Beyond the Bubble

How to Keep the Real Estate Market in Perspective—and Profit No Matter What Happens

Authors: Michael C. Thomsett , Joshua Kahr
Pub Date: 2007
Your Price: $24.95
ISBN: 0814474098
Format: Hardcover

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The Regional Character of Real Estate

News reports remind you, almost daily, that the real estate market is changing. Mortgage rates are at an all-time low, housing prices are going through the roof, and sales are booming. Then things change. Housing starts are down, mortgage rates are up, and sales are slowing down. But what does it all really mean?

National stories about real estate are always based on averages. But the real estate market in your city or town is regional and all of the changes in that market are going to be in reaction to what happens in your area. Watching averages is dangerous because it tells you nothing about what you can expect in your own investments. It is like picking stocks based on the Dow Jones Industrial Averages. Although that index does give you some hint about the general health and mood of the market, it does not tell you what is going to happen to any one stock.

Real estate is strictly regional, a feature not seen in other investments. Local and regional factors have far more to do with prices and value than any national averages. In fact, even national trends (unemployment, for example) do not really relate to prices of property locally. While the national averages include large-scale layoffs in Detroit, New York, and California, employment in your city may be booming; so what value are those averages?

When you consider the possibility of bubbles bursting and prices falling, you need to look at a combination of local and national trends. The only national trend that is likely to affect local property values directly is that of monetary policy. If rates rise, the continuation of a property bubble is going to be unlikely. Price growth will slow down and may even stop. In some cases, prices will fall. But if you have already bought property and if you have financed the purchase with a fixed-rate mortgage, those trends will not affect you.

Local influences on property valuation will include trends in population and the related changes in demand for housing; employment; and quality-of-life issues (crime statistics, traffic levels, and climate, for example).


COMPARING REGIONAL EXAMPLES

If you compare several different regions in terms of real estate valuation, you'll immediately see how local influences greatly affect property value. You'll also see that these things are not universal—so it's useless to make generalizations. Many of the more important aspects of a community and a region are unique. For example:

San Francisco, California

The "City by the Bay" has a distinctive feature of geography. Since it is a peninsula, outward growth of the city itself is impossible. However, growth around the base of the peninsula has been substantial and, as prices rise, commuting distances increase as well.

With median housing prices in the city hovering at about $800,000, few people can afford even a modest 1,500-square-foot house in San Francisco. One demographic consequence of this high-priced situation is a decline in the number of families with children. The more likely buyer is a working couple with no children. In fact, in the decade from 1990 to 2000, according to U.S. Census data, the population grew by 3 percent. At the same time, the percentage of households in San Francisco with children declined from 21 percent down to 19 percent.

Changing demographics like this will ultimately affect the market both in terms of the types of properties that will be high in demand and quality-of-life issues like populations of school districts.

Albuquerque, New Mexico

Compared to other cities with a population of about 500,000 people, New Mexico's largest city falls short in many aspects. The median home price is $118,500— highly affordable by most people's standards. But local jobs are limited. Albuquerque is isolated in comparison to other metropolitan areas, which makes jobs more scarce as well. Unemployment is 5.3 percent compared to the national average of 4.8 percent. Median income is $38,272, or 9 percent lower than the national median of $41,994.

Because of these factors, prospects for growth in housing prices are slim in Albuquerque. There are no apparent driving forces, and the city is not a destination for large-scale tourism or retirement. For many, the mountain desert climate is not the most desirable compared to other places like the South and, notably, Florida. You will notice significant differences in economic trends and real estate prices between cities like Albuquerque and cities with larger satellite populations.

Detroit, Michigan

Few large cities in the United States have the profound demographic and economic problems of Detroit. Unemployment was at 7 percent as of early 2006, 46 percent higher than the national average. The city depends primarily on the Big Three auto markets headquartered in the immediate area. A decade ago, Detroit was termed the city most acutely vulnerable to economic cycles, due to its singular dependence on the auto industry. The situation is even worse today.

