Sunday, October 01, 2006
The Bubble-Rooter
All you ever wanted to know about real estate bubbles.
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A gentleman from South Carolina has sent an e-mail last week. He has been reading my Articles on Real Estate Economics, and wants to know how I can possibly take the position that there is no real estate bubble bursting out there. This gentleman believes not only that there is a burst in full progress but that, in fact, it looks more and more like a ‘market crash’ – at least in the area where he is located. He corroborates the e-mail with an impressive set of figures taken from local sources.
While I am grateful to this individual for taking the time to send his otherwise lengthy message privately, I thought I’d present my response also to the public at large, in hopes to shed some light on this subject matter. Following, therefore, is a FAQ on bubbles formulated in accordance with the points and concerns raised in the e-mail. I have, furthermore, notified this person that this Article represents my response and have invited him to come and read it in this forum.
So here we go.
Q. What is a real estate bubble?
An economic bubble is a particular market condition, wherein prices of commodities or assets increase to levels so high as to no longer reflect the utility of usage of the commodities or assets being exchanged. The main cause of an economic bubble is speculation. Speculation is one of the many forces that act on capital at any given time. In theoretical Economics, speculation is defined as ‘the acquisition of financial or capital assets made solely to quickly profit from fluctuations in their prices, or of goods or commodities with no real intent to consume or otherwise use them for production’.
Contrast this with investment, which is defined as ‘the acquisition and use of financial or capital assets with a view to generate income, or of goods and commodities for the purposes of consumption or production’.
Clearly, pursuant to the foregoing definitions, the real domains of speculators are the stocks, bonds, treasuries, futures and debentures markets, cumulatively referred to as the Stock Exchange. Many ‘investors’ in the Stock Exchange actually speculate, since they bet on a quick gain dependent upon the volatility shifts of the market they operate into, and since they do not intend to consume the products they buy. A purchaser of one-hundred shares of IBM does not intend to actually go work for IBM, nor does he necessarily intend to start consuming outputs produced by IBM. He merely intends to buy IBM shares at a lower price and resell them with a mark-up.
Speculators do operate in the real estate markets, but to a far lesser extent, mainly because real estate typically moves in slow, very slow motion – even when real estate markets are ’fast’. The fluctuations in prices that occur in the Stock Exchange in a few hours typically take days, or even weeks, to happen in real estate. Additionally, fluctuations expressed as a percentage change of their nominal market value are far greater and substantial in the Stock Exchange than in real estate. For instance, it is not unusual for stocks to gain or lose 30-, 40- or 50-percent of their value in the round of a week, sometimes even in a single day, but no such dramatic variations exist in real estate. One never hears of a rancher abutting a golf course that on Monday morning is offered for sale for $500,000, and which by Friday afternoon has been reduced down to $250,000. Because of this, speculators tend to shy away from real estate markets.
The few speculators that do operate in real estate are those who engage in the ’flipping’ of real property assets. Many investors think of themselves as masters of flipping, but truth of the matter is that they do not flip at all. They resell for profit. True flipping, in real estate, consists in the purchase and selling of an interest in land without paying for it with one’s own money. Thus, a speculator flips real estate buy putting in an offer to purchase an asset, and then ‘flips’ the same asset (which the speculator does not own as of yet) to a second purchaser for a higher price, who will complete the transaction on the same day as the speculator’s original transaction. The speculator will then take the money from the second purchaser, retain his profit margin, and transfer the balance to the Seller. The speculator, in other words, will pay the Seller with the money of the second purchaser, not with his own money. This is a practice known in the United States and some Canadian Provinces as ‘double escrow’.
Needless to say, all those who purchase fixer-ups, refurbish, remodel and then resell them, and think of themselves as great speculators, are not speculators at all. They are also no masters of flipping. They are just merely ordinary investors, with a super ego.
Here is the classic comparative economic breakdown, by category, of market participants operating in both the Stock Exchange and Real Estate:
Stock Exchange ... Real Estate
Speculators
65% ................ 5%
Investors (short term)
25% ................ 35%
Investors (long term)
10% ................ 60%
I have seen some sources last year pegging the percentage of real estate speculators to double the one of the forgoing table, and am further aware of some economists and market analysts who cite a 15 percent figure. But even if, by hypothesis, speculators represented a 20 percent of real estate market participants, 4/5 of all participants would still be made up of regular short and long-term investors. Therefore, as the primary cause of economic bubbles (speculation) is almost entirely absent from real estate, or has otherwise minimal or reduced impact, it is ludicrous to speak of ‘real estate bubbles’.
