Is the real estate boom over?

The United States housing bubble refers to an economic bubble in real estate in the United States. Many economists believe the US currently has a housing bubble, following the stock market bubble in the 1990s (called, among other things, the dot-com bubble). A real estate bubble or property bubble (or housing bubble for residential markets) is a type of economic bubble that occurs periodically in local or global real estate markets. It is characterized by rapid increases in the valuations of real property such as housing until they reach unsustainable levels relative to incomes and other economic indicators. This in turn is followed by decreases that can result in many owners holding negative equity (a mortgage debt higher than the value of the property). Just like any type of economic bubble, it is difficult to identify except in hindsight, after the crash. A May 2006 Fortune magazine report on the US housing bubble states "The great housing bubble has finally started to deflate … In many once-sizzling markets around the country, accounts of dropping list prices have replaced tales of waiting lists for unbuilt condos and bidding wars over humdrum three-bedroom colonials."[2]

There are several factors believed to explain the U.S. housing bubble. The Economist magazine said that "the worldwide rise in house prices is the biggest bubble in history,"[3] so any explanation must consider global causes as well as those specific to the United States. Former Federal Reserve Chairman Alan Greenspan said in mid-2005 that "at a minimum, there's a little 'froth' (in the U.S. housing market) … it's hard not to see that there are a lot of local bubbles." President Bush said of the U.S. housing boom in early 2006 "If houses get too expensive, people will stop buying them … Economies should cycle."[4]

Bubbles may only be positively identified by some in hindsight, after a market correction,[5] and consistent with other economic bubbles, there has been debate about whether unprecedented price increases were caused by sustainable economic reasons such as larger demand due to increased population and liquidity, and limited supply, or by mania.

Explanations for the existence of a U.S. housing bubble

Harper's magazine, May 2006, "The New Road to Serfdom: An Illustrated Guide to the Coming Real Estate Collapse."[6]

Robert Shiller's plot of U.S. home prices, population, building costs, and bond yields (from Irrational Exuberance, 2d ed. Princeton University Press).[7] Shiller shows that inflation adjusted U.S. home prices increased 0.4% per year from 1890–2004, and 0.7% per year from 1940–2004, whereas U.S. census data from 1940–2004 shows that the self-assessed value increased 2% per year.

Inflation-adjusted housing prices in Japan (1980–2005) compared to home price appreciation the United States, Britain, and Australia (1995–2005).
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Mania for home ownership
That Americans love their homes is widely known and acknowledged;[1] however, many believe that enthusiasm for home ownership is currently very high even by American standards.[8][9] Many have commented anecdotally on this phenomenon,[10][11][12] as evidenced by the cover of the June 13, 2005 issue of Time Magazine[1] (seen above). This newfound enthusiasm would be consistent with and explained by other factors and beliefs.

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Widespread belief that home prices never fall
This folk wisdom is often heard, and appears to be encouraged by the real estate industry.[13] However, it is manifestly untrue, as evidenced by the relatively recent price history of housing in locations such as New York, Los Angeles, Boston, Japan, Vancouver, Hong Kong, and myriad more. In direct contradiction to this belief, this plot shows the one-year fall between 2005–2006 in the median sale prices (inflation-adjusted) of single family homes in Massachusetts:

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Widespread belief that housing is a sound investment
Over the holding periods of decades, inflation-adjusted house prices have increased less than 1% per year.[7][14] Robert Shiller shows[7] that over long periods, inflation adjusted U.S. home prices increased 0.4% per year from 1890–2004, and 0.7% per year from 1940–2004. Shiller also showed comparable results for housing prices on a single street in Amsterdam (the site of the fabled tulip mania, and where the housing supply is notably limited) over a 350 year period. Such meager returns are dwarfed by investments in the stock and Bond markets. If historic trends hold, it is reasonable to expect home prices to only slightly beat inflation over the long term. Furthermore, one way to assess the quality of any investment is to compute its price-to-earnings (P/E) ratio, which for houses can be defined as the price of the house divided by the potential annual rental income, minus expenses including maintenance and taxes on the rental income. For many locations, this computation yields a P/E ratio of about 30–40, which is considered high or very high for the stock market. For comparison, just before the dot-com crash the P/E ratio of the S&P 500 was 45.