Detroit's problems are reflected in other ways. For example, it's ranked the second most dangerous city in the United States based on crime statistics, after Camden, New Jersey. Median income according to the U.S. Census was $14,717, or 65 percent under the national average. And the median home price as of the latest Census data was only $55,300.

These problems are only aggravated by the city's falling population over the past fifty years. From 1950 (pop. 1.8 million) to 2000 (950,000), Detroit's size ranking among U.S. cities went from fifth highest down to tenth highest. In this market, considering recent historical trends, any changes in auto industry employment rates are going to have a disastrous effect on the real estate market. Even if a housing boom should occur, this continuing vulnerability to a single industry makes Detroit one of the most troubling real estate regions in the United States.

Miami-Dade, Florida

Perhaps the best model for a residential property bubble is Miami Beach, Florida, and the surrounding area of Miami-Dade County. The city is relatively small, with a population of approximately 362,000. However, the county's population is over 2.2 million. Growth over the past century has been rapid: in 1900, fewer than 5,000 people lived in this region.

The housing market in the area does not operate as you would expect, given the other economic indicators. Miami Beach's median income is $27,322, or 35 percent below the national average of $41,994. However, the median price of houses is $684,000 compared to the national average of $89,600. Dominating this real estate market are condos and, more specifically, rampant speculation in preconstruction.

Miami Beach is a study in economic contradiction: exceptionally high real estate prices (driven largely by the condo market), very low median income, and low unemployment (3.3 percent compared to the national average in early 2006 of 4.8 percent). But with condo prices of up to $34 million for prime beachfront locations, the Miami Beach region was in the middle of an ever-worsening pricing bubble by 2006.

The market was hot by the autumn of 2006. Numerous websites specializing in preconstruction sales had popped up. One such site (www.condoflip.com) downplays concerns about inflated prices with its slogan, "Bubbles are for bathtubs." Another site (www.kevintomlinson.com) specializes in both preconstruction buying and selling in Miami Beach.

But consider the actual statistics for this market: The number of unsold condos in and near Miami doubled from early 2005 to early 2006. As of 2006, 25,000 new condo units were under construction, and that was more than twice the number of condos purchased during the previous nine years. The demand, though, is mostly artificial. Local experts claim that three-fourths of the condo purchases in Miami are completed by speculators, with the intention of selling to other speculators once prices rise. This trend is driven by a 63 percent rise in condo market prices from 2002 to 2006. However, the more speculators in the market, the greater the price pressure and the more vulnerable the market becomes. Miami Beach was named one of the five locales in the United States most vulnerable to price correction.¹

Miami-Dade is certainly a model for the housing bubble phenomenon. But the lesson to be learned from its status is that the same rules do not apply elsewhere, and its problems are not universal. It's the unique mix of local influences that created this bubble. When the south Florida condo speculation bubble bursts, the latest speculators will be stuck with overvalued properties, and the market will collapse. The mere fact that the number of units being built is equal to a nine-year supply tells the entire story. Because this particular brew of problems is occurring nowhere else in the world, the problems that Miami-Dade will eventually experience will not affect you. Bubbles do not burst everywhere at the same time or for the same reasons.

New York City

The average price for Manhattan residential two-bedroom homes was well over $1 million by 2004, and twice that for three or more bedrooms. Prices had risen more than 10 percent since the year before. If you ask anyone in New York, the housing bubble is alive and well. But with the largest population in the country and the highest population density, what is the future of New York?

With a city population over 8 million and metro area population over 22 million, New York City's housing situation is far more complex than most places. Restrictions on additional building, especially on the island of Manhattan, have driven prices high in recent years; but even with employment woes and the cyclical budget problems the city faces, it is not realistic to compare the New York "bubble" to the situation in southern Florida, where speculators are running prices higher each month. In the case of New York, many more economic and demographic factors have to be considered.

