The Bubble Part Four

This is the final part of an article on the nature of investment bubbles and how to recognize them.



In parts One and Two I quoted a paper by Jacob Fiefeld about various historic bubbles in an attempt to set some background to the discussion of real estate bubbles in particular.



In part Three I discussed a couple of the characteristics of bubbles and attempted to show how they related to the current real esate market.



In this final part I will discuss a few more characteristics of Bubbles and make some suggestions about how to invest in Bubble markets.

3) The bubble requires widespread participation. A bubble is a kind of mass hysteria, a group dynamic where the participants convince each other that the roller coaster only goes up.



When one person attempts to create a bubble we don’t call it a bubble we call it a corner. The most famous example, of course was Gould and Fisk’s attempt to corner the New York gold market in 1869. Their attempt came to naught when President Grant and the Treasury Department reversed a previous stance not to sell gold held by the U.S. treasury (at Fort Knox) and dumped $7 million in additional gold into the market. At one time in the scheme, however Gould and associates owned options on $40 million in gold. Only one problem—there was probably no more than $15 million in gold in the whole market up until Treasury’s intervention.



Perhaps the most successful corner in history has been the DeBeers corner in diamonds. For nearly a hundred years the DeBeers cartel has held a large enough stake in diamond production and marketing to manipulate prices. This has resulted in an extremely stable diamond market that has little connection to the actual scarcity of diamonds. This is an especially nice gig if your name is Cecil Rhodes but it makes the diamond business very difficult for startups and there are signs that even this most successful corner may be starting to show signs of strain.



Anyway, returning to the bubble. In order to generate a bubble you need a lot of people convinced that the in spite of past rises in the price of the commodity in question there is still lots of room to go up. This belief is, sooner or later, wrong. But we see it a lot in some real estate markets and these days we don’t hear a lot of dissenting voices.



Most of the people in the real estate market are not investors—they are homeowners and it is very difficult for homeowners to cause the speculative price of houses to rise enough to create a bubble. This is because the homeowner who occupies a house is pretty sensitive to the use-value/speculative-value equation. At some point in the decision making process they say, “Jeeze, I think I’ll just rent, I get the benefits of the neighborhood and it’s cheaper.” The price point where enough of them make that decision is what establishes rental rates. As I have argued before that is the use-value of the real estate.



So, in order for a bubble to get going investors have to come into the market in significant numbers. Therefore one way to get a feel for whether your market is bubbling is to track the number of new buys that are investors rather than owner-occupants. When you show up for the trustee’s sale at a foreclosure auction and there are 50 people there and the home sells for as much or more than it would after 90 days in the MLS that’s a pretty good sign that you are in a bubble.



The increase in investor buys is large enough to have come to the attention of FNMA and has been previously discussed here at TCI



http://www.thecreativeinvestor.com/modules.php?name=News&file=article&articleid=733



I merely want to add one observation: FNMA has noticed an almost doubling of investor buying in real estate in the last year. My guess is that the investor community in the places where real estate prices have been increasing only at sustainable rates has been pretty stable which means that the “hot markets” have had a lot more than double the prior number of investor buys.



4) Prices in a bubble tend to rise quickly and at unsustainable rates.



The truth of the matter is that real estate prices over the last 75 years have risen at a rate slightly higher than the rate of inflation. That is because the population has grown (increased demand) and the standard of living has increased (i.e. we have more money to spend so we tend to buy bigger houses and more toys.) But to assume that real estate prices are going to go up at 8-10% more than inflation for years and years is probably not a good bet based on past performance.



But when I read that prices in a certain market have gone up 30% or more in each of the last three years I know that market is ready for a major cool down unless there is some extenuating circumstance.



Examples of such extenuating circumstances:



a.) a major employer has moved into the area creating a significant number of new jobs thus both putting pressure on supply and increasing the standard of living.



b.)The houses we are pricing now are not the same houses as we were pricing three years ago. This happens frequently when rural, relatively low income areas have a sudden influx of gated golf course retiree communities with lots of units selling a prices much higher than the older houses. These higher priced homes pull average prices up quickly but do not necessarily reflect the underlying increase in price in the same units and do not necessarily signal a bubble.



The point is that unless the underlying economics have shifted real estate prices cannot sustain price increases of that magnitude for very long. You cannot divorce price from the under-lying productivity of the commodity.



5) The bubble requires leverage (debt) and that leverage eventually multiplies the effect of the collapse.