Thus my position.
Q. Still, prices are tumbling down. If it’s not a bubble, what is it?
Price deflation. Plain, ordinary, old-fashioned, lemon-flavoured price deflation.
Deflation is a decrease in the general pricing levels of assets or goods, which occurs when the equilibrium between supply and demand is altered, resulting in a higher or lower purchasing power of money within the market (in the present case, the purchasing power is higher since prices are coming down).
There are two, and only two variables capable of altering the equilibrium of supply and demand: 1) a tightening or expansion of the money stock which, in turn, alters the cost of borrowing, i.e. a shift in interest rates, or 2) an increase in inventory supplies. Alfred Marshall (1842 – 1924) was the first to attempt to explain price behaviour within the context of the equilibrium between supply and demand in competitive markets. Marshall discovered that consumers attempt to equate prices to their marginal utility, defined as the measure of happiness or satisfaction gained by consuming goods and services. Given this measure, one may speak meaningfully of increasing or decreasing utility, and thereby explain consumer behaviour in function of shifts in pricing.
The propensity to invest in real estate is partly dictated by the expectations of future profitability and by the present perception of market risk. The table above shows that a good 40 percent of real estate market participants is composed of speculators and short-term investors. These folks are in the market solely to increase their level of wealth, in the short and very short run. When the perception of market risk on the part of 40 percent of market participants increases sharply - which is exactly what has been happening these past few months - capital will exit more and more from the sphere of real estate and will find its way elsewhere (typically the stock market). There occurs, in other words, a shift in volatility risk.
The turnover in real estate markets drops when the pool of buyers ready, willing and able to consume real estate products abates. This, in turn, discourages consumer spending on real estate products, demand lowers and markets cool off.
Q. Bubble, deflation ... call it any which way you want, the result is all the same for me.
But not for me.
The difference consists in the repercussions and effects that bubble bursts and deflation have on market wealth, defined as the combination of materials, labour, land, services and technology in such a way as to capture a profit (Adam Smith). The aftershocks of a bubble that bursts are usually terminal and irreversible: market wealth disappears, it vanishes entirely. And it takes forever to re-build it, right from scratch. The greatest example in recent times is the infamous Black Monday – October 19, 1987 – when the Dow Jones collapsed 22.6 percent in value in a single day! It took nine years for Wall Street to lure investors back.
The burst was so powerful that even today, nineteen years after the fact, there are people out there still hurting. Lives were changed forever, companies were wiped out, families were ripped and broken apart and a few people committed suicide. And not only in the United States, but all over the world. Markets fell 41.8 percent in Australia, 22.5 percent in Canada, 45.8 percent in Hong Kong, and the 26.4 percent in the United Kingdom.
Now, that’s a bubble burst!
With deflation, on the other hand, wealth can be recovered. It is still there, though it cannot be tapped.
Finally, a few words about the soundness of real estate as a wealth-generating vehicle, even during times of deflation. Homes have appreciated consistently to the tune of 7.5 percent per year over the past thirty years, notwithstanding the numerous ups and downs the industry has been going through. Unfortunately, 40 percent of Americans and 35 percent of Canadians are renters and that is too bad, since the fastest way to riches is buying real estate, as opposed to buying just about anything else, including stocks and bonds. The average Canadian renter has a net worth (assets minus liabilities) of CAD $6,000. The average Canadian homeowner has a net worth of CAD $225,000 (source: Canadian Real Estate Association). Figures in the States are comparatively similar.
One of the best wealth-generating source is mortgages. Even the so-deprecated ARMs are good, since they are used to buy homes and build up value. We do everything with our homes in addition, of course, to live and sleep inside them: we use them as collateral for personal lines of credit, we use them to increase our net worth, we use them to establish our hierarchy within society, we use them to improve our own self-esteem and, last but not least, we also use them as the parachute of last resort to save us from dire financial straits. Ownership of our homes is everything to us.
My concluding remark is that a slow-down in real estate has actually a positive influence on the economy by allowing salaries and wages to catch up and thus to regenerate the pool of buyers, especially first-time Buyers, entitled to take their first steps into the world of real estate. The ratio between wages and real estate market values is too skewed to values. Whereas market values in metropolitan areas have appreciated an average of fifteen percent per year for the past five years - or a total of seventy-five percent, salaries have increased an average four percent per annum – or twenty percent total. There is, therefore, a fifty-five percent gap, which accounts for the problem buyers are facing today when it comes to go to the bank and qualifying for a loan.
Thank you for the e-mail.
Luigi Frascati
Real Estate Chronicle
