the number of transactions falls sharply.
    –the danger when demand drops in housing markets is that the volume of sales may drop precipitously. This would do more damage to the U.S. economy today than a modest decline in prices.
    –however, judging from the historical record, nationwide drops in real housing prices are unlikely, and the drops in different cities are not likely to be synchronous: some will probably not occur for a number of years. Such a lack of synchrony will blunt the impact of the bursting of the bubbles on the aggregate economy.

  15. Jason Youngquist on March 30, 2005 at 7:18 AM said:

    Here’s another person’s take on the real estate market…

    http://www.safehaven.com/article-2815.htm

  16. Tommy Milf on March 30, 2005 at 7:55 AM said:

    Chad-
    Sorry for the bad influence, but I think coming up with Excel spreadsheets is fun.

    I have just a couple more points/questions:

    1) The $900 a month includes taxes and insurance, so that might move the break-even point up a tad. To be exact, the way I have it figured is $920 a month for mortgage ($785), taxes ($86) and insurance ($49). I guess taxes and insurance would grow at inflation.

    2) This also assumes that I live alone (which I don’t). Having roommates paying 1/3 of the $920 is a tremendous upside. I get the same return while paying less.

    3) I would like to see how the model would turn out if the fictional “Chad” were my only roommate, paying 1/3 of $920. I’m looking at the amount of assets acquired in the same time period for the same amount of money, because Chad already proved that he could get a better rate of return with $1 than I can with my house. So, if Chad was paying rent of $307 ($920/3) to Tom, at a rate increasing at 4% per year, thus reducing Tom’s cash outlays, what rate of return would Chad need on his remaining $613 ($920-$307) in order to match Tom’s assets at the end of 5 years?

    I am really interested in the results because if the rate were low enough, it would be a good way to convince my accountant friends to consider moving in with me.

  17. Chad Brand on March 30, 2005 at 8:17 AM said:

    Tom,

    I think Excel is fun as well. I will plug in rental income for the first 5 years. I do have a question about the taxes figure you offered ($86/month). Aren’t the property taxes on a $150,000 house going to run north of $2,000 a year, or just under $200/month?

  18. Tommy Milf on March 30, 2005 at 8:22 AM said:

    Answering your own question is fun. If Chad and Tom were to use the same $920 a month to invest and to put a roof over their head, and Chad moved in with Tom for $307 a month, Chad would only need to get a return of 4.15% on his $613 a month to match Tom’s assets of $41,000 at the end of 5 years.

    Tom earns a measly 2.26% a year on his $613 a month, which is lower than the 2.6% he currently gets on his savings account. The only good news for young Tom is that if he gets that third roomate, and ends up only paying $307 to acquire $41,000 in assets, he will be making 25% a year on his money. Not too shabby.

    Moral of the story: if you are smart enough (or have a broker that’s smart enough) to get you more than 4.15% a year, go rent. If not, come live with me.

  19. Tommy Milf on March 30, 2005 at 8:23 AM said:

    Taxes paid on my house last year were $1,038, a house that appraised for $177,000 that I bought for $151,000.

  20. Chad Brand on March 30, 2005 at 8:48 AM said:

    Wow, that’s a very favorable tax rate on property. If the Fed continues to raise rates, the interest rate on an ING Direct savings account might get up to 4.15% per year. That reminds me of the mid-1990’s when money market rates were 6%-7%. Those were the days…

  21. Jason Youngquist on April 3, 2005 at 6:21 PM said:

    Did a little bit of Excel hacking myself this weekend…

    Decided that the selling price devided by the sq ft of the home would be a relatively easy way to determine if the home prices have gone up. If the average sqft jumped from 70 to 90 in one year, that would point to a real estate market bubble.
    Plotted the average price per sqft from homes that were sold in Columbia. My next goal is to get all of 2003 data (think I only had a bit) and all 2004 and current 2005 data. Once I do that, I have a listing of subdivison, but want to break that down into geographic such as central north east, central north west, east, west, etc.

    here’s a picture of my analysis

    As you can see from the data, it looks like 200 – 2003 average sqft prices are above the linear trend line.

    –Jason

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