A bubble market?

a bubble market?

[Note: This article was written in late 2003, when some began to speculate about a real estate bubble. I’ve updated it periodically since but left much of its original emphasis intact, because I think that potential buyers should see the debate as it was first joined six years ago. As you’ll see, in 2003 the skeptics believed that home prices should be declining from their “inflated” dot-com era highs. Then realize that from September 2003 to September 2005, the median price of a single-family home went up 33.5 percent in Santa Clara County and 31.3 percent in San Mateo County. There's probably not an active buyer out there today who doesn’t wish he or she had bought in 2003. "Will the market cool?", I asked in June 2006 when I first updated this, and by then it already had in many but not all local markets. Will home prices give back everything they've gained since late 2003? Yes, it’s possible, just as it’s possible that you'll be run over by a bus tomorrow. It's your call as to whether either possibility is likely enough to plan your life around. Even in the perfect storm of tech bust, terrorist attack and national recession in late 2001, the median single-family home price dipped just 14.1 percent in Santa Clara County and 9.8 percent in San Mateo County. Will real estate see the catastrophic collapse that some have been predicting since 2003? It didn’t happen in 2003, or in 2004, or in 2005, or in 2006, or in 2007. In fact, prices in most local midrange neighborhoods didn't peak until early 2008. Mea culpa: As you read, you'll see that I underestimated the effect speculation and the subprime epidemic of 2005 to early 2007 would have on the low end of the market, in places such as East Palo Alto, parts of San Jose and the Central Valley, anywhere $600,000 or less got you a house. Why the blind spot? I wasn't in those neighborhoods. The midrange neighborhoods I was in held up remarkably well, much as I predicted, until a stock market crash that only a handful of diehard pessimists predicted took them down. Which proves that every thirty years or so it pays to be a diehard pessimist. So if I'm still around in another thirty years, remind me to be a pessimist. But for the next twenty-nine, I'll take my chances with optimism. I like the day-to-day pay-off better.]

There’s been lots of talk lately that real estate is a “bubble market”. Nationally, real estate prices are rising so quickly that some fear they’ll deflate just as quickly, with disastrous consequences to over-extended home-buyers. Locally, real estate prices have exceeded their 2000 highs except at the high end, and skyrocketing prices have the skeptics believing that home values will crater just as badly as did the stock market in 2000.

I’m no expert on bubbles, but after doing a little research it’s obvious that “bubble” has become a buzzword, thrown around with more enthusiasm than accuracy.

Add to that the usual misconceptions about real estate, even in a normal market, and you have a recipe for certain confusion. Go to any bubble blog and you’ll see that many posters have what might be called a “pre-scientific” view of how the real estate market operates. (Extrapolate this view to the stock market and it’s no wonder that the average person does so miserably in that market too.) Just as the ancients compensated for their lack of scientific knowledge by ascribing supernatural causes to natural events, these blog posters ascribe real estate price run-ups not to supply and demand but to the supernatural powers of agents. It’s a feeling so commonly shared, even among the journalists and academicians who should be shedding light instead of heat on real estate, that I’ve come up with a phrase—“agent ju-ju” —to describe the voodoo-priest like control we supposedly have over the market. (Then why do we allow prices to go down?) Throw in that other handy substitute for real knowledge, conspiracy theory—“real estate is a cartel”, as if the thousands of self-employed agents in your area, each scrambling for your business, could ever combine to rig the market—and you can understand why so many think real estate such a scary, out-of-control place.

“Bubble market”, mystical, menacing and catastrophic, is a symptom of pre-scientific ju-ju real estate. I’ll look at what a bubble market really is, and how (and if) it relates to owner-occupied real estate. I’ll also speculate on why some people find the bubble theory so compelling. Finally, I’ll make a pitch for some historical perspective on the housing market and on the current state of Silicon Valley.

Since I’m a real estate agent, you won’t be surprised to learn that I don’t think we’re in a bubble market, at least not here in the San Francisco Bay Area. Nor was the hot real estate market of the late 1990s a bubble, at least by the definition economists use when they’re not making up quotable quotes and mucking around in a market they weren’t trained in and don’t particularly like or understand.

Down here in the trenches, beneath the ivory towers, the bubble theory is sometimes a convenient smokescreen for inertia and wishful thinking. Often it's married to market timing, a wealth-building strategy successfully executed only by accident.

However, the bubble theory not only has a grain of truth to it, it has two. First, real estate prices do go up and down. That’s the nature of real estate, especially in an area where a limited supply of housing has a multiplier effect on increases in demand. And make no mistake, there’s a serious shortage of housing in this area, at least in places where most people want to live.