The 9/11 attacks affected the economy directly, but only temporarily. Employment trends in recent years include large-scale layoffs on Wall Street. For example, Merrill Lynch laid off one-fourth of its workforce (18,600 jobs) between 2001 and 2003. But that two-year period was post-9/11 and also involved the corporate scandals at Enron, WorldCom, and other companies. Large brokerage firms like Merrill Lynch were named in multiple lawsuits and paid fines to regulators for wrongdoing.

Since that period of time, New York's economy—including Wall Street—has returned to pre-2001 levels. So even with economic cycles in play, New York's market is complex and multifaceted. While many New Yorkers are convinced that they are in the middle of a real estate bubble, few are experiencing speculator-driven excesses like those in the Miami area. True, housing prices keep going up, but this is based mainly on the overall population growth, the steadily growing need for housing, and the number of available units, not on wild speculation in preconstruction properties that may never be occupied.


THE DIVERSITY OF REGIONAL MARKETS

Comparing San Francisco, Albuquerque, Detroit, Miami-Dade, and New York City demonstrates the diversity of regional markets. You can make similar comparisons with other cities or regions in the country and discover unique differences everywhere. As you make these comparisons, it becomes clear that the real estate cycle is regional in nature. It is reassuring to know that valuation of real estate in your community is not going to be affected by speculative activity thousands of miles away.

If you look to the stock market as a model, you get a somewhat exaggerated and inaccurate picture of how markets behave. The stock market, which is an auction market, is highly liquid and the daily buying and selling activity reflects trading ranges and millions of agreements between buyers and sellers. When markets are judged by indices, the effect of price changes on individual stocks is immediate and short term. For example, if the Dow Jones Industrial Average index falls 150 points in a single day, many stocks—perhaps most stocks—will fall as well. But this wrenching daily reaction to what are essentially false indices is highly technical (price-driven) and it normally reverses direction within a few days at most.

You cannot use the stock market as a model for real estate. One major reason is that real estate does not operate as an auction market. Another is that real estate is very illiquid compared to stocks. Finally, stock prices tend to operate without regard to regions at all, but real estate is nearly entirely regional in nature.

Unlike a stock, whose market value exists in the vapor of "the market," real estate's value is largely dependent on local factors. Property in midtown Manhattan is worth far more than grazing and shrub land in west Texas, for example. And it is not merely the use of land that defines its value; it is also the combination of regional factors at work that ultimately determine how much real estate is worth, how much the price changes, and whether change in price is rational or bubble-driven.

Defining the "Region"

It is essential to define a region in economic terms. This involves identification of commonality of economic and demographic features. For example, when you consider the alarming preconstruction condo bubble of Miami Beach, you probably need to encompass real estate values in the many surrounding towns and cities making up the Miami-Dade metropolitan area and perhaps all or most of Dade County, Florida. Does this region include other south Florida regions? The answers rely on what activities are going on in those communities. For example, if a preconstruction condo market is rife with speculation, then the same economic consequences will be suffered when the bubble bursts. If an identical set of demographic and economic factors make other southern Florida communities the same (in terms of employment, income, and population features) then it is likely that a bubble would affect the entire region.

Now consider a different example: Detroit. This city has numerous problems with crime, low income, depressed property values, and other poor trends. You may think of Detroit as a type of "reverse bubble"—a situation in which property values are artificially held down due to profound social and economic problems. What would happen if those problems were to disappear? And how far would the outcome spread? In order to define Detroit, whose economic problems are tied unavoidably to the auto industry, you need to evaluate the range of area where employees reside. The Big Three auto manufacturers are located in Detroit (GM), Dearborn (Ford), and Auburn Hills (Daimler Chrysler). The greater Detroit area encompasses these communities, and it is a fair assumption that the majority of employees of the Big Three live within a 100-mile radius of the Detroit metropolitan area. So using the employment factor as a crucial one in determining value, the "region" should be defined based on those assumptions.

In the same vein, because the Boeing Company is one of the largest employers in the Seattle area, the Seattle region may be defined based on assumptions about Boeing's employment base. This is never entirely accurate, because employment is only one of many factors in regional property valuation. In Detroit, Seattle, and all other regions, distinct differences among cities and towns within an area demonstrate a broad range of price differences. But using the employment model as one aspect of defining a region certainly makes sense, to a degree.

