Thursday, May 26, 2005

Why There Is A Real Estate Bubble

Why There Is A Real Estate Bubble
In a market economy, prices are set by supply and demand. If supply is constrained or demand increases, prices will rise. Despite the efficient market hypothesis, this doesn't mean that prices are necessarily rational.

The current market has relied on every-increasing demand. People invested in real estate because it seemed like better asset class than equities (crashing) or bonds (with interest rates at all time lows, there's little yield, and little prospect of capital appreciation).

The market would have reached equilibrium in a year or two except for one fact: demand kept rising.

Normally, when an asset goes up in price, the demand for it decreases. In the case of this housing bubble, the more prices have increased, the more demand has increased. The question is why?

The answer is easy credit. The following is a true quote, though my source has asked me not to identify him too specifically:

"I work next to a mortgage loan agent, and I can't believe my ears!

She’s a very nice lady and she’s just doing her job and she does caution the buyers of *some* of the risks, but there’s this couple who emptied their 401K and bought a 300K condo for no-down payment, interest only and no documentation (ie. you don’t even have to prove you have the income to support the mortgage payments). And it turns out their entire 401K and savings can barely cover the closing costs! She kept asking them “are you sure”, “do you want to sleep this over”?.. and they were pretty adamant. Of course she could’ve asked them to consider what would happen if the house price goes down, but that would be career suicide ;-)

Apparently, if you have “good credit” ie. 700+ on the FICO, ANYONE can buy a house for no-down payment, interest only, no-documentation up to a value of 1Million dollars. Everyone seems to be operating on an assumption that house prices would go up at least 10% annually and that they would be able to “exit” their investment in a few years for a profit. It is hard to believe that Fannie Mae would not implode (since I believe they are the end buyer of these “iffy” mortgages?) if the housing markets turn south since these people would literally leave their homes as they had paid not a cent of down payment, and have no money to pay any more should interest rates go up even a little."

As we have with low interest rates, we have also reached the limits of easy credit. When you can borrow $1 million with no down payment, no principal, and with an introductory teaser rate, credit is as loose as it can get.

So to sum up:

1. There is no way to further increase the domestic demand for real estate. What are we going to do, let homeless bums borrow money to buy homes?

2. There are a large number of homeowners that will lose their homes unless A) home prices continue to increase, and B) there are no external shocks.

When the end comes, it will be swift. At first, it will be a small thing. A number of buyers will be forced to sell their homes when interest rates rise and the principal repayments begin. When they go to sell, they'll find that demand is tapped out. As a result, home prices will begin to drop. As more homes come onto the market, the prices will continue to drop. As prices drop, nervous homeowners who see their equity eroding will rush for the exits, hoping to sell and lock in profits. As homes flood onto the market, prices will drop. As homeowners find themselves unable to make payments and unable to sell their homes, foreclosures will rise. Those houses will come on to the market, lowering prices further, convincing more people to sell, and so on.

And on the day when the newpapers and magazines are running articles about "The Death of Real Estate," I will buy a house.

1 comment:

Martian Anthropologist said...

Your #1 is wrong. The reason why real estate goes up most of the time is very simple. There are always more and more people, but the same amount of land.