Second, there’s no doubt that some (but not all) of real estate was bid up to temporarily unsupportable levels in 2000, just as it was in 1989. Will history repeat itself? It’s entirely possible, but bear in mind that in most of this area 2008 prices were substantially higher than 2000 prices, which in turn were substantially higher than 1989 prices. That’s the kind of long-term timeframe you need to buy real estate; it isn’t dot-com day-trading. And speaking of irrational exuberance, many of us are still paying psychologically for the late 1990s in ways we don’t even know. Not only did the good times lull us into expecting quick, easy riches, but the bust has us seeing bubbles where they don’t exist. But as we’ll see, the real estate market isn’t the stock market.

what is a bubble market?

Let’s start with what a bubble market isn’t. A bubble isn’t a market in which prices go up quickly or significantly. That’s just a market in which demand exceeds supply. In real estate this price run-up often occurs in the spring, when buyers enter the market en mass before sellers have put enough houses on the market to meet this sudden spike in demand. Because demand temporarily exceeds supply, much of real estate’s annual price appreciation occurs during the spring, yet no one calls this a bubble.

Even in normal markets, home prices are far more fluid than most people realize, varying by season and month. The time tables of buyers and sellers rarely match, creating continually shifting mismatches throughout the year that lead to imbalances in supply and demand. These imbalances subtly raise and lower home prices in any market.

For example, the mind-bending boom market of Spring 2000 was caused by both seasonal and fundamental shifts in real estate: an influx of stock market wealth (fundamental) at a time of year when inventory is usually tight (seasonal). When more money chased less inventory, prices went through the roof.

The occasional waves of price reductions that have skeptics thinking the real estate “bubble” has finally burst are sometimes due to normal seasonal fluctuations. For example, buyers go on vacation (decreasing demand) in summer just as more sellers go on the market (increasing supply). Less demand plus more supply equals flattening or even declining prices. The same situation usually occurs between Thanksgiving and early January. These are routine and predictable market shifts.

But price reductions may also signal a non-routine, fundamental shift in real estate, as when layoffs reduce the number of buyers and increase the number of sellers. This is what the bubble theorist and market timer live for, yet the uncertainty that drives down home prices has them fearful of making their move. Will prices go down again next month? Will I get a paycheck next week? Besides the employment rate, fundamental shifts in real estate are caused by changes in interest rates, consumer confidence and the stock market. [And as we've seen in 2007, cut-backs in the availability of subprime lending can seriously impact some markets while leaving unscathed others just a few miles away.]

And just to make things interesting, a fundamental shift in real estate can show up disguised as a normal seasonal shift. Were home sales down in December 2000 because buyers were celebrating the Holidays? Or were they down because declining stock market wealth no longer supported rising home prices? We soon found out.

Here’s a bubble: when the greed of speculation overwhelms that other driver of financial markets, fear, and common sense gets thrown out the window. Investors cross the line into speculation when they stop believing that what they’re buying is worth the price, but continue to buy because they believe the next buyer will pay even more. This is sometimes called the “greater fool theory”.

The Tulip Mania of early 1600s Holland is a classic bubble and an enduring favorite, perhaps because of the subject—“Tulip bulbs? What were they thinking?”—but other early examples are just as interesting. There’s the South Sea Company mania, an 18^th century version of “pump and dump”. There’s England’s railroad frenzy of the 1840s, when companies supposedly formed to create wealth from a new technology merely separated speculators from their money. Closer to home is the 1920s Florida land boom, when gullible speculators bought and sold (often sight unseen) undeveloped land (often under water) at exponentially increasing prices.

real estate and the stock market: joined at the hip?

There’s no doubt that these classic bubbles resemble the over-hyped, momentum-driven “this changes everything” stock market of the 1990s. And with that deafening boom and bust still ringing in our ears, it’s tempting to see “bubble” whenever the price of an asset goes up dramatically.

But linking the financial markets and the real estate market ignores a significant difference between the two that makes owner-occupied real estate an unlikely prospect for a bubble.

Remember, bubbles are caused by speculators, and speculators need to sell quickly and easily. Let’s go back to the Tulip Mania. While it’s true that tulip bulbs were bought and sold at rapidly escalating prices during the Mania, it was call options, the right to buy bulbs at a certain time and at a certain price, that made the tulip market vulnerable to widespread speculation and broadened its economic impact. For just a few guilders your up-to-date market-savvy Dutchman of 1637 could wheel and deal in bulbs without the need to store and transport them. “Hey, this is an easy way to make money” are the famous last words that precipitate a bubble.