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The "ownership society" versus renting
Though he did not specifically use it in this way, President George W. Bush's 2004 reelection campaign slogan "the ownership society" reflects the strong preference of Americans to own the homes they live in, as opposed to renting them.

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Popularity of home investing and flipping in the media
In late 2005 and into 2006, there are an abundance of television programs promoting real estate investment and flipping.[15][16] In addition to the numerous television shows, book stores in cities throughout the United States could be seen showing large displays of books touting real-estate investment, such as NAR chief economist David Lereah's book Are You Missing the Real Estate Boom?: Why Home Values and Other Real Estate Investments Will Climb Through The End of The Decade—And How to Profit From Them[17] published in February 2005. One year later in February 2006, Lereah retitled his book Why the Real Estate Boom Will Not Bust—And How You Can Profit from It.[18]

NAR chief economist David Lereah's book[17] in February 2005.
NAR chief economist David Lereah's book[18] in February 2006.

Commenting on the phenomenon of shifting NAR accounts of the national housing market (also see David Lereah's comments[19][20]), the Motley Fool reported,[13]

"There's nothing funnier or more satisfying … than watching the National Association of Realtors (NAR) change its tune these days. The latest news release from this sunny-Jim industry group finally fesses up to its past fiction, but even when it admits the bubble's going to pop, it can't muster the courage to just come out and say it. … the NAR is full of it and will spin the numbers any way it can to keep up the pleasant fiction that all is well."
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Speculative purchases of homes

Plot of inflation-adjusted home price appreciation in several U.S. cities, 1990–2005.As median home prices began to rise dramatically in 2000–2001 following the fall in interest rates, speculative purchases of homes also increased.[21] Fortune magazine's article on housing speculation in 2005 said,[22]

"America was awash in a stark, raving frenzy that looked every bit as crazy as dot-com stocks."
In a 2006 interview in BusinessWeek magazine, Yale economist Robert Shiller said of the impact of speculators on long term valuations,[23]

"I worry about a big fall because prices today are being supported by a speculative fever",
and NAR chief economist David Lereah said in 2005 that[19]

"[t]here's a speculative element in home buying now."
Speculation in some local markets has been greater than others, and any correction in valuations is expected to be strongly related to the percentage amount of speculative purchases.[20][24][25] In the same BusinessWeek interview, Angelo Mozilo, CEO of mortgage lender Countrywide Financial, said in March 2006,[26]

"in areas where you have had heavy speculation, you could have 30% [home price declines]. … A year or a year and half from now, you will have seen a slow deterioration of home values and a substantial deterioration in those areas where there has been speculative excess.”
The chief economist for the National Association of Home Builders, David Seiders, said that California, Las Vegas, Florida and the Washington, D.C., area “have the largest potential for a price slowdown” because the rising prices in those markets were fed by speculators who bought homes intending to “flip” or sell them for a quick profit.[27]

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Crash of the dot-com bubble
It has been said that the dot-com crash in 2000 and the subsequent 70% (or so) drop of the NASDAQ composite index resulted in many people taking their money out of the stock market and investing in what is believed by many to be a more reliable investment: real estate.[28][29][30]

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Historically low interest rates

Inventory of houses for sale in Phoenix, AZ from July 2005 through March 2006. As of 10 March 2006, well over 14,000 (nearly half) of these for-sale homes are vacant.[31] (Source: Arizona Regional Multiple Listing Service.)Another important consequence of the dot-com crash and the subsequent 2001–2002 recession was that the Federal Reserve dropped short-term interest rates to historically low levels, from about 6.5% to just 1%. The Federal Reserve acknowledges the connection between lower interest rates, higher home values, and the increased liquidity the higher home values bring to the overall economy.[32] A Federal Reserve report reads,[33]

"Like other asset prices, house prices are influenced by interest rates, and in some countries, the housing market is a key channel of monetary policy transmission."
For this reason some have criticized then Fed Chairman Alan Greenspan for "engineering" the housing bubble,[34][35][36][37][38] saying, e.g.,[39]

"It was the Federal Reserve-engineered decline in rates that inflated the housing bubble."
The interest rate on 30-year fixed-rate mortgages fell 2 percentage points (from about 7.5% to about 5.5%). The interest rate on one-year adjustable rate mortgages (1/1 ARMs) fell 3 percentage points (from about 7% to about 4%). A drop in mortgage interest rates reduces the cost of borrowing and should logically result in an increase in prices in a market where most people borrow money to purchase a home (for instance, in the United States). If one assumes that the housing market is efficient, the expected change in housing prices (relative to interest rates) can be computed mathematically. The calculation below will show that a 1 percentage point change in interest rates would theoretically affect home prices by about 10% (given current rates on fixed-rate mortgages). This represents a 10-to-1 multiplier between percentage-point changes in interest rates and percentage change in home prices.

