Should homebuyers worry about a California housing bubble?
Resting on a foundation of stable loan products and backed by can-kicking loss mitigation practices, the risk of future real estate declines is low.
Real estate prices do not always go up. Prior to the housing bubble, and despite two previous bubbles in California where house prices went down, most buyers clung to the belief that real estate prices only go up. The housing bust ended this delusion forever, and in the process created a latent fear of future price declines.
The fear of falling prices is rational. Without this fear, buyers become foolish and pay any price even when it’s way, way too much. The lack of fear of falling prices contributed to the housing bubble. But is this fear rational today?
For house prices to crash, two conditions must exist: first, aggregate loan balances must drop significantly, and second, large numbers of must-sell homes must come to market. Based on current conditions in the housing market, neither condition is likely to be met.
Back in August 2007, the mortgage market suffered an abrupt credit crunch as investors stopped funding toxic loan products such as option ARMs and interest-only loans, the primary products used to inflate mortgage balances and house prices. Overnight the credit crunch reduced the amount lenders were willing to loan by about 30%.
There was no way for the market to adjust to such a large and abrupt decline in aggregate loan balances without adjusting price. At first, sales volumes dropped significantly, and if no must-sell inventory came to market, the crash might have been less violent, but some amount of price correction was inevitable.
The credit crunch occurred for a reason: it wasn’t some exogenous shock like an asteroid impact. Lenders stopped originating option ARMs and interest-only loans because borrowers were defaulting in large numbers. These defaults were processed according to the loss mitigation procedures in place at the time — which meant foreclosure — and the resulting flood of must-sell bank-owned inventory pushed prices lower quickly.
Could it happen again today? Not likely.
The unstable loan products that caused the bubble and the credit crunch were effectively banned by Dodd-Frank, and none of these loans have been originated since 2007. For the last eight years, the housing market has been built on a base of stable loan products.
It is still possible for aggregate loan balances to drop, and this is a concern. To prop up real estate prices, mortgage interest rates were pushed down to record lows. As mortgage rates rise back up to their historically normal levels, this will put pressure on aggregate loan balances unless wages rise significantly to take up the slack. However, this transition is likely to be far more orderly than the credit crunch of 2007, and mortgage rates probably won’t rise faster than rising wages will allow. If they do, sales volumes will suffer.
The biggest lesson lenders learned during the housing bust was that they must keep must-sell inventory off the market. They learned to can-kick bad loans and deny short sales in order to remove supply from the market to prop up prices. While I believe this is a dangerous form of moral hazard likely to lead to reckless lending in the future, in the short term, it solved the problem, and these new loss mitigation procedures will be used again if prices weaken.
In short, between the stable loan products and the new loss mitigation procedures, I think another epic bust with a 30% or more decline in house prices is very unlikely, and fear of such a bust shouldn’t deter people from buying homes in today’s market.
it’s time to put the word out that the second greatest bull march in history is finally coming to an end. It’s done.
Wall Street thinks this is a correction – a 10% drop, maybe 20% at worst, followed by more gains. They think we’re just six years into a 10 if not 20 year bull market. This is just a healthy breather.
Of course they think that! It’s the same “bubble-head” logic you find at the top of any extreme market in history!
Every single time – without exception – we delude ourselves into believing there is no bubble. We think: “Life’s good, why should we argue with it?”
And every time, we’re shocked when it’s over. Only in retrospect do we realize, yes, that was clearly a bubble, and oh, how stupid we were for not seeing it.
Bubbles don’t correct. They burst. They always do. And if anyone is still doubting whether this is a bubble, they need to get with the program – now! …
China’s stock market will also keep crashing – it’s already down 42%. When it does, its real estate will follow – with devastating consequences to real estate in the U.S. and the globe. And over the next several years, we’ll see the greatest global crash in real estate in modern history.
As home prices rise ever higher in Los Angeles, some are beginning to wonder if the region is in another housing bubble, one that’s ready to burst. Real estate blogs add to the hysteria by pointing to the most ridiculous listings, the million-dollar bungalows in need of a complete renovation, the $3-million teardowns.
Dear Dr. Housing Bubble,
That one was aimed directly at you. You are adding to the bubble hysteria! Great work! Keep it up!
But the data suggest that the market is not, in fact, on the brink of collapse.
Using the all-transactions house price index from the Federal Housing Finance Agency, I examined price history in Los Angeles County, adjusted for inflation, from 1975 to the present — 1975 being the first year data were available. Along with some short-term fluctuations, we can see four major housing price cycles in Los Angeles since 1975:(1) Bull market (first quarter of 1975 through the third quarter of 1980): real home price increased by 69% over 23 quarters.
Bear market (1980 Q4 to 1984 Q2): real price decreased by 9% for 15 quarters.
(2) Bull market (1984 Q3-1989 Q4): up 67% for 22 quarters.
Bear market (1990 Q1-1997 Q2): down 37% for 30 quarters.
(3) Bull market (1997 Q3-2006 Q4): up 166% for 38 quarters.
Bear market (2007 Q1-2012 Q2): down 43% for 22 quarters.