Speculators need liquidity—the ability to get in and out of a market, inexpensively and at a moment’s notice—to take advantage of its constant fluctuations. But houses don’t fit the get-rich-quick market timing of the speculator. As any seller can tell you, real estate is a classically illiquid asset. Home buying and selling is a complex process with high costs and a transaction time measured in months, not seconds. Yes, some people do speculate in houses, but this “flipping” is a miniscule part of the market in our area. Why? Probably because high prices make the cost of carrying an investment property prohibitively expensive for the small-timers who typically flip. The vast majority of local houses here are bought to be occupied by the purchaser for the longer term, typically from five to seven years.

Even flippers spend months adding value to a house—carpet, paint, landscaping—before returning it to the market. Add at least another month or two for marketing and escrow, and flipping is a long way from day trading. Given the fluidity of real estate prices, even in normal markets, this significant lag time between purchase and sale means that profit opportunities in real estate can disappear even as money is pouring into a property.

your home: investment or asset?

Hint: What investment ever had a pink flamingo in front of it? Here’s a novel, perhaps even heretical idea: buying your own home, far from being the wild speculation that leads to bubble markets, is so far removed from speculation that it isn’t even the investing that, taken to extremes, becomes a speculative bubble.

The cliché “buying a home is the largest investment most people will ever make” is unfortunately misleading because it puts home ownership in the same basket as stocks, bonds and commodities, and then it’s easy for many to link “home” with “bubble”. But your home isn’t your biggest investment. Your home is your biggest asset. You buy your home primarily for shelter, not because it offers earnings growth potential and a good income stream. Your home’s price goes up over the long term not because its earnings per share or dividend goes up, but because of inflation, population growth and (in this area) a supply that’s severely and permanently restricted. Sure, they’re building thousands of homes in Brentwood and Modesto, but that’s not where most people want to live. By itself, “cheap” is rarely a compelling reason to buy a home.

yeah but

What about the hyper real estate market of March 2000, with its multiple offers and huge overbids? Wasn’t that a bubble market? Didn’t those buyers pay too much? [Note: if you don't care about dot-com's effect on home prices, a hot topic back in the day but a moot point today except for bubbleheads with long memories, then skip this section.]

There’s no doubt that stock market wealth raised Silicon Valley mid-range home prices to a level not sustainable in the short run. The top end, where most of the dot-com money went, still hasn’t recovered. But that run-up, no matter how dramatic, lacked the speculative element found in bubbles. Buyers weren’t buying to sell quickly at a profit. That’s an important distinction, because it means that buyers were paying what they thought was a fair price for something intrinsically useful—they weren’t buying just so they could sell tomorrow to the next hotshot down the line. This keeps a degree of rationality in the market…even though, if you were trying to buy in 2000, you might not think so.

And even though the stock market bubble injected huge amounts of money into real estate almost overnight, mostly at the top end, this comes with an asterisk: it happened during a time of year when inventory is typically low, amplifying the effect.

Despite the stock market’s effect on real estate, two facts suggest that current real estate prices aren’t the bygone relic of a stock market wingding [as the bubbleheads were claiming in 2003].

First, real estate prices weren’t flat before the Fall 1999 run-up. Prices had been rising steadily for several years on the back of a strengthening local economy. A case can be made that today’s [late 2003’s] prices are in line where they would be if the gradual price appreciation of 1995 to October 1999 had simply continued. In fact, Menlo Park’s average sales price per square foot in December 2002 was the same as it was in October 1999, just before the run-up. Palo Alto prices as of December 2002 were higher than in October 1999, but were at a level easily attained if prices had simply continued the gradual upward trend they showed prior to Fall 1999.

In other words, the Half Dome cliff-like rise of November 1999 to March 2000 has been removed from current [2003] prices. That’s not to say that prices can’t or won’t go down over the short run, just that the irrational exuberance has been forcibly extracted from the market.

Another indication that current prices are in line with current conditions [in late 2003] is that the stock market bubble didn’t have the same effect on every one of real estate’s price ranges. In fact, one market segment wasn’t affected, at least not directly, suggesting that local real estate would have appreciated even without the NASDAQ’s brief flare-up from September 1999 to April 2000.

