Housing Bubble Correction Update
Geographic Regions Cascade

Weekly Commentary - March 29, 2006
We’ve written three articles on the housing bubble since 2002.  In Yes. It’s a Housing Bubble in August 2002, we made the case that the U.S. housing market was comprised of a number of regional real estate market bubbles. At the time, there was still controversy on the topic of whether or not a bubble existed.  Now that many housing bubble markets around the country are in decline and are getting covered on NPR and the front page of the business section of your local newspaper, only the most dedicated mortgage or real estate broker still claims that no bubbles existed.

The Fed took the strictly accurate but misleading position at the time that no national housing bubble existed.  True, real estate bubbles occur within regions – areas of concentration of jobs or especially desirable areas where land is scarce, such as water-front property -- not across the nation as a whole.  Housing bubbles happen wherever there are good paying jobs and monthly mortgage payments are declining, not just low.  With mortgage rates at 40 year lows, housing bubbles were happening in nearly every populated area of the nation that had not experienced unusual sudden job losses, as occurred for example in manufacturing industry regions of Ohio.   

Housing bubbles may not be “national” but that doesn’t make them any less dangerous for the national economy.  Contrary to the Fed’s predictions, we expected that the decline of these regional real estate bubbles was going to put a significant hurt on the U.S. economy, especially at the point many regional bubbles decline simultaneously.

We argued that a housing bubble creates its own fuel: employment within the housing industry itself.   Many high tech workers left unemployed by the collapse of the technology stock bubble, for example, moved into the real estate or financial services industries.  In fact, 43% of all private sector jobs created since 2001 were related to real estate.

In an update Housing Bubbles are not like Stock Bubbles in 2004, we explained that when a regional real estate bubble ends, it does not “pop” the way stock market bubble does, with a sudden collapse in prices.  Instead, the region experiences a collapse in real estate transactions.  The reason is that stock markets are very liquid.  When investors head for the exits, transaction volumes rise and prices can fall rapidly.  Bubbles in housing markets, on the other hand, become illiquid when they correct.  For a town or other region that experienced significant real estate price inflation, long periods can pass when there are no transactions at all.  The more time that elapses between transactions, the more uncertainty buyers feel about the “market” price for comparable properties.  

Certainty about price gains is replaced by uncertainty.  This motivates further delays in buying decisions.  Market psychology shifts to the classic deflationary “I’ll wait to buy because the price is likely to fall” decision process, the reverse of the inflation cycle psychology of “I’d better buy it now before the price gets further out of reach.”  Deflationary psychology is especially self-reinforcing in declining property markets because a home usually represents the largest purchase a household will make and involves the greatest leverage as well.  The stakes are high.

Our last piece on the housing bubble Housing Bubble Correction January 2005, we projected the trajectory of a price decline in U.S. real estate markets.  Using historical rates of home equity extraction as a yardstick, we projected a ten to 15 year reversion to the mean for housing prices, using the rate of equity extraction as our guide.
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Yes.  It's a housing bubble.

Housing Bubbles Correction

Housing Bubbles are not Like Stock Market Bubbles

High Commuting Costs Push Rural Property Owners Past the Tipping Point

Home Equity Extraction

Housing Bubble Correction predicts that in housing markets where bubbles occurred, prices will go through seven stages of decline, Stage A through Stage G as shown above, over a ten to fifteen year period.  So far, anecdotal evidence indicates that this prediction may have been optimistic with respect to the rate of change, and we will not know for many years if our estimate of the duration of the correction is accurate.  Today, certain markets are at the latter part of Stage A of bubble growth while others are at Stage B of decline and yet others are at Stage C or further. 

Here we offer a theory that explains the variations in regional housing bubble declines and how they are likely to unfold geographically over the projected ten to fifteen year period.  This applies the housing bubbles centered in metropolitan areas versus resort areas.  Bubble pricing in the latter is largely driven by money generated by participants in the U.S. Speculative Financial System (see The Big Bet) and will decline in line with the decline of The System, of which, adding to the complexity of an analysis, real estate is itself a part.  Here we will focus on housing bubble markets tied to metropolitan areas.