Other Key Regional Characteristics

Beyond the employment-based regional definition, some areas are easier to define. Most people recognize the similarity of regional attributes to most metropolitan areas, where property investment is so often concentrated. A region may include the following additional distinctions:

1. Common Employment Base and Commuter Patterns. The definition of regions varies broadly from one place to another. Commuting distances into New York City expand far into Pennsylvania, Connecticut, New Jersey, and north to New York State communities. In comparison, the geographic commute region for Denver, Colorado, is more restricted. This is due to a smaller economy, fewer people, and the geographic attributes of the area. Los Angeles includes a commute region that is exceptionally large, while, in comparison, San Francisco's commute region is far smaller (again, due partially to geography and partially to population differences).

2. Population Characteristics by Age. When you compare regions in terms of population makeup, you find distinct differences that also define the area. For example, cities and towns with large universities tend to have populations with relative low average age, while places like San Francisco report dwindling children population as prices have risen over the years. These types of differences clearly distinguish one region from another.

3. Cultural and Traditional Uniqueness. Most people are aware of numerous differences among regions in terms of heritage and culture. For example, the Minnesota and Dakota regions have higher than average percentages of Norwegian and Swedish families; Pennsylvania has areas dominated by those of German heritage. These factors often define regions as well. Places with larger numbers of immigrants further define regions or, within larger cities, distinguish neighborhoods from one another as well.

These concentrated population and cultural groups may inhibit real estate bubbles by maintaining their characteristics, if only by resisting outside development pressures.

4. Proximity to Other Regions. The region of some areas is defined by what is found nearby. For example, the portion of New Jersey in proximity to New York City (New York metropolitan area) can be defined partially as a commuter region for the city. By the same argument, areas surrounding San Francisco and Chicago are also commuter-based in character. Areas around Orlando, Florida, or Anaheim, California, are more accurately described as tourism-based.

5. Shopping and Activity Centers. The tourism of a region defines its economy and character; but in outlying areas, proximity to shopping and other activities also defines regions. In rural areas, satellite economies—those within rings of a central area—define regions in terms of shopping and activity-based regional character.


EXAMINING REGIONAL ECONOMIC FACTORS

The actual outcome of condo speculation in Florida will no doubt be disastrous for those last speculators who purchase units right before prices crash. But as long as the New York and San Francisco condo markets remain priced according to actual supply and demand realities, the effects will not be widespread—in spite of commonly held beliefs to the contrary.

Many people assume that there is but one real estate market, and that the bubble will burst everywhere at the same time. But that is not going to occur. If you examine a range of regional economic factors, you soon realize that local real estate trends respond to (and are at times caused by) local trends and are not particularly affected by national price changes or market conditions.

Here are some guidelines for analyzing your local market:

1. Study price trends for the past five years. Historically, average home prices rise over the long term. This is a potentially misleading statistic, because in any market, price trends look most promising immediately before a crash. So recent price movement should not serve as an indicator of where trends will move in the future. But the price trends over the past several years can give you a clearer picture of the regional market.

Because reported averages are just that, they are not reliable as indicators in your city or town. Just as the Dow Jones Industrial Average or the S&P 500 Index cannot be used to reliably predict where an individual stock's price will be next year, average home prices are equally unreliable. Even if you confine your study to regional home prices (the National Association of Realtors [NAR] and the U.S. Census Bureau both report regional price trends) you still don't know what your property values will be in a few years. Clearly, price differences in cities only a few miles apart may be subject to vastly different economic and demographic trends. So you really need to study price trends over at least a five-year period; but limit that study to prices in the immediate area and ignore regional and national averages.

