You cannot read a newspaper or turn on a television these days without being confronted by the media discussing a bubble in the housing market. According to the man on the TV, there is zero doubt as to the existence of a housing bubble. In fact, the media has told us that housing will crash, if not today then probably this afternoon or next week. Before you throw your hands up in panic though let’s take a rational look at the situation. Facts and logic seem to indicate that the housing bubble is nothing more than a media myth.
For the past several years, returns on housing in the USA have been far above historical averages, approaching 20% YOY returns in quite a few hot markets. This is by far the number one reason that aptly named “bubbleheads” give for the existence of a housing bubble. Any rational investor will tell you though that big returns in the recent past don’t necessarily indicate steep declines in the future. MSFT common stock showed a 400% return over several two-year windows, but I doubt it will be returning to 1991 valuations anytime soon. What comes up doesn’t necessarily come down.
Intrinsic Value of Housing
A wise investor will forget the past because it is irrelevant. The only meaningful question at hand in valuing an investment is “what is the intrinsic value”? In land-constrained busy metropolitan areas like Boston, New York, and San Francisco, the intrinsic value of housing is not defined by normal economic principles. The value of a car as a means of transportation is bounded on the high end by the cost of a bus fare plus a price given to the inconvenience of taking longer to reach your destination. The value of a computer on the high end is constrained by the cost of inconvenience given to visiting the public library for Internet access. On the other hand, there is only one bound on the rise in the price of housing: the ability of the consumer to pay.
The fact is that a large number of Americans are willing to pay any price to own their own home. Many people will gladly pay whatever they can manage to set aside, as much as 80% of their income, just so they can become a homeowner. No, I do not think this behavior is wise. No, I do not think this behavior is rational. Nevertheless, this is the reality of the situation. Do not ask “why”, instead ask “how will this irrational behavior influence the market”?
Loosening Lending Practices
Housing will continue to rise as long as buyers can pay more, which in this situation is completely determined by how much money the average person can borrow. Contrary to the beliefs of housing bubble aficionados, the ability of the buyer to pay has not even begun to be tapped out. Lending practices have gotten looser over the past decade, and they will continue to get looser still. ARMs have replaced 30-year mortgages in great numbers in recent years, creating more buying power. Look for even looser loans to replace ARMs. Negative amortization loans, 45 year fixed loans, or to go to the extreme, interest only loans where the principal never comes due.
The lending market will continue to move to these new “innovative” loans that increase the borrowers ability to borrow. Lenders do not want to see the system collapse; they will do whatever they can to maintain the status quo. Look for Fanny to begin to loosen its buying standards very soon; Ms. Mae will be a willing participant in the move to even looser loans.
Interest Rate Hikes
The one ace card that the housing bubble crowd had going for them was the interest rate increases. This card has already been played though and there is nothing more to fear. The fed will stop its tightening cycle with one or two more hikes, and the 10 year has barely even moved. Note that if the bond market weakened as a result of the reserve rate hikes and lenders in turn were forced to raise their rates, that would have defiantly spelled a disaster for housing. This has failed to materialize though and the worst is already over.
Want to know how bad the housing bubble is going to get? Look around you right now, today December 30th 2005 is as bad as it’s going to get. We have rampant consumer pessimism fueled by the doom and gloom housing bubble media, many people are trying to sell their homes, the fed has tightened about as far as it can go, and it’s the middle of winter, traditionally a slow season for buyers. In spite of all these negatives the housing market is not collapsing.
Intelligent contrarian investors are buying housing right now. Homebuilder stocks trading in the mid single digit P/Es are very attractive buys, as are lender stocks which have sold off recently.
Want to see a housing bubble? Go to sleep and wake up around 2012. The fed will be weakening soon and it will be the last five years all over again. Buyers will take out loans in amounts they never have before thanks to new loans that make ARMs look conservative. Let the doomsayers continue on with their chicken-little armageddon predictions. Meanwhile the smart money is buying housing.
Article by Ninjak