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Markets: Housing Mania
New York: July 18, 2005
By John R. Stephenson

Housing is all the rage. While academics and journalists hotly debate whether we are, or are not, experiencing a housing bubble, most of us are just happy to watch the price of our biggest asset soar. And soar is exactly what house prices have done. So much so, that real estate and everything related, are back in vogue with late night television hucksters informing us how we can get in on all the easy money. But for my money, there really isn't much debate.

Housing, while hot and likely to get a little hotter, will no doubt get quite a lot colder before all is said and done. Housing is a market, like the stock and bond markets and yes - house prices can rise and fall just like everything else. The forces for change? Those old culprits: supply and demand. But for now, hot housing is a fact of life, being fueled by low interest rates (demand) which has encouraged people to go out and spend - and spend big. Hey, why not? It can make a lot of sense to borrow a wack of dough to control a big asset such as a house, so long as house prices continue to rise. Most of us don't contemplate falling prices. But fall they can. For most of us, our only care is the affordability of the monthly payment. And right now, those monthly payments are looking pretty affordable. With the stock market a little anemic, real estate has seemed like the near-perfect money-making machine for many of us.

No doubt, if your timing is perfect, you can come out ahead in real estate. But, rarely does timing work out perfectly. Eventually the party will end and when it does, you had better hope you're not caught holding the bag. As Stephen Roach, the chief economist of Morgan Stanley writes: "With a saving-short U.S. economy now hooked on an increasingly frothy property market, risks of the ultimate post-bubble shakeout are mounting. That's because unlike the equity bubble of the late 1990s, the housing bubble has been built on a mountain of debt. The history of asset bubbles tells us they almost always last for longer than we think. That was true with the dot-com mania and is most assuredly the case today."

Figure 1: Change in U.S. House Price - Year over Year

Source: DrKW Investment Research

But the data is clear. House prices have been on a tear. And while prices themselves are not the only determinant of a bubble forming, they are a pretty good indication. The real test of whether a bubble is forming is whether the price levels for housing, or any other asset, have diverged significantly from their underlying value. In figure 2, we examine just that possibility, by comparing house price to rental income. By this measure it is clearly evident that house prices have been on an upward trajectory, but more important, is the divergence between what a house can fetch on the open market and what that same house can throw off in terms of rental income. The conclusion? House prices are way out of line with their underlying value.

Figure 2: U.S. Housing - Expressed as a PE Ratio

Source: DrKW Investment Research

But, investors remain optimistic. According to a recent survey conducted by the Los Angles Times , homeowners expect house prices to rise by 22 percent annually for the next ten years. A 22 percent increase over ten years works out to an 800 percent appreciation in home prices over that interval. Not only that, but a UBS/Gallop poll showed that 67 percent of investors see housing as more profitable and 77 percent see it as a safer alternative to the stock market.

Figure 3: Supply Continues to Surge While Demand Slows

Source: Goldman Sachs

In spite of the optimism amongst investors there is cause for concern. First and foremost, we are rapidly increasing our stock of housing at the same time that demand is starting to falter. Last year in the U.S., we built 2 million new homes. Yet, we only added some 1.2 million new households, meaning that some 800,000 homes were absorbed as either second homes or for investment purposes. But with supply outstripping demand, is it likely that house prices can continue to rise at an exponential rate?

Of all the tell-tale signs of a bubble formation, few are as obvious as the loosing of standards. This was clearly the case during the craze as investors were more than willing to buy the shares of companies with no track record, no customers and no profits. The same is true in real estate with some 35 percent of all mortgages now in the form of adjustable rates (ARMS) which leave borrowers extremely vulnerable to rising rates. As well, interest-only mortgages are commonplace as are 105 percent loan-to-value mortgages which allow the buyers to even cover the cost of buying. But one of the most worrisome trends is the rise in sub-prime lending. Sub-prime lending is lending to those with poor or blemished credit histories or unusually high debt to income levels. And its been rising. Today, it accounts for nearly 17% of all home equity lending.

Figure 4: Sub-Prime Lending is on the Rise

Source: JCHS

In spite of the press coverage on the risks to the housing market, the public remains upbeat. A recent study out of Yale University (Goetzmann and Dhar) reveals that 50 percent of respondents think that a crash in real estate is unlikely. According to the National Association of Realtors, 23% percent of all homes purchased in 2004 were for investment purposes while 13 percent were for vacation homes. Not only that, but recent figures just released show that some 40 percent of the new homes being purchased have not yet been constructed - a sure sign of speculative activity in the housing market.

Figure 5: The Percentage of New Homes Not Yet Under Construction Continues to Rise

Source: DrKW Investment Research

For my money, there is little doubt that a housing bubble exists and it is only a matter of time till the fundamental factors of interest rates, unemployment or investor sentiment turn against the homeowner. But in spite of these concerns, as long as interest rates remain low, we will likely see housing continue to surge for a little while to come. Like it or not, the world is awash in capital, much of it destined for the U.S. which is bidding up the price (lowering the yield) of government bonds and helping to keep borrowing costs for you and me, down. With low interest rates and no end in site for the world's economic imbalances, it looks likely that U.S. rates will stay low enough (10 year bond below 5.5%) to spur continued investment in real estate.

But the fundamentals for the real estate market are not solid. And while it may seem like a great idea for us as individuals to lever-up by borrowing at cheap rates, all of this easy money has made us rush head first into a market where valuation is increasingly becoming divorced from the fundamentals - a recipe for long-term pain. While real estate may be your largest and best investment currently, it may make sense to stop doubling down and instead look to take some of your chips off of the table. While a downturn in the real estate market isn't imminent, it is certain and when it does happen, the fact that things have gotten so stretched will only make the final result more painful.

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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