2. Collect regional economic information. Where is the market heading? To develop a reliable estimate of how residential prices are likely to change in the near future, you need to also study those economic factors that are going to affect supply and demand directly. Is the local economy largely dependent on tourism, or is it a bedroom community for a large metropolitan area? Is it a college town? What future changes are likely to occur based on economic trends today? For example, if the area consists primarily of retirement-aged singles and couples, and little or no job market exists, what forces would cause future increases in property values? Compare this to a nearby city in which many jobs are found, the population is growing, and development is occurring in response to new residential demand.

3. How much real estate is under construction today? How does this compare to recent population growth? Many people overlook the trend in new construction, and base their assessment of real estate solely on current sales prices of homes. But this is a current and historical view only. Perhaps more revealing are two related trends: the number of new units currently being built, and the number of planned units not yet started.

If you limit your analysis of your local real estate market to existing units, you are not considering the impact of new housing that will be available within the next one to two years. If the population of your area is growing at twice the rate of new construction, property values are going to rise in the future. But if construction rates exceed the demand, a bubble has been created that will burst in the future. A prime example of this situation is the one described above in Miami Beach, where more condo units were being built than the total of nine years' sales.

4. What are the employment and population trends? Is the population growing or shrinking? Is the number of jobs in the region increasing or decreasing? The jobs market is probably the most reliable indicator of where real estate prices are headed. Ironically, speculators tend to look more to prices and development trends and ignore real demand elements. Developers are just as likely to be wrong about the market as speculators. For example, why would a developer invest in building more condo units in Miami Beach when the current number of available units exceeds the nine-year sales numbers? The population isn't increasing—in fact, the often-cited retiring baby boomers are not likely to have an effect, because the majority already own homes—but it is speculation that drives such markets. So in order to decide whether prices will rise or fall, it is more reliable to look at the population and job trends together, and to ignore the speculative short-term trends in real estate.

This is not a difficult comparison to make. A primary driver of population growth is the creation of new jobs. If employers are moving into an area and creating new jobs, people will follow. This places greater demand on housing. If there are going to be more families than new houses, it creates greater demand.

On the other hand, what does it mean when the opposite is going on? If local employers are shutting down operations and laying off employees, it means that people will be moving to find employment. That means that more homes will be for sale in the future. For example, in the Seattle area in 1971, layoffs took employment at Boeing from a high of 100,874 in 1967, down to 37,200. This caused a local recession through most of the 1970s and a big decline in housing prices. So many people were leaving the area that locals were known to say, "Will the last person to leave Seattle please turn off the lights." Seattle is typical of areas dependent on large employers or industry sectors (much like the Detroit area). Downturns, cutbacks, and layoffs can have a disproportionate effect on the local population and, in turn, the local real estate market.

With this in mind, a study of employment and population trends should also include a critical view of dependence on companies and industries. Detroit and Seattle are examples of such potential problem areas. What happens to Detroit property values if General Motors lays off thousands? What happens in Seattle if Boeing goes through another of its cyclical recessions? It is not enough to study an area with historical trends in employment and population; it is also critical to evaluate the area's dependence issues.

For example, Seattle real estate prices rose in the 2004–2005 period, when median home prices went from $282,500 to $321,100. At the same time, the average number of days that properties were on the market fell, and active listings went down significantly, as shown below.² Collectively, these are very strong indicators for the real estate market:

In the case of Seattle, the strength of the housing market is always related directly to the conditions of employment at Boeing. Does this mean Seattle was in a bubble by the end of 2005? It was, in one sense: The bubble was caused specifically by the employment cycles at Boeing, and history demonstrates this as well. When Boeing lays off thousands of people, it creates a local recession in housing prices and elsewhere. When Boeing begins hiring once again, housing prices rise.

5. Look beyond price to review other important factors. Looking only at prices is deceptive because it ignores the actual drivers of future real estate values—the kinds of activities that cause bubbles. The specific factors that are going to determine future long-term real estate prices include the mix of population, climate, traffic, crime statistics, and economic drivers (such as tourism, or the mix of populations in the area).

