August 7, 2005

WHAT ELSE MAKES A HISSING SOUND?:

That Hissing Sound (PAUL KRUGMAN, 8/08/05, NY Times)

In the nation as a whole, housing prices rose about 50 percent between the first quarter of 2000 and the first quarter of 2005. But that average blends results from Flatland metropolitan areas like Houston and Atlanta, where prices rose 26 and 29 percent respectively, with results from Zoned Zone areas like New York, Miami and San Diego, where prices rose 77, 96 and 118 percent.

Nobody would pay San Diego prices without believing that prices will continue to rise. Rents rose much more slowly than prices: the Bureau of Labor Statistics index of "owners' equivalent rent" rose only 27 percent from late 1999 to late 2004. Business Week reports that by 2004 the cost of renting a house in San Diego was only 40 percent of the cost of owning a similar house - even taking into account low interest rates on mortgages. So it makes sense to buy in San Diego only if you believe that prices will keep rising rapidly, generating big capital gains. That's pretty much the definition of a bubble.

Bubbles end when people stop believing that big capital gains are a sure thing. That's what happened in San Diego at the end of its last housing bubble: after a rapid rise, house prices peaked in 1990. Soon there was a glut of houses on the market, and prices began falling. By 1996, they had declined about 25 percent after adjusting for inflation.


It's strange enough that Mr. Krugman takes such glee in imagining the economic pain of fellow Americans, but even odder is the scenario he paints as a crash. Sure, some speculators who just bought recently and need a rapid turn around might get burned, but if San Diego housing prices were to follow the path he proposes here most folks who've owned for awhile would still enjoy a (whatever 75% of 118% is) increase in the value of their home and after this correction would expect to see another run-up in a couple years, just as this one followed shortly upon the last. You'd think a professional economist would know the difference between a simple market correction and a bursting bubble, even if he's praying for the latter. As for his notion that folks would only want to own, rather than rent, as a money-making proposition, well, that's the kind of denial of fundamental human nature you'd expect from a man of the Left.

Posted by Orrin Judd at August 7, 2005 11:54 PM
Comments

Aren't house prices mostly a result of what monthly payments the average house dweller can afford in that job market?

Posted by: Randall Voth at August 8, 2005 2:21 AM

(whatever 75% of 118% is)

That frames the problem incorrectly, since the hypothetical 25% decline in value will affect the entire value of the home, not just its appreciation since purchase.

Thus, for a home purchased for $ 300,000: ($ 300,000 * 2.18) * .75 - $ 300,000 = $ 190,500, or 63.5%.

As for the notion that folks would NOT want to own rather than rent as a money-making proposition, well, that's the kind of denial of fundamental human nature that you'd expect from a man of the daft.

It's surely not the only reason, nor the primary one, but when three out of four homes cannot be purchased by people making the median income for the area, you can be sure that it's not nesting families driving the market.

Posted by: Michael Herdegen at August 8, 2005 2:44 AM

So, 3 out of 4 homes are bought by non-working families? That seems ridiculous.

Posted by: Randall Voth at August 8, 2005 7:21 AM

Michael:

As he says, it declined 25% from its peak. You aren't under the impression that a house in San Diego cost 25% less in 1996 than it did in the early 80s, are you?

Posted by: oj at August 8, 2005 8:08 AM

Michael's formula is ok, although somewhat inartfully framed. The $190,000 is not the value of the house, but the increase in value after the run-up and run-down. So, the owner who holds through the whole thing puts down $60,000 at closing and sells for $590,000. After paying off the mortgage (let's call it $200,000 at this point), he pockets $390,000 for a better than 400% profit.

Posted by: David Cohen at August 8, 2005 9:19 AM

Buyers in places like the San Francisco Bay Area and San Diego are whistling past the grave yard.

Any reasonable look at the economics of investing in real estate there shows there is nothing to justify an investment unless you assume a continuation of rising prices. If you want to assume that, fine. But if you think it isn't a bubble, your nuts.

Interest only loans, negative amortization, borrowed down payments and razor-thin equity. These are not sound economic choices. They are the things that houses of cards are made up of.

