Where the Next Huge Real Estate Bubble May Be Building

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The 2000s real estate bubble—which burst in 2007 and precipitated a once-in-a-century financial crisis and recession—is not something most folks are excited to see repeated. But five years of declining or stagnating housing prices, the market turned around big time in 2012, making some analysts worry that we’re seeing the beginnings of Housing Bubble 2.0.

Case-Shiller Home Price Index: Composite 20 Chart

Case-Shiller Home Price Index: Composite 20 data by YCharts

As you can see, home prices in most of the country are far from the bubble levels of mid-2000s, but if you drill down deeper to look at individual markets, one sees a different picture. Jed Kolko, housing economist with the real estate site Trulia, has been tracking home prices across the country to see which markets are over and undervalued. In a forthcoming “Bubble Watch” report, he finds that while most of the U.S. real estate market remains significantly undervalued, there are certain markets that are straying into bubble territory.

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According to Kolko’s analysis, which looks at several factors like price-to-income ratio, the price-to-rent ratio, and prices relative to their long-term trend, markets in Orange County California and Los Angeles are more than 10% overvalued. Kolko also pegs the Austin, Texas market at 10% overvalued, while 7 other markets range from 4% to 7% overvalued. Those include:

  • San Antonio, TX;
  • Honolulu, HI;
  • San Francisco, CA;
  • Houston, TX;
  • Riverside-San Bernandino, CA; and
  • Oakland, CA

Unsurprisingly, these markets — concentrated in Texas and California, have also seen double digit home appreciation over the past year, with Orange County real estate appreciating a whopping 23.4% since October of 2012.

So are we in danger of another housing bubble like we experienced last decade? Not quite yet, at least nationally.  According to Kolko, the market remains roughly 4% undervalued overall. And in some markets, like Cleveland, Ohio and Palm Bay-Melborne-Titusville, Florida, home prices are still 20% below their fundamental value. Furthermore, even the most frothy markets are less overvalued than the national market was in 2004, when home prices were 24% overvalued nationally.

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That being said, these numbers are evidence that policies like the Federal Reserve’s quantitative easing program, which have driven mortgage rates to historical lows, are encouraging buyers to snap up homes aggressively in certain markets. And some real estate analysts like housing market veteran Mark Hanson think that analyses like Kolko’s are too optimistic. Writes Hanson:

When comparing house prices and affordability today vs the bubble years people make a critical error.  That’s, they don’t “normalize” the bubble years metrics to account for the fact that the incremental buyer/refinancer used “other than” 30-year fixed mortgages.  In other words, they forgot about the popularity of “exotic loans” and assume everybody always used market-rate 30-year fixed rate financing.

In other words, the world has changed. Young folks can’t afford to leave their parents houses. Even the ones who can aren’t getting mortgages because credit is much tighter than it was in the pre-bubble years, and recent price increases have been fueled by over-enthusiastic investors rather than true economy-wide demand for housing. Every real estate analyst is forced to used assumptions when forecasting the future prices of homes, and given the fact that home price appreciation in California has slowed in recent months, Hanson may be going to far in arguing that markets like California are a full-blown bubble.

But a California-centered bubble is certainly a possibility, and even Kolko’s more nuanced analysis argues for buyers in some of the more frothy markets to approach with caution. One of the enduring lessons of the last real estate bubble is that while there are many reasons to buy a house — like the tax-deductibility of mortgage debt, the forced savings mechanism of paying a mortgage, and the pride of homeownership — expecting significant appreciation in your home’s value shouldn’t be one of them.

6 comments
szentmiklosy
szentmiklosy

Investors betting on people will need to rent. Of course you have to have a job so you can rent. 

vadertime
vadertime

I have to disagree with Simpleandsold. From everything I am reading, between 40-50% of the buyers in the current real estate market are investors. Large investors looking for a better rate of return on investments are buy inglarge swaths of homes on the market to put out on the rental market. My understanding is that these institutional investors are looking to park very large sums of money in these rental properties, which should offer predictable rates of return as rental income, until such time as the real-estate market fully recovers. When this happens, these institutional investors plan to sell the properties.


However, I think there is a fundamental flaw in all of this. The entire paradigm has changed for the first-time home buyer. I recall how difficult it was buying my first home 25 years ago, but it became successfully easier with the next 3 purchases. One needs first-time home buyers to prime the market. Currently, the first-time home buying public is at it's lowest level in over 3 decades. Demographically, first-time home buyers tend to be young couples, in stable jobs who may just be starting out in their careers or have only been working in their jobs for a few years. For them, home ownership is much more difficult due to the tighter lending standards. 


The additional change in the real-estate market is the growth of rental properties. We appear to be reverting to a nation of renters, much like we were 60 years ago. The collapse of the real-estate market in 2007 has rattled so many folks who would have purchased homes as long-term investments, that they have chosen to put their money somewhere else and to rent instead of buying a home. As the article above suggests, there are many reasons to buy a house, but the primary reason should be to buy a house, because one wants to live in it and all other considerations should be secondary.

Simpleandsold
Simpleandsold

Let me preface this by saying I do think there will be some price adjustment in the residential market but this is a very different time than 2007. We have a few more checks in place and one of them was the naming of Robert Shiller as the Nobel Prize recipient for Economics.

As early as 2006, Nobel Prize recipient Robert Shiller was sounding the alarm: the real estate market was going into free fall. At the same time, the National Association of Realtors' Chief Economist, Lawrence Yun, was telling the American people they could either buy a house or miss this golden opportunity.

Before you write this off as an innocent mistake, remember that the National Association of Realtors is a lobbyist group. It is 100% funded by real estate agents and brokers, and has only their interests in mind. Getting your real estate information from the NAR is like getting your smoking advice from big tobacco.

A few weeks ago, Shiller predicted the housing market would be slowing down. As you may have guessed, Lawrence Yun disagreed. We see this kind of shameless self-promotion all the time. But it becomes dangerous when our government is depending on accurate information to decide how to handle the economy. And, ultimately, Shiller is correct. We are going to see home sales slow down.

What we have seen in the past two years is a bit of a frenzy, the result of pent up demand. It's similar to the effect you see when Apple announces a new product. You get an influx of consumers, ready to buy, who were just waiting for the latest product. This same mentality is at work in real estate. Buyers were waiting to feel confident with their decision.

The buyers coming to the market now are what I call Second-Tier-Pickys. They are a bit more selective and don't get caught up in the buying frenzy. The property has to meet more of their specifications before they step up to the plate, regardless of whether it is an investment property or a home. With this, comes a new pace for the real estate market. A normal pace. The way it should be.

eli@eliherron.com
eli@eliherron.com

@Simpleandsold Perfect comment!  This is who I want to be, "They are a bit more selective and don't get caught up in the buying frenzy." but the fear is losing the all time low interest rate even when I know the house is overpriced.