The mix of population is going to include several groups. For example, communities may be dominated by retirement-age people, commuters, or college students. A mix of many different population groups is also likely, in which case you need to decide which group dominates the market. It is not enough to observe that a city's population rose by 20,000 people in two years if the bulk of that increase came from the expansion of a local university. Because college students are not likely to buy homes, the change in population will cause increased demand for rentals but have little direct impact on demand for owner-occupied housing.

Climate is also important in terms of the kinds of people who will want to live in an area. Florida and Arizona have been retirement destinations for decades and, recognizing this, developers have aggressively constructed housing/recreation communities in massive numbers. This trend has much to do with year-round warm weather in those states.

Traffic patterns emerge as a consequence of other trends. As prices rise for property in large cities, satellite communities move farther away and commuter levels grow. So traffic density increases along with pollution, delayed travel time, and noise. This affects property values directly, notably as commuter alternatives are sought and families are required to move farther away from city centers.

Crime statistics directly affect property values. As the rates of violent crimes grow, property values fall. Families move away so that actual demand declines significantly. High-crime areas like Camden, Newark, and Detroit report exceptionally low median housing prices and little if any increase over time. It is reasonable to assume that crime statistics in a region are going to directly affect housing prices as well.

An area's primary economic centers are also going to affect property values. The area around Orlando, Florida, has experienced significant growth in property values because of the expansive reach of Disney World and other destinations. For some areas dependent on tourism, the effect is highly seasonal. A very busy spring and summer season may be offset by dismal winter levels of activity, high unemployment, and a stand-still in property sales. While tourism may impact an area's housing market, offsetting conditions (like a tourism area that also boasts high employment levels) will counter this trend.


THE CLASSIC REAL ESTATE CYCLE

In the classic description of economic supply and demand, a simple model explains why prices rise and fall. As a real estate investor or homeowner, you may need a more complex model to help you understand the nature of real estate bubbles.

The basic model describes the local real estate cycle in the following "cause and effect" steps:

1. Demand for real estate rises. A starting point that is easily observed in the cycle is growth in demand for real estate. Symptoms of this include the obvious excess of buyers over sellers. When more people want property than there are properties for sale, that is clearly a strong sign that the cycle is entering an upswing.

Other symptoms of demand include the three basic market tests: time on the market, the price spread, and trends in local inventory. Time on the market is a test of how long it takes properties to sell. As the time on the market shrinks, it is a sign of growing demand; as it rises, it signifies reduced level of demand. The price spread is the percentage difference between the asked price and the final sales price. The lower the percentage, the stronger the market.

A third test is to watch trends in the inventory of properties available. If there is less than a six-month supply (calculated by dividing homes for sale by the average monthly completed sales), that is a healthy market; in fact, the six-month level is widely viewed as a point of equilibrium in the market. As you see the inventory declining, demand grows, and vice versa.

These tests—taken together with the observation of prices and the number of buyers—indicate the degree of demand and the change over time.

2. Development follows demand. When demand begins to rise, developers and contractors respond by increasing development activity. Your study of local conditions must include a review of current construction and planned construction, to estimate future trends. For example, the so-called preconstruction market for condos in Miami Beach demonstrates that the construction-unit-to-perceived-demand ratio is out of whack, which means the market is likely to fall apart at some point.

3. Demand levels begin to slow down. In an orderly market, demand simply is reduced over a period of time. In a bubble environment, it may occur quite suddenly, and speculators will find themselves holding overpriced and overvalued properties. However, even in a bubble real estate market, speculators are often able to spot the signs that the market is slowing down, simply by tracking the trends in time on the market, spread, and inventory, as well as noting the correlation of these demand factors to on-going and new construction.

4. Supply exceeds demand. Development of units tends to not slow down just because demand is itself slow. The tendency is to continue building new units as long as prices are rising. But eventually the demand stops. This may be due to a reversal in the demographic trend, sudden shifts in economics (jobs leaving the area), or simply the on-going trend in overconstruction. Because no two real estate cycles are the same in terms of duration, this phase seems to always take everyone by surprise, especially developers and speculators.