The computation proceeds by designating affordability (the monthly mortage payment) constant, and differentiating the equation for monthly payments

with respect to the interest rate r, then solving for the change in Principal. Using the approximation (K → ∞, and e = 2.718… is the base of the natural logarithm) for continuously compounded interest, this results in the approximate equation

For interest-only mortgages, the change in principal yielding the same monthly payment is

which yields about a 16% change in principal for a 1% change in interest rates at current rates. Therefore, the 2% drop in long-term interest rates can account for about a 10 × 2% = 20% rise in home prices if every buyer is using a fixed-rate mortgage (FRM), or about 16 × 3% ≈ 50% if every buyer is using an adjustable rate mortgage (ARM) whose interest rates dropped 3%. Robert Shiller shows that the inflation adjusted U.S. home price increase has been about 45% during this period,[7] an increase in valuations that is approximately consistent with most buyers financing their purchases using ARMs. In areas of the United States believed to have a housing bubble, price increases have far exceeded the 50% that might be explained by the cost of borrowing using ARMs. When interest rates rise, a reasonable question is how much house prices will fall, and what effect this will have those holding negative equity, as well as the U.S. economy in general. Shiller does compare interest rates and overall U.S. home prices over the period 1890–2004 and concludes that interest rates do not explain historic trends for the country. The salient question is if interest rates are a determining factor in specific markets where there is high sensitivity to housing affordability.

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Interest-only and adjustable rate mortgages

Massachusetts Single Family Home Year-Over-Year Inflation Adjusted Price Changes, 2004–2006, from publically available U.S. government and Massachusetts Association of Realtors data. (Source: bostonbubble.com.) Note that: (1) the inflation-adjusted year-over-year price is decreasing; (2) the rate of price decrease is accelerating; (3) the overall shape of this curve is consistent with a market that peaked in summer 2005, with a critical point at mid-August, and is falling.The recent use of the adjustable-rate and interest-only mortgages to finance home purchases described above have raised concerns about the quality of these loans should interest rates rise again.[6][7][40] Factors that could contribute to rising rates are the U.S. national debt, inflationary pressure caused by such factors as increased fuel and housing costs, and changes in foreign investments in the U.S. economy.

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Predictions and status of a market correction
Based on the ahistoric trends in valuations of U.S. housing,[7][41] many have predicted a market correction, ranging from a few percentage points, to fifty percent or more from peak values in some markets.[42][43][44][45] The amount and timing of any correction is impossible to forecast.

The booming housing market appears to have come to an abrupt halt in late summer of 2005, and as of summer 2006, several markets are facing the issues of ballooning inventories, falling prices, and sharply reduced volumes, so much so that Fortune magazine labelled many previously strong housing markets as "Dead Zones."[2] In Boston, year-over-year prices are dropping,[46] sales are falling, inventory is increasing, foreclosures are up,[40] and the correction in Massachusetts has been called a "hard landing."[47] The previously booming housing markets in Washington DC, Phoenix AZ, and other cities have stalled as well.[48] Searching the Arizona Regional Multiple Listing Service (ARMLS) shows that in summer 2006, the for-sale housing inventory in Phoenix has grown to over 50,000 homes, of which nearly half are vacant (see graphic).[31]

As the housing market begain to soften in winter 2005 through summer 2006,[49][50] NAR chief economist David Lereah predicted a "soft landing" for the market.[51] However, based on unprecedented rises in inventory and a sharply slowing market throughout 2006, the chief economist of the California Association of Realtors, said that he is not comfortable with the mild term "soft landing" to describe what is actually happening in California's real estate market.[52] Others speculate on the negative impact of the retirement of the baby boom generation on the already declining market.[53]