(4) Bull market (2012 Q3-2015 Q1): so far the price is up 27% for 11 quarters.
Can these past cycles help us predict the future? To some degree, yes.
Actually, no, they can’t. Looking at cyclical ups and downs is like trying to trade an Elliot Wave: in retrospect everything looks obvious, but in real-time, it never is.
His analysis lacks one very important component: a measure of value. I use rental parity, the balance point where the cost of a rental equals the cost of ownership. The relationship of current pricing to rental parity establishes a basis of value.
Using this basis of value, and changes in the new mortgage rules, I was able to predict that the housing market would hit a ceiling of affordability at a very specific price level, and this ceiling has held prices in a tight range for the last two years.
I don’t believe LA is currently in a housing bubble because current prices are not above fundamental values. I don’t rely on vague interpretations of cycles; I rely on verifiable data with a simple and unambiguous interpretation.
Which method fills you with more confidence?
Unlike the stock market, real estate dynamics tend to hold over time, in part because transaction costs keep prices from bouncing around wildly in response to external events.
If history is any guide, the L.A. housing price cycle seems to last about 12 years on average, of which seven years is spent in the bull market with at least 65% real price appreciation, and five years is spent in the bear market. We are three years into the housing recovery that started in 2012, with 27% appreciation so far. On average, there will be four more years or 38% more price growth before we reach the turning point.
Of course, it’s possible the bear market could come earlier or later than four years, but that is quite unlikely to happen in the very near future.
Prices may or may not go down earlier or later than four years from now. That clears it up, doesn’t it?
The data suggest that the market is not, in fact, on the brink of collapse. –
How can I be so sure?
I’m eager to know too….
Often, during a bubble-making period, we see an accelerating rate of home price appreciation, as in 1988-89 and 2004-06. In the last two years, we haven’t seen that kind of rapid appreciation in Los Angeles.
Actually, yes we have.
Look at the report below from 2014. At the end of 2013, the year-over-year change was nearly 50% — in one year!
If a lack of rapid appreciation is his basis, he is mistaken.
Another way to understand housing price cycles is by looking at building permit numbers. Speaking roughly, if developers are investing in new properties, that’s a good sign that demand, and prices, are rising or keeping steady. If developers are holding back, that suggests demand, and prices, will soon fall.
I know many developers who were active in 2008 and 2009 buying broken projects for pennies on a dollar.
L.A. housing permit units peaked in 1977, 1988 (50,500 units) and 2004 (26,900 units), one to three years ahead of the real housing price peaks in 1980, 1989 and 2006. Permits bottomed in 1982, 1993 (7,300 units) and 2009 (5,700 units), a few years before the housing price troughs in 1984, 1997 and 2012.
Over the last three years, we have seen L.A. building permits increase from 11,200 units in 2012 to 18,200 units in 2014. The 2015 number will most likely be higher than 2014. Therefore, we can predict the next home price peak is at least two years away.
His prediction may prove to be true, but he would be right for the wrong reasons.
Yet another measure of rational housing value is a simple price-to-rent ratio. The ratio is calculated by taking the median home price over the annual median rent in L.A. If the ratio is high — meaning that home prices are beyond their fundamental value based on expected rental revenues — that points to a bubble. Again, let’s look at history.
Two previous peaks were in December 1989, with a ratio of 14.8 to 1, and in February 2006, with a ratio of 24.4. According to Zillow, the current price-to-rent ratio in L.A. was 17.1 in May, which is far below the 2006 bubble level but still higher than any time before 2003.
The price-to-rent ratio fails to account for the impact of interest rates. I discussed this at length in Price-to-rent ratio suggests housing is 30% overvalued. The price-to-rent ratio signals a bubble, but since he has no benchmark of value, he can’t see the problem.
That doesn’t worry me, though. A high ratio doesn’t spell danger for Los Angeles because, similar to New York (ratio: Manhattan 25, Brooklyn 23) and San Francisco (ratio: 21), it’s now a “superstar” city.
This evidence doesn’t mean LA is not in a bubble. Unless he establishes that neither New York nor San Francisco are in a bubble (good luck with that), then he can’t establish LA is not in a bubble: all three may be bubbled.
L.A.’s size, amenities, weather and geography make its houses an investment target for the global elite. Wealthy individuals from all over the world don’t care that it might make more financial sense to rent, because they’re not simply buying Los Angeles houses to live in them, they’re also trying to diversify their financial portfolios.
Now he appeals to the fallacy that everyone wants to live here. Fail.
Even though Los Angeles is one of the least affordable cities in the U.S., all factors indicate that it is not in a housing bubble. Of course the bull market will end eventually, but that doesn’t mean we’re heading for a devastating crash, like in 1990 or 2007. Whether you should put up a million bucks for that bungalow is another story.
William Yu is an economist at the UCLA Anderson School of Management.
Mr. Yu’s predictions will turn out to be right, but not for any of the reasons he outlines.
While prices are high in California, they are not in bubble territory. While the potential for a minor price decline to to rising mortgage rates is real, the chances of a catastrophic price collapse is low, and fear of such a drop shouldn’t prevent anyone from buying a home.