The Bubble Part Three

This is part three of a discussion of Bubbles in investment history and the signs by which one can tell whether any given local real estate market is in a bubble. Parts One and Two were a paper by Jacob Fefield regarding historic bubble markets (Again, thanks to Mr. Fefield for the permission to use his article). Now I will turn to a discussion of how this information relates to real estate markets in particular.

So what are the signs of a bubble and how can you tell if you are in one?



1) The bubble divorces productivity and price.

This is perhaps most easily seen in the “classic” Tulip and South Sea Company bubbles. Even the most beautiful flower in the world is, in the end, just a flower. It is not capital in the classic sense that capital represents the past excess production of society invested to improve productivity in the future. The South Seas Company had an exclusive license from the government of England to trade throughout South America, in essence a monopoly on overseas trade with the west. Only one problem. Most of the territory covered in the license didn’t belong to England. It belonged to Spain and they didn’t recognize the license.



For an example in the realm of real estate I offer the following TCI post.



“Now I have 5 SFR all in nice neighborhoods, rented out with negative income of $300 to $500 each a month PITI. I also have a goal of becoming a full time investor and to buy about 20 of these properties. . . . . Prices in CA have gone up but rents are not catching up. So the thought of having 20 properties with negative [cash flows] is not encouraging. I don't see how I can accomplish my goal without having a job to cover all the negatives.”



The key phrase here is “rents are not catching up.”



Imagine a hypothetical person who wants to live in a certain neighborhood. He has a choice. He can rent a house for $1,000 per month or he can buy one for a mortgage payment of $1,500. What is the advantage of renting? His landlord takes the maintenance risk of the property. If the furnace breaks the landlord must pay for the repair. What is the advantage of buying? He participates in any future increase in the value of the property (there are other advantages, as well, like he adds stability to his life but for the moment I want to ignore those). So I am going to call the capitalized value of the rents the “use value” (or the “productive value”) of the house and the sale price the “speculative value”.



Now clearly the closer to each other these two values are the more advantageous it is for our prospective house occupant to accept the maintenance risk in order to get the ownership benefit. In some markets it is even possible to buy a house cheaper than to rent it. Clearly in those markets being a landlord is a good idea.



But in markets like the poster’s where the speculative value of the house is higher than its use value one has to make an assumption that the sales prices are going to continue to inflate or that the rental rates are going to catch up in order for the investment to make any sense.



My point here is simple— if there is no sign of a strengthening in the rental market the assumption that prices will continue to appreciate is a very risky one and the widespread acceptance of such an assumption is the most basic cause of the bubble.



In the end the value of asset in a capital market is determined by the cash flows that that asset produces. Price cannot separated from productivity.



2) The Bubble begins with a real increase in the use-value of the product.



The bubble always starts with the seed of a true growth in value. The tulip was a new product in Holland in the early 1600’s (imported from the Mediterranean). People were very enthusiastic about this new flower and the growing of tulips was a legitimate business enterprise with real profits. The South Seas Company grew out of the “new” (at the time) idea of a publicly traded corporation and enthusiasm for the new possibilities of world trade. Both of those innovations legitimately increased the productive capacities of the society.



This growth in use-value, however, at some point leads to a belief that the price of the commodity in question will continue to rise independent of its actual use.



The next stage is the speculative frenzy that drives prices out of touch with the use value of the investment. Finally comes the return to productive value.



So it is necessary to come to an understanding of where the roots of increase in use-value are in real estate. Not every increase in Real Estate prices is a bubble. In order to understand when a price run-up is becoming a bubble we must first turn to look at the use-value of real estate and how it changes.



There are three sources of increase in the use-value in real estate, Demand, Development and Inflation. Development first:



When you buy a piece of vacant land and build a house or a shopping center or a radio antenna or any other improvement on that land then the resulting increase in the value is not the result of an increase in real estate prices—it is the result of the value added by the development. This kind of value increase adds to the pressure of the bubble, but only slightly because the increased value is tied to the increased productivity of the land.



Likewise there can be increases in the use-value of a piece of real estate because demand in the area increases. In fact this kind of demand increase is often the preliminary to a bubble. In the Florida land bubble of the 1920’s, for example, there was a substantial increase in value in the period from 1900 forward mostly because of increased demand because of the completion of railroads making it possible for winter-plagued farmers to escape to the sunny climes and still get back home in time for the spring planting (winter-plagued factory workers still did not have the privilege of a two week paid vacation). This demand-driven price increase in turn led to the speculative furry of the Florida land bubble of the 1920’s.



Finally, inflation: the truth of the matter is that almost all real estate is worth more than it was 50 or 75 years ago mostly because the dollars we pay for it with are worth less. Because we do not typically track real estate prices in inflation-adjusted dollars this situation is largely ignored leaving the impression that real estate prices “always” go up over the long haul. While it is true that real estate is an excellent hedge against inflation (as is gold and other hard commodities) this is not exactly the same as saying that its value has actually increased.



None the less the inflationary reality of the last 75 years has created a myth that real estate prices cannot go down over the long run. Even if that were true, however, the problem is one’s definition of “the long run”. As Keynes said, in probably the most quoted economic aphorism of all, “in the long run, we are all dead.” An investment strategy that needs 50 or 75 years of inflation (or even 20) may not serve you well in the next 3 to 5 years.



And with that I will conclude this installment of "The Bubble" Next, more Bubble characteristics and how to invest in a bubble market.