During the early growth stage of various regional housing bubbles, housing prices increased first in metropolitan areas, then in the suburbs and finally in rural areas.  (These are admittedly crude geographic designations designed to simplify the explanation of the theory without invalidating it.)  Prices cascaded geographically outwards from areas of high employment (income) and population density (housing demand) in metro areas to areas of lower employment and population density in the suburbs surrounding metro areas and finally, once demand pushed housing affordability to extremes there, to areas of low employment and low population density beyond the suburbs.  This process of geographic price cascading took approximately ten years, from around 1995 to 2005. 

The dynamic that drove prices outward was the need for workers in the cities and later the suburbs to escape high real estate prices, to move to where real estate was relatively cheaper and the cost of living lower, but still within an “affordable” commute.  As homebuyers traveled farther from metro areas, they encountered lower real estate prices.  At the extreme top of the market in late 2004 and early 2005, some home owners who bought property in the mid 1990s in market bubble areas before a housing bubble reached their region, sold their property at a huge profit, purchased equivalent property in size and quality in a rural area, and retired on the profit with perhaps a low wage retirement job.  For example, home owners from Boston and nearby suburban towns, as well as from new York and Connecticut, sold their homes and purchased homes in Amherst and surrounding towns, 90 minutes from Boston and have retired using the profit on the transaction.  However, most rural homebuyers who purchased at the top of the rural market in mid 2005 did so to have a chance to buy an affordable home.  Of course, as more and more homebuyers searched farther away from metropolitan areas, prices increased in outlying areas as well until property values in rural areas reached historical peaks and experienced bubbles of their own. 

Living in rural areas and working either in the suburbs or metropolitan areas increased commute time and expense, but this was affordable with gasoline under $1.50 per gallon as it was before hurricane Katrina.  But combined increases in gasoline, heating oil, natural gas and propane prices plus higher interest payment on ARMs combined in mid 2005 to pushed many household budgets past the tipping point for those living in homes purchased in rural areas at or near the top of rural market housing bubbles.

Housing bubbles are driven by the same psychological factors that drive all late stage asset bubbles, the popular assumption that prices only rise.  A steady drumbeat of negative press today, as evidence mounts that the boom is over, reinforces the negative price expectations, but nothing gets the fear juices flowing like watching home prices collapse in a neighboring town, or  watching one’s neighbor lose his or her home. 

This change in psychology will start to cause housing bubbles around suburban then metro areas to decline in a reversal of the process that drove prices from metropolitan markets outward to suburban and rural markets.   The trigger, it should be remembered, was rising gasoline and energy prices and their impact on rural homeowners who purchased at the top of the market.

Housing Bubble Cascade
After a year or so, broad regions covering metropolitan areas out to rural areas that experienced real estate bubbles will experience simultaneous price declines.  The extent of price decline in any area will depend on several factors, but most importantly the diversity of the local economy.  A local economy that is dependent on one or two industries, and especially one or two employers, is vulnerable to significant housing price declines.  An unusual characteristic of this housing boom is the extent to which it was self-reinforcing by producing jobs that in turn drove up prices.  Declining demand for housing related employment will further add to the self-reinforcing housing price deflation dynamic. 

On the top of our list are areas at risk are those that depend heavily on employment from:
  • Housing Related Industries (e.g., construction, realty services, landscaping, building supplies, etc.)
  • Financial Services (e.g., mortgage lending)
  • Venture Backed High Technology
  • Venture Backed Biotechnology
Our best estimate is that eventual price stabilization will be transmitted from the outside in, just as price declines were.  This does not mean that prices will stabilize at the same levels relative to their peak prices in all areas, however.  Prices will tend to fall dramatically from their peaks in rural areas, less so in suburban areas, and even less so in metropolitan areas, largely as a result of the relative lack of employment opportunities in rural versus metro areas and relatively high commuting and energy costs. 

Over time, prices will, or course, stabilize and recover to their mean rate of growth, at more or less the same rate as the rate of inflation.

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