In the bubble that resulted from Gould and Fisk’s attempt to corner gold the price of gold rose from $134 to $162 in a matter of months but because so much gold was bought and sold on options with very small margins of cash the change in the value of the options amounted to tens of millions of dollars. At the beginning of the scheme the estimated value of all the gold in the market was $15 million (in 1869 dollars) when all was said and done Gould may have profited by as much as $10 million on the bubble. Whether Fisk profited or not is an open question since he was in the market buying even as the price collapsed back to $133 in a matter of hours (perhaps in an attempt to distract people from the fact that Gould was selling at the same time through straw men). The amazing thing is that the whole scheme was funded with a relative pittance borrowed from the 10th National Bank of New York. On each trade the gold was pledged for dollars that were in turn used to buy more gold options. A lot like taking out of a HELOC on the equity in a house in an appreciating housing market.



Let’s go back to our discussion of the house with the $500 per month loss: Assuming a 6% interest 30 year amortization that $500 monthly loss represents a present value of approximately $84,000.



My contention is that the house is over-valued in the current market by most of that value. In our example of the house where the rental rate was $1,000 per month that would represent paying almost 1.5 times the actual value of the house. If the rental rate were $3,000 per month and the payment $3,500 then the over-valuation drops to only 15%. But how many investors have 15% equity in the house? Assuming that the house was 90% levered and that the bubble bursts then the value of this house is now something like $30,000 less than the owner owes on it. In other words his equity has gone from $84,000 positive to $30,000 negative.



What is the effect of being “upside down” on the debt-to-value ratio? It means you get to feed that $500 per month alligator for a long time while you hope that the larger (but much slower) inflationary trend bails you out. Or you are looking at a foreclosure. Assuming that some substantial number of the houses in a market are in similar positions that means substantial foreclosures. And those foreclosures in turn mean more downward pressures on the use-value of the houses.



In addition there is another part of this puzzle that is appropriate to discuss in the current real estate market. We are in a period of low interest rates. Interest rates are likely to increase from here with even greater downward pressure on the speculation price.



Again, taking our house that rents for $3,000 per month and has a $3,500 per month payment. In the current speculative market that house sells for around $585,000. If interest rates increase from 6% per year to 8% then the house looses almost $110,000 in value to still have a $500 per month negative cash flow. But in a market where prices have just dropped almost 20% who’s going to be willing to hold onto that $500 per month negative waiting for appreciation? Prices will drop to the use price—around $410,000 in an 8% interest market. Again assuming the house was 90% levered at the top-of-the-market $585,000 price this represents a loss of about $115,000 more than the mortgage or about 200% of the equity at the top of the bubble.



I know people can pick nits over whether these rates are correct (you can borrow adjustable rate money at less than 6% now, rates are unlikely to go to 8% anytime soon) but the principle is the same: holding onto negative cash flows in a bubble market hoping that the speculative value will continue to rise is a loosing proposition.



So, assuming you conclude after this analysis that your local market is a bubble how do you deal with that information? What are the correct strategies for investment in a bubble market?



First—do not buy for long term hold. That means no rental properties with negative cash flows in hope that the appreciation train goes on forever.



Second—Take at least part of your cash to other markets. When you do sell and make money don’t put it all back into the same hyper-appreciating market. Put a substantial portion into either a different geographic market or a different segment of the local real estate market where prices make sense.



Third— Know your risks. The biggest danger in a bubble is the euphoria, the belief that this time is different, that this bubble will not burst. Keep your head, have an exit strategy. What if your market drops 10%? 20%? Remember real estate prices do go down as well as up. And frequently they go sideways for a long time.



Fourth—Add real value, not just speculation. For the most part rehabbers and developers are cushioned from the effects of the bubble because they are not counting on the speculative value of the real estate to rise (there are exceptions of course). They are increasing the use-value of the product. There are hundreds of ways to increase the use-value of real estate and the rewards for creativity in adding use-value are high.



Fifth—a little humility is in order. One of the psychological causes of the bubble euphoria is the “look how much money I have made” fallacy. Having profited from the run-up so far it is easy to believe you are a financial genius. Unfortunately the track record of geniuses in bubbles is no better than the rest of us because the bubble is about mass psychology, not rational analysis. Isaac Newton, one of the great geniuses (financial or otherwise) of human history was one of the thousands of losers in the South Seas Bubble. He owned stock early on, sold out for a ₤7,000 profit but re-invested ₤20,000 (around $250,000) which eventually went to a value of zero. His response: “I can calculate the motion of heavenly bodies, but not the madness of people.” A strategy that recognizes the possibility of madness in the current market is always a good thing.