Housing Bubbles Are Not Like Stock Market Bubbles
If you're looking for the housing bubble to end like the stock market bubble, you'll be surprised. Housing bubbles may run on the same fuel as stock market bubbles, excess money from the Fed, but they grow and collapse according to a different set of functions and dynamics.
January 29, 2004

The last update to iTulip.com was on the topic of the Housing Bubble, in August 2002.  I deemed the housing market was indeed an asset bubble. The main thesis was that rational housing prices are determined by cash flow, and cash flow is determined by incomes and interest rates.  Incomes have been falling real terms (9.3% since 2000) while key real estate markets (read: where most people live), experienced housing prices rising between 100% and 400% faster than incomes.  The explanation for rising housing prices was too low interest rates, which also caused the the stock market bubble of the 1990s.

The Fed wrote a recent piece on how housing isn't a bubble, reminiscent of Greenspan's now famous New Era rationalizations in 1999 for the stock market bubble.  The Fed explains that housing prices are high because interest rates are keeping monthly payment costs low.  In my view, that's not an explanation of rational pricing, only for the underlying cause of the bubble.

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How does it end? On the way up, housing bubbles grow differently than stock bubbles.  They're regional, because folks buy homes near where they get their income, usually withing a 40 minute drive.  Now I realize that in Northern California that could be two miles away on Rt. 101, but bear with me.  That means prices fueled by too low interest rates will manifest where people and the jobs they drive, take a bus or train, or walk to are concentrated. Also, they happen in areas where land is scarce, such as waterfront property; speculation is encouraged by the reality of land limitations.  Popular belief today is that prices won't decline much in the future because land is limited relative to the number of people who want on it.  Tell that the the Japanese who have seen real estate prices decline for more than 12 years. Too much land and not enough people in Japan?  No.  Even though interest rates have been near zero for years, the problem is that their incomes have been declining.

Low rates are the input of a housing bubble, areas of concentration of population or scarce land are where they happen, but low interest rates will not sustain the bubble forever.  Just as housing bubbles are unlike stock bubbles on the way up, they're different on the way down, too.

Unlike stock market bubbles, real estate bubbles don't pop.  Collapsing stock market bubbles are characterized by a sudden collapse in prices because stock markets are highly liquid.  You see huge volumes of transactions at ever lower prices during a stock market collapse.  Collapsing housing bubbles, on the other hand, are characterized by illiquidity, a sudden collapse in transactions.  Buyers and sellers seem to disappear. 

The reason is a reversal in the psychology of buyers that developed at the top of a speculative housing market.  Buyers had been buying at prices they knew were too high but on the assumption that they'd be able to sell if they needed to.  The thought was: "Ok, maybe it's overpriced, but at least I'll be able to sell it later for at least what I paid for it, but likely more."  What happens on the way down is that houses go on the market and just about no one shows up to look. That's because buyers weren't buying earlier primarily because they needed a place to live, but because they thought the price would likely rise and that, in any case, they'd be able to get out when they wanted with all of their money or more.  On the way down, neither condition is true.  So buyers stay home, so to speak.

Can't buyers be enticed by declining prices, by bargain hunting, you ask?  No.  Once housing sale transactions suddenly fall from, say, several hundred a month in a large community to, say, one or two a month, this creates fear and loathing about prices.  Long periods of time pass when there are no transactions at all.  Think of it this way.  What's the comparable on your 3000 square foot home in San Mateo when the last sale was, say, seven months ago?  Is it 10% less than the last sale of a similar home on the area? 30% less?  This happened in Japan, and prices nationally are still more than 60% below peak prices in 1992, where real estate prices continued to climb for several years after their stock market bubble popped.  Sound familiar?

If you'd like to read more on this topic, Blanche Evans, the editor of real estate professionals' site RealtyTimes.com, has written a good series titled "The Perfect Real Estate Storm".

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