RateWatch #416 – The Housing Bubble Bubble

July 17, 2004 by Dick Lepre

What's Happening

Core CPI was +0.1 (below expectation) on Friday and Treasury markets rallied behind this. 
(Core PPI was +0.2% - at expectation). For the last four months core CPI has been +0.4%, +0.3%, +0.2% and now +0.1%.  This is either a fortuitous bit of mathematical luck or a sign that
inflation - at the consumer level - is under control.  On the talking front we have a Fed member warning about inflation and cautioning that the Fed was ready to raise rates to prevent inflation.  The Fed's plan is apparent: inflation is the foremost enemy and rates will be raised to nip it in the bud.

The Fed seems to be more confident about economic growth than equity buyers have been as of late. The net result is a moderately strong breakout to the upside in Treasury prices (lower yields)
which, with the short-term technical being bullish, could drive Treasury yields and mortgage rates
even lower until the next bit of economic data.

The Housing Bubble Bubble

There have been at least two articles in the San Francisco Chronicle lately addressing a “housing bubble” in the Bay Area.  The first puts forth the idea that since interest rates are up the “housing bubble” may burst. The second article expostulates the thesis that housing prices will fall because rents are down and draws an analogy to P/E ratios for stocks. 

Treating housing prices as P/E ratios has, in general, limited validity. It has some validity for markets where there are a lot of rentals.  Condo complexes with high percentages of rentals would be an example of where the housing market is affected by rents. The value of apartment buildings (5+ units) is greatly affected by rents. Buyers of single-family homes care little about what rents they can get if they move out. San Francisco is a bifurcated market. There are a lot of rentals in San Francisco but those rentals are apartment buildings and some multi-family dwellings.
There is even a perverse irony operating here. Rents in San Francisco have dropped significantly
from where they were about four years ago but the strongest price appreciation may be in two-family homes.  This is likely because they are much simpler to TIC than three and four unit properties.  If there is a major force driving prices it is most certainly not rents.

Housing prices are determined in a market situation. In this market, prices are driven almost exclusively by two things: the number of buyers and the number of sellers.  If the numbers of buyers starts increasing and the numbers of sellers decreases or stays constant then the price goes up. If the number of sellers goes up and the number of buyers falls or remains constant
then prices fall.

Housing prices are affected by two other forces
1) construction costs (the price of building material is annoyingly volatile and
2) zoning or more accurately the willingness or unwillingness of municipalities to allow construction.  In general this acts as a constraint on supply.

The notion that there exists a “housing bubble” is invalid.  True “bubbles” exist only for items that
become trendy or have inherent value that is much lower than the market (Dutch tulip bulb bubble,
South Sea Bubble, dot-com bubble).  These bubbles exist as the result of greed and stupidity. Bubbles cannot generally exist in the single-family housing market because people live in houses and are unlikely to start moving out en masse at any time in the near future.

Buyers of single-family homes are not driven by greed and stupidity.  Largely, people do not buy
single-family homes for speculation.  Bubbles exists in real estate in commercial real estate markets (think South of Market office rents post dot-com) when rents rise rapidly and then the demand contracts. This has happened in San Francisco twice in the past 15 years. 

Some people buy houses because they see them as investments and, as housing prices drop or stabilize, they will be perceived as less attractive investments. This has some validity in single-family housing but will more greatly affect the rental and second-home markets.  The second home market is discretionary. The primary residence market is not.

Rising mortgage rates will mitigate price increases or flatten the housing market. Mortgage rates and even recession will affect housing prices greatly only when the number of sellers exceeds the number of buyers.  This assumes that "rising mortgage rates" means "rising but not rising too much
mortgage rates".  If fixed rate mortgages rose 2% from where they are now prices would be noticeably impacted but the situation would hardly resemble a bursting bubble.

Prices may, down the road, be more affected by demographics - baby-boomers selling and moving into rentals. In California that force may be met with a new wave of buyers who are the children of immigrants.  Local decreases is property values will occur in geographic regions that lose jobs. Housing prices have been amazingly robust in places like Las Vegas and, in general, the South-East which has been resilient in regard to producing new jobs lately.  The San Francisco Bay area has prices which are so high that they are hurting the ability of employers to compensate employees enough to enable them to afford housing.  This, however, is hardly a new phenomenon. 

Rising interest rates are being met with a change in strategy from fixed rate loans to, for example,
5/1 ARMs. It is likely that rising interest rates will calm the increases in housing prices.  The
description of this as a “bubble” is inaccurate. The increase in rates and the calming effect on
housing prices may, in the longer run, be precisely what is needed to prevent a crash from occurring.

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