5. Development activity slows or stops. When supply overtakes demand levels, developers tend to either slow down or stop altogether. Their prices for properties are often based on the assumption that ever-growing price trends will continue indefinitely. When prices become soft and flatten out or fall, development itself eventually stops altogether.

6. Demand ceases and the market hits bottom. At the bottom of the cycle, demand reaches all-time low levels due to oversupply. This is the end of the demand-supply cycle and the beginning of a new one. Price levels at this point are not necessarily the same as at the beginning of the cycle. When growth trends rise over time, the end of one cycle may include price levels above previous prices. But in the case of a severe real estate bubble, market prices may fall far below those levels at the beginning of the "bubble cycle." This occurs because the rise in prices was driven by speculation, reduced interest rates, and other short-term causes. The remaining long-term influences on the real estate cycle—which always go back to actual economic supply and demand—may lag several years behind the short-term influences of noneconomic factors.

A summary of the traditional supply-and-demand cycle is illustrated in Figure 2-1.

This typical supply-and-demand cycle involves gradual change. Note also that price, the major determinant in the economic "health" of the real estate market, follows the actual economic changes. Even as supply softens, for example, the momentum of price growth is likely to continue, fueled by buyer enthusiasm and speculation. An extreme case (such as Miami Beach) involves developers and speculators apparently oblivious to the signs that the market peaked and that the bubble is likely to burst at any moment.

Figure 2-1. Traditional Supply and Demand Cycle.

THE BUBBLE-DRIVEN REAL ESTATE CYCLE

In a bubble-driven real estate cycle, economic supply and demand is buried under the price growth and decline caused by other factors. Figure 2-2 is a revised look at the real estate cycle when the trend is bubble-driven.

In this variation of the cycle, the changes are more extreme and, in terms of time, may also be more sudden. For example, when the bubble bursts (at phases 5 and 6) prices tend to fall drastically and suddenly. This is when speculators find themselves holding overpriced properties and are taken by surprise.

Supply-and-demand cycles do not happen spontaneously or without cause. Every change in price is the logical result of specific events and a series of previous changes. So as long as the property you own is well priced and demand levels are reasonable, you will not need to worry about the real estate bubble. But if your property's value has increased in recent months or years and the levels of growth make no sense to you, you may experience a correction in the future. This is especially true if the growth in prices was the result of speculation and other forms of artificial short-term demand.

Figure 2-2. Bubble-driven real estate cycle.

Given the fact that the causes of market bubbles are well known, they can also be anticipated. What you cannot anticipate is the precise timing of cyclical changes. But it is useful to evaluate real estate on locally based models, taking into account the current trends and activity underway in real estate development.

A supply-side example should include a study of the current residential market and the number of housing units that are:

1. Existing

2. Under construction

3. Planned

Second, you need to analyze the population trends. Are people moving to the area and if so, how many per year? How does this trend compare to the number of housing markets existing and planned? This comparison tells the "supply-side" story fairly accurately, even though it is based on recent historical trends. If you estimate how those trends are going to continue into the future, you identify the influences on real estate prices that come from the supply side.

A demand-side example includes some of the same data, but from a different perspective. If you remember that development tends to outpace actual demand, you can critically analyze how and when housing units are being planned and built. To return to the classic bubble example, the number of condo units being constructed by 2006 in Miami Beach was a case of lunacy. Any outsider could see the glaring excess in investing in construction of supply exceeding nine years' worth of demand. But when prices are going up, those with cash on the line tend to be blind to the realities. They actually come to believe that "bubbles are for bathtubs," and they argue against the problems of overpriced housing units. A study of demand-driven cyclical trends demonstrates the two important factors in bubble-driven environments: the "greed factor" and the "greater-fool theory."

The greed factor is a tendency to want to get into a market because prices are rising. For speculators, the profits earned are never enough. Once they double the capital invested, they are likely to put those profits back in and to buy two units, then five, then ten . . . and ultimately they'll have thousands of dollars in paper profits that will evaporate overnight when the bubble bursts.

