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Markets: Hot Housing?
New York: May 30, 2005
By John R. Stephenson

Everybody's talking about it. It's featured in the curriculums of business schools, on television shows and in books. No doubt about it - real estate is a hot topic. And why not? Most people consider real estate investing to be low risk with the potential to make outsized returns through the use of leverage - as long as interest rates remain modest.

With the stock market slumping and interest rates low, is there a better investment out there than in the bricks and mortar you call home? For many folks, the answer is "no". In fact, house prices in North America have been on a tear. Eager buyers have been snapping up houses to be sure to get in on the best investment you can make . But with house prices up over 138% in the last five years in San Diego and up over a 100% in Las Vegas over the same period, you might wonder if the best days are behind us for real estate investing.

For the last twenty years, interest rates have been falling. With interest rates so low, housing has become increasingly affordable resulting in a strong surge in demand for residential housing. Not only have rates made housing more affordable than at any time in the recent past, there has also been a surge in non-traditional (i.e. away from bank and credit union) lending, which has made borrowing a whole lot simpler. With the percentage of non-traditional lending surging from 44.4% to 60.2% of outstanding mortgages over the last fourteen years - borrowing has gotten a lot easier. With easy money and easy borrowing, real estate has become red hot.

But the fear is that it has gotten a little too hot. All indicators seem to be suggesting that there is a speculative bubble forming in real estate - particularly along the coasts of the U.S. While many people argue that strong demand from immigrants and echo-boomers are the reason for the frothy real estate market, the numbers don't seem to support this claim. Numbers from the National Association of Realtors suggests that fully 25% of all real estate activity in the country is for speculative purposes. In other words, investors are gambling that the rising tide will lift their investment boat - and in short order.

But with more and more people thinking that real estate is a sure thing is this not the time to start thinking of taking your chips off the table rather than doubling down? For our money it is. Today in America, there are more homes than households and more cars than people with driver's licenses. Not only that, but the number of new homes under construction has hit an all-time high. Surging supply and steady demand is never a good sign for elevated prices in any market.

Not only are there too many homes hitting the market all at the same time as people are thinking that real estate is a can't loose proposition but it is occurring at a time when household debts stand at record highs. No doubt low interest rates have encouraged people to keep on spending but now the whole real estate game rests on the fulcrum of low interest rates. But yet the rush to own real estate continues. Some 60 percent of mortgages written in California during the first two months of this year alone have been of the interest only type - further underscoring the bubble that has been forming. Not only are people gambling that rates stay low by shifting into bigger homes than they can afford (by utilizing interest only mortgages and other lending innovations) but they are also pulling money out of their homes in record numbers. Last year, Americans pulled some $400 billion from their homes - in effect turning their houses into ATMs.

Figure 1: Consumers Have Used Their Homes As ATMs!

Source: Phillips Hager and North

With our friend Alan Greenspan making it clear that interest rates are going higher, not lower, the party may be coming to an abrupt end. As with all market bubbles, this point coincides with the point of maximum euphoria. While the punch bowl might remain out for a little while yet, it seems certain that the perfect storm of low savings rates (the average American is now saving less than 1% of what they make), high personal debt levels and large speculative activity may be ready to crash America's overvalued real estate market.

Real estate investors who are worried about the potential problems brewing in the U.S. housing market can ensure that their own house is in order by paying down debt, renegotiating variable rate mortgages (to a 30-year fixed) or exiting the investment altogether. Stock market investors can profit from the coming real estate storm by selling short (selling today and hoping to buy back at a lower price) real estate investment trusts (REITs) which have seen a pretty steady rise in valuation over the last thirty years.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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