Maybe if you bought stock in Ask Jeeves or Exodus Communications in the fall of 2000 you know what I mean. Just because you don't want to hear it from a "leftist" doesn't mean it isn't true.

Posted by: Pug at August 8, 2005 9:37 AM

Pug:

if you owned a tech stock you owned a piece of paper. If you own a house you own a house. The bubble can't deflate in the way a mere stock market can crash.

Posted by: oj at August 8, 2005 9:43 AM

Randall Voth:

No, three out of four homes in some areas, or even four out of five, are being bought by those earning more than the median income, plus speculators. Most of them have jobs.

In the San Diego example, a critical clue is that rents are dirt cheap compared to the costs of ownership. This signifies that the supply of rental properties is huge, relative to the number of potential renters, meaning that a lot of residential real estate in San Diego is owned by people who don't intend to live in it - speculators.

Your concept that home prices are determined by what most of the locals can pay is somewhat accurate, but far from the whole story, and has no bearing whatsoever in these local bubbles.

The rate of growth of the housing supply, constraints on growth, growth (or decline) of the local population, and non-local demand can all be larger factors.

David Cohen:

I would guess put down $ 10,000, hold for ten years, sell for $ 490,000, pay $ 30,000 sales commission, pay off mortgage balance of $ 240,000, and pocket $ 220,000 for a gross profit of over 2,000%, net unknowable but much less.

Posted by: Michael Herdegen at August 8, 2005 10:06 AM

Michael: In this, as in all things, I was being conservative.

Posted by: David Cohen at August 8, 2005 10:22 AM

Michael: even so, what would you invest in as an alternative? It seems to me that the market is doing what markets do, seeking the best available return.

Posted by: joe shropshire at August 8, 2005 11:45 AM

He says that housing prices in SD fell 25% from 1990-1996 "after inflation", but inflation was about 21.3%. So essentially housing prices stayed the same. So really Mark's calculation of profit above should be ((300,000*2.18)*.963)-300,000=$329,800, and then you can figure out what you want to do about inflation.

Posted by: Brainster at August 8, 2005 12:12 PM

joe shropshire:

Exactly.

The problem is, "the best available return" requires both risk analysis, and buying before the herd arrives. (Which all that Warren Buffet has done, just much better than anyone else).

Without the former, one might as well buy lottery tickets, since after all, where else can one get a $ 20,000,000 return on a one dollar investment ?
Without the latter, one has to count on continued growth on top of already sky-high valuations.

Markets behave like animal populations - as Orrin has pointed out time and again in reference to Darwinism - and they are self-regulating in the same way that animal populations are.

If there's a prime spot at which to feed, it first gets mighty crowded, and then the food runs out, and some animals starve.
THAT is how the market regulates capital flows, crudely but effectively, and how most investors know that they're no longer in a market sweet spot - they get their heads handed to them.

The potential profit calculations in this thread are for someone who bought at the end of '99, BEFORE the 118% runup in prices.
Anyone buying the hypothetical property now, when it's selling for $ 650,000 or so, could face a $ 160,000 DECLINE in the value of the property by 2011, if the '90 - '96 slump were to repeat itself exactly.

If one believes strongly in the future of the American economy, then the stock market is the place to be now, before the herd.
Once real estate cools down, investors will turn back to the stock market, so that's the best bet for the next ten years.
Alternatively, one could buy real estate ahead of demographic trends.
Buying Florida coastal properties along the Gulf of Mexico should pay off handsomely in a few decades.
Buying property in Colorado south of Denver and north of Colorado Springs is a pretty good long-term bet as well.

Posted by: Michael Herdegen at August 8, 2005 12:41 PM

Michael:

"Anyone buying the hypothetical property now, when it's selling for $ 650,000 or so, could face a $ 160,000 DECLINE in the value of the property by 2011, if the '90 - '96 slump were to repeat itself exactly."

No. If the slump were to repeat exactly, that person would experience about a $25,000 decline in value. Remember, Krugman said the 25% decline was "after inflation", but inflation was about 21.3% in those years, so really he's talking about a net decline of 3.7%.

Posted by: Brainster at August 8, 2005 1:57 PM

Don't lecture about "glee" when a few posts upward you gloat about a man's death from cancer.