The greater-fool theory tells speculators that, even though they are paying more than the property is actually worth, a greater fool will be available in a few months to pay an even higher price. Eventually, the greater fool—the last person to put money into a property—gets stuck with the overpriced deal and loses everything. But this is not necessarily a new speculator. The tendency (remember the greed factor) is for speculators to want to parlay their early modest profits into ever-larger profits. So in a sense, the greed factor works to make today's sucker tomorrow's greater fool.

In a true economic analysis, demand is recognized as being the result of actual, tangible causes. These include incoming jobs and migration of people. For example, in the San Francisco Bay Area, the late 1980s price boom in the north, east, and south Bay areas was a direct result of major employers leaving San Francisco to relocate to the suburbs. This was a response to an ill-conceived city payroll tax. Employers recognized the high cost of this tax and responded by moving their large employee base to other counties. As a consequence, the real demand for housing—a result of people relocating out of San Francisco—created rapid increases in housing prices. Even though the price changes were rapid, they were not bubble-driven. There were actual economic causes for the change.


ANTICIPATING REGIONAL CHANGE

Regional characteristics—like most aspects of real estate—are not always set in stone. They change as population shifts occur, highways are rerouted, and employers relocate. You need to be able to anticipate possible changes to identify:

1. Whether you are in a bubble or a developing bubble

2. Potential investment bargains

3. Likely future changes in value based on economics and the traditional supply and demand cycle

You spot regional emerging trends by watching the local attributes affecting real estate: changes in employment levels (plus or minus), new housing starts, and any outside influences on the local economy (relocation of employer facilities, closures of existing facilities, plans for new recreational sites). These trends can then be compared to price trends in local residential markets to try and spot whether changes are likely to occur, and in which direction. If you live in an area where prices have risen far more rapidly than you can justify based on identifiable economic and demographic causes, your region might be in a real estate bubble.

How severe is the bubble? Some areas (such as, again, Miami Beach) may be extreme, others only mild. Additionally, the bubble may refer specifically to only one type of real estate. If all of the activity involves the condo market, how does that affect other property? Of course, if the market were to realize that many more condo units had been built than demand can meet for the coming decade, the effects will be seen in single-family housing as well, although not as severely.

The recessionary effects of a bubble bursting will also affect the overall regional economy. When Boeing laid off tens of thousands of workers in the early 1970s, Seattle's economy experienced a ten-year recession. Every job creates, indirectly, as many as three to five additional jobs in support industries. So as new jobs are created in a region, it translates to a multiple of higher employment; if employers leave an area, the same statistical reality applies in the opposite direction.

In judging the kinds of changes likely to occur in your region, avoid using national averages as definitive indicators of what is likely to occur in the future. The overall trends—normally providing you with little more than average housing prices—may be broken down by broad regions (the Northeast, the Northwest, the South, the Southwest, etc.) but these are not "regions" for the purpose of your analysis. The regions as defined by the Census Bureau and the NAR are only geographical distinctions of the entire country; but the statistics provided on this level are virtually useless in your regional tests of real estate values.

As demonstrated in this chapter, a region may be quite narrowly defined. It may consist of a single county or city. Within one area, regional impact may involve only a slice of the market (such as the preconstruction condo market). So when you are analyzing property in Miami-Dade, national price statistics for "eastern United States" are useless. National price statistics are quite valuable for judging the overall health of the real estate market and of investment values on a broad scale, but they tell you absolutely nothing about a particular region. You need to narrow down the actual region in terms of local economic forces, demographics, and the recent price history for that region—not the price trends in national "regions" found in overall statistical summaries.

It is not enough to simply look at prices and price trends to decide whether homes are affordable. Chapter 3 examines the larger economic impacts on real estate bubbles.

NOTES

1. Stephane Fitch, "The Last Speculators," Forbes, March 27, 2006.

2. Maura Webber Sadovi, "Seattle Housing Market Remains Strong," Real Estate Journal (Wall Street Journal), July 6, 2005.

© 2007 Michael C. Thomsett and Joshua Kahr.
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