Are We In A Bubble?
Arguments in support & against
Is California in the midst of another bubble?
One of my least favorite buzz words is “bubble.” The resurgence of our economy has incensed doubt in some potential purchasers and sellers. One of the top real estate related questions I’m hearing from my clients is, “are we in a bubble?” The cheap answer is there is no way to know with certainty, while partially correct, as your real estate professional, I owe you more than a canned response.
8 years of uninterrupted price growth, which means we have entered the second-longest bull market in US history.
All 1.3M jobs were lost during the recession. 2.6M jobs have been added during the expansion.
Statewide median price plunged to $245,000 in 2009. The median price is now closer $550,000, still 9% below the pre-recession peak.
Unemployment remains at all time lows. Income is growing and expected to increase.
According to Wikipedia, an economic bubble or asset bubble, sometimes called a speculative bubble, is a situation in which asset prices appear to be based on implausible or inconsistent views about the future.
So, what’s the problem?
The foreclosure backlog has been wiped out, homeowners have equity, and there is significant new wealth creation for many families.
Home price growth is far outpacing income growth. The home price-to-income ratio measures the relationship between home costs vs. median household income.
Currently, the median home price is roughly 8 times higher than the median household income, which is well above its historical average of 5-times income.
The housing affordability index, which measures the percentage of households that can afford the median-priced home has dipped to 28% – meaning 72% cannot afford the median price home.
Over 830,000 working-aged adults have left California, in the past decade, to states where home prices are dramatically lower.
Low housing inventory, deteriorated affordability, and declining rates of homeownership are the concern. Studies show that high housing costs are burdening the top employers, either by not being able to develop competitive enough hiring packages or being able to subsidize relocation costs.
How are the economics today different from the previous crash?
The average FICO score for closed conventional purchases was 752. This represents excellent creditworthiness for most people purchasing real estate.
Most borrowers have skin in the game, meaning they are putting anywhere from 5-20% down.
Most borrowers are locked into fixed-rate loans.
As long as the borrowers keep their jobs and the economy doesn’t experience an external shock, then there is little incentive to default or walk away from a mortgage.
During the run-up to the previous crash, borrowers were in loans they couldn’t afford, in adjustable rate mortgages, and many in zero-down payment products. Further fueling the drive up in prices was loose lending standards, which drove speculation and a house of cards real estate market. This is certainly not the case now.
What are the tipping points?
Look out for interest rates increases, which will affect affordability and place downward pressure on price appreciation. The Federal Reserve recently raised interest rates for the 6th consecutive time since the previous financial crisis.
Also, keep an eye on potential external shocks to the economy that will affect the demand side of housing. It’s simple; California housing prices grow because demand outstrips the chronically under-supplied market. An economic shock that takes away demand by ramping up job losses or impacting wealth or incomes will most certainly reduce price growth.
Right now, the stock market or global economy look like the most likely targets for a potential shock. The national price-to-earnings ratio is above its normal range, hinting that the value of many publicly traded companies is higher than their profitability suggests. It’s important to note that if we see an external shock that causes a decline in home prices, the damage will likely not be as widespread as the previous “Great Recession.”
What do I think?
To intelligently analyze the market, you have to be able to differentiate between a symptom and a cause. For example, the flu is an infectious illness, which causes symptoms like fever, chills, cough, runny nose, etc. The inability to systematically produce enough new housing units is the flu, and the symptom is the run-up in prices. LA, which is currently the most underbuilt county in California, must build up and/or become denser.
Approximately, 180,000 new housing units must be produced each year just to tread water on housing affordability. We will likely see more high rises, townhomes, an expansion of public transportation, and changes. Every time I drive around our scenic city, I can’t help but notice there is almost zero vacant lots/land. This may be unpopular for some, but a likely path.
Areas once considered low income or undesirable will become the next “it” neighborhoods. This has already happened in individual pockets. If you’re looking to take advantage of double-digit price appreciation, some areas are still trending at above average year over year price growth. You just have to know how to search.
I also don’t believe we are at the tipping point yet. Sentiment among local agents and the buyers and sellers I speak to is optimistic. There is still room for more growth. We will likely not see a downturn this year and possibly even next year unless an external shock hits the US or global economies. I’m of the opinion that the current tax reform bill will likely fuel wage increases, corporate profitability and continue to stimulate growth in the markets. According to the report in the link below, the two most overvalued regions are the Bay Area and Orange County. However, not all markets are overvalued, but if prices do fall, they will likely hit those areas hardest.
The wildcard is tax reform, which could tip the balance in either direction.
What’s the silver lining?
Most economies in large cities are mainly made up of Finance, Insurance, Real Estate, Law and Health Care. Los Angeles additionally features technology, film/tv, creative, media, and international trade sectors which help keep it slightly more insulated than other cities.