Real estate’s top end felt the stock market bubble far more, with spectacular run-ups when money flooded this area and spectacular flame-outs when the money dried up. Isn’t that a bubble? Doesn’t that mean that top-end buyers paid too much in late 1999 and 2000? No, not if they bought with the inflated currency of the stock market, as most did, because those stocks are usually worth far less today—and some of them aren’t even traded.

Real estate’s midrange was also affected by the fall of stock market wealth but with 10-15% variations. That’s still sizeable but far less than the top end’s 30-40%. Why the difference? The dot-com bust stripped away one level of midrange buyers to reveal another with good income but without the instant wealth necessary to compete during the boom.

The low end of real estate, basically anything currently selling in the low 8s or less, has also appreciated well but without either the high peaks or low valleys. That’s because buyers in this price range depend not on stock market wealth but on wages and family assistance to buy a home [and, in 2005 and 2006, on loose lending practices].

a real-world experiment?

This steady rise in prices at the low end of real estate, independent of the ups and downs of the stock market, is intriguing. In effect, the low end has been the control group, the test subjects who got the placebo instead of the drug. In this case the “drug” was stock market wealth, yet even without it, low-end prices still rose just as much over the long term as midrange and top-end prices. This suggests that real estate prices would have risen strongly even without the sudden and massive infusion of stock market money that occurred from late 1999 to early 2000.

But is it really this simple? Probably not. True, the low-end buyers I’ve worked with were either not in the stock market or only minimally invested, but there’s no question that they benefited indirectly from the stock market’s wealth effect. Perhaps when so many are invested, it isn’t possible to remove stock market wealth from the equation. Regardless, the low end has benefited from it the least yet still done extremely well. This performance, plus the resiliency of the mid-range, suggests that local real estate can stand on its own two legs. Top end prices may still have too much air, but that’s a small part of the market with little effect on the real world.

home buying as a weed-out process

One of the major drawbacks to the bubble theory is that it short-changes the care and prudence people use when buying a home. That’s understandable, since the bubble theorist usually hasn't gone through the home-buying process. Because of that, the bubblehead doesn't understand that home-buying is a real test of focus and dedication. Yes, occasionally an offer is made on a whim and quickly rescinded, but no buyer gets to the closing table on a whim. A home is too costly and too much a long-term commitment. The buying process, from first open house to sign off, is too lengthy and dauntingly complex.

the bubble theory as permission to not buy

Whether buying real estate is in or out of fashion, both buyer and bubble theorist operate under the same economic conditions and hear the same economic news and rumors. When times are good and buying real estate is socially acceptable, both buyer and bubblehead feel the same overwhelming momentum impelling them toward home ownership, yet the bubblehead manfully resists. (Years later in a candid moment he confesses that yes, I made an offer once and thank goodness it wasn't accepted!) And when times are bad, both buyer and bubblehead have a friend in widgets who swears that widget orders are tanking, widget inventories are soaring and a widget catastrophe will soon bring this proud and foolish Valley to its knees. Truly a scene of Biblical retribution, yet the buyer will still buy on this information and the bubblehead will see it as permission to not buy.

I’ll share an experience, not to ridicule but to illustrate that the bubble theory offers as much risk as it seeks to avoid.

At an open house in 2003 I met a man who told me he was waiting to buy until prices went down. He knew they would because he was in tech and had inside information on the dismal state of the industry. When I didn’t deny this possibility, he decided I was reasonable and we had a long talk. But when he started to give me his contact information, his exasperated wife broke in to remind us that we had had this same conversation in 1998! Then it all came back. I had phoned him a few times, gotten no response and filed him in the circular file—wisely, as it turned out. Not only had he not bought, he was still renting the same cramped apartment. And homes in his price range had gone up some 60 percent between when we had first met in 1998 and our reunion in 2003 [and they doubled from 1998 to 2005].

Just another case of market timing gone horribly wrong? Perhaps, but I think it goes deeper than that. Lots of baggage is attached to the concept of homeownership because, fairly or not, we use it to measure a person’s achievement and stability. Add to this the tremendous emotion of home-as-shelter and things get really heavy. So the nagging question Why don’t you (I) own a home? requires, no demands a seemingly robust, pragmatic answer. For some people that face-saving, ego-preserving answer is the bubble theory: “I’m waiting for prices to go down.”

Open houses are a great way to meet bubble theorists, and early in my career I took them seriously. After all, it was possible that real estate could collapse like a house of cards—never say never—and these people had the confident air of the credible insider. And inevitably, they’d be right half the time. Because prices did go down…and then up…and then down…and then up… hey, do I detect a trend?