Posted by: Rick Perlstein at August 8, 2005 2:41 PM

Rick:

I expressed my sadness that such is how we'll remember him.

Posted by: oj at August 8, 2005 2:46 PM

Brainster:

Krugman does not mean "25%, including inflation", he means "25% of nominal value, plus inflation".

Thus, someone who purchased a $ 100,000 home at the very peak in '00, and sold at the nadir in '06, received $ 75,000 nominal dollars.
Using your figure for inflation, the unlucky seller had only $ 60,000 worth of purchasing power, in 2000 dollars, and suffered a real loss of 40%.

Posted by: Michael Herdegen at August 8, 2005 3:26 PM

Michael:

Yes and the person who bought in 1982 for $100k ended up with a home worth something like $181k at the nadir and if your buyer just held the house through the correction they made a ton selling it now--odd sort of burst bubble, no?

Posted by: oj at August 8, 2005 3:33 PM

oj:

Your example contains a lot of qualifiers.

The end of a mania doesn't have to mean "everyone loses everything", and long-term holders may indeed come out alright whatever the situation.

Buffet looked washed up through the dot.com bubble, but was well-positioned afterwards.

Those buying near the peak, who end up waiting ten years to break even, may not be as casual about the situation as you are.
Also, the timing of housing sales are often not completely up to the homeowners, for various reasons. Most people don't have an infinite investment horizon.

Posted by: Michael Herdegen at August 8, 2005 4:17 PM

Michael:

What's your Pets.com stock worth?

Posted by: oj at August 8, 2005 4:23 PM

Is this the crux of your argument ?

Real estate bubbles don't exist because some people won't lose money ?

We can call them "localized hypervalue discontinuity zones", if you like.

Or simply a mania.

In any case, it takes a bold person and/or a fool to advocate investing in San Diego single family residential real estate right now.

Posted by: Michael Herdegen at August 8, 2005 4:50 PM

Michael:

No, they don't exist period. A house has intrinsic value. Housing prices vary over time.

Posted by: oj at August 8, 2005 4:54 PM

Michael:

"Krugman does not mean "25%, including inflation", he means "25% of nominal value, plus inflation".

Thus, someone who purchased a $ 100,000 home at the very peak in '00, and sold at the nadir in '06, received $ 75,000 nominal dollars."

Nonsense. Let's go to the primary data, shall we? Median home selling price in San Diego in 1990: $183,210. Median home selling price in San Diego, 1996: $174,460. Decline: 4.8%. Not 40%. Not 25%.

Posted by: at August 8, 2005 6:04 PM

oj:

A tulip bulb has intrinsic value, as well.

Just because an object will always have some value to someone, does not mean that the current owner of said object didn't overpay so greatly that they will never recoup the cost.

Fashion apparel and accessories are a great example. A Kate Spade handbag has intrinsic value as a bag, but almost all of the price has to do with desire, and not functionality.
Bubble purchases are made with the same rationality.
The difference is that the fashion buyer has no expectation of gain, she knows that what she's buying will, at some point in the future, be near-worthless.

Monsieur anonymous:

And that $ 174,460 in '96 was worth $ 148,290 in 1990 dollars.
Decline: 19%, not 4.8%.

Further, your statistics don't necessarily tell you what you think that they do. Comparing median home prices across time periods and locales is a ROUGH estimate, and does not ensure that you're comparing apples to apples.

What you would need to do is to define the characteristics of the properties that you'd like to compare, (for example, three beds, two bath, with a garage and deck), and then see what the price differences are.

Posted by: Michael Herdegen at August 9, 2005 1:04 AM

Michael:

No, it doesn't--it's a fasion. A home is a necessity.

Posted by: oj at August 9, 2005 11:17 AM

Michael:

"And that $ 174,460 in '96 was worth $ 148,290 in 1990 dollars.
Decline: 19%, not 4.8%."

Agreed. But you acknowledge that you were wrong on "nominal dollars"?

Posted by: Brainster at August 9, 2005 1:01 PM

oj:

Not one that must cost a million dollars.

People need shelter, but they can pay either a little or a lot to get it.

Just because people are willing to pay a lot now, doesn't mean that they