The Housing Bubble

Wednesday, December 28, 2005
Most of the readers who read my blog know that I believe there is a housing bubble going on right now. I believe the top has been reached and that we are going to start to see price declines over the next year. How steep those declines will be remain to be seen.

What is interesting to me is the talk on the other side of the isle by those who do not believe a bubble is formed, who believe that prices will rise or stagnate.

I am a huge fan of real-estate. I believe it is normally an excellent investment. You get to live in the asset while the price appreciates. It is tax-favored so you can realize large captial-gains without having to fork anything over to Uncle-Sam. But what has gone on over the last three years is bordering on mania.

Economics is called the dismal science and it is a aptly named. You see, economics is not kind. We are witnessing a huge asset bubble that, when it burst, is going to hurt a lot more people than anything before it. Most everyday American's don't own stocks, and certainly didn't participate in the internet stock bubble. But most American's do own homes. And many new home owners have bought homes on exotic mortgages. It would be like all these Americans not only buying Microstrategy and at the height of the bubble, but buying them on margin!

Of course the naysayers say that houses aren't stocks. Well stocks aren't tulips either, and we all know how that one ended up. An asset is an asset. And any asset can be prone to speculation. It is true that housing is more illiquid than stocks, but that may just compound the problem as pepole will be unable to get out of their homes and thus be upside down in their mortgage. The problem with the dot-com bubble was that the assets were illiquid. When everybody went looking for the way out, nobody was left to buy. They had to dramatically drop the price because the asset wouldn't sell. It wasn't liquid.

During the bubble it seemed like any idiot could become a millionaire. He just needed an idea, a web-page, and Bam! he would issue an IPO and make millions. Well the same thing is going on in real estate. Idiots are making money. People who have no experience in housing, who wouldn't know a closing statement is or a 1031 exchange is, are making lots of money.

Near the top of any bubble, you will see that even idiots can be richly rewarded. But it can not last. You see, housing prices can not rise indefinitely, no asset can. Housing prices can not diverge from its underlying fundimentals for long, and real estate has. Stock prices are tied to the earnings the company is able to produce. Over the long haul, stocks MUST be tied to the earnings created. The price of a house MUST be tied to the rental income that it could generate if rented out. Over the long haul, a renter must be cash-flow positive, no one can sell at a loss forever. There is no magic behind it. It just must be. It's simple economics. Ignore reality at your own peril.

Because of the above facts, most recent homeowners are in for a scare. Wages have not increased. Rents have not increased. How can housing prices be justified? The answer, they can't be. When people realize the game is up, don't be standing in front of the door; you will get trampled. When nobody is left stupid enough to pay what you paid for your asset, what are you going to do?

People are hopeful. They always want to believe that this time is different. Economics tells us that it never is. Believe me on this one. The housing market is on the cliff, and its about to take a dive.