Gradually I began to realize that effective listening at open houses is like watching a foreign-language film with sub-titles. When I hear only fools are buying homes at today’s inflated prices I see sub-titles that say I’m priced out or I can’t afford what I want or I’m not ready to buy or I don’t like this area enough to commit or, simply, I’m afraid—all legitimate reasons to stay out of the market. But unlike the dialogue, the sub-titles don’t try to deny the reality of the market: that one person does not determine market value; the many do. But if one person naturally assumes that the many feel the same fears and hesitation he feels, yet buy anyway, it’s easy to see why he calls them reckless fools.

bubble theory or crystal ball theory?

What really challenges the credibility of bubble theorists is the idea that anyone can predict the future with enough certainty to take it to the bank. I can think of at least ten events that have significantly influenced real estate prices since 1998, from the international currency crisis of 1997-8 to the war in Iraq, and if any home buyer predicted more than two of these events accurately enough to profit from them, I’ll be the first subscriber to the newsletter he or she should be writing. Predicting the future is simply our way of trying to control the uncontrollable. Even the “experts” can’t do it. Especially the "experts".

Real estate is influenced by far too many random events to be predictable. I’m actively developing a theory that real estate will do exactly the opposite of what most real estate agents think it will. This business has some bright people and they’re in the trenches every day. If anyone knows where real estate will be a month or a year it’s them—and they don’t. The Spring 2001 market was going to be red hot—and it tanked. The Spring 2002 market was going to be dismal—and it skyrocketed.

and now, some perspective

I won’t minimize what’s happened to Silicon Valley since mid 2000 [remember, this was written in 2003, two years before this area's economy began to recover]. Like most agents I’m a small businessperson working without a net, so I’m particularly sensitive to swings in the economy and their effect on the people who live here (or who once lived here).

Yet while pessimism replaces exuberance in Silicon Valley, real estate shows amazing strength. But perhaps that strength is less amazing if you know the Valley’s staying power over the last 150 years. I’ve met people who think this was a sleepy backwater until they hit town in 1995, and that tech’s decline will return us to that former lowly station with a corresponding crash in home prices. But I’ve checked into it and guess what? None of this—the boom, the bust, the steep housing prices—is new.

There’s a book in the Menlo Park Library, Silicon Valley Fever: Growth of High-Technology Culture, that notes that the tech boom has pushed home prices to outrageous levels. It was published in 1984. Prices have increased five-fold since then. How many of you would like to buy at 1984 prices? Raise your hands. And as far back as the late ‘70s, high home prices made it a challenge to recruit employees from out of the area. In the early ‘70s the high cost of housing had local companies transferring manufacturing out of the valley. “Inflated” home prices are nothing new.

Silicon Valley booms and busts are nothing new. Silicon Valley has had five major recessions just since it got its high-tech moniker in 1971. Back in 1989, in my first days in real estate, the local Business Journal was filled with stories of empty office buildings. It is again, fourteen years later [but not today]. Obviously the law of business cycles was merely suspended, not repealed, during the 1990s. Perhaps also still valid (but a tough proposition to sell) is the idea that the ups and downs of the business cycle are each necessary, inevitable and inextricably linked: irrational exuberance creates wealth but sows the seeds of bust, which clears the field for another boom.

The valley’s economic mainstays have come and gone over the past 200 years: cattle-raising, logging, vineyards, orchards and farms, defense, personal computers and then the recent dot-com boom and bust. Yet this area keeps bouncing back. To understand why, remember what brought you here or keeps you here. Look around you at the natural beauty and unique lifestyle that’s drawn people, especially since after World War II. Remember that there’s no room to build more homes, and that the NIMBYs resist the only answer, high-density housing. It looks like local housing will always be a scarce, desirable commodity.

This area has been challenged before. Twenty years ago “Japan, Inc.” was going to do to Silicon Valley what it had just done to Detroit. Other regions in the U.S. and throughout the world have tried to replicate Silicon Valley, but the critical mass that’s accumulated around Stanford since the early 1950s remains unique to this area.

But for how long? The excesses of the last boom/bust may have you wondering if any area can go through that kind of whipsawing—too much money for bad ideas, then no money for good ideas—and keep its edge. After all, other regions have dominated an industry for a time and then lost it. Then you find out that Silicon Valley went through the same thing in the early ‘80s, and that the pattern is endemic to the economic cycle.

So it may be premature to bury Silicon Valley and its real estate market. So far, at least, anyone who’s bet against local real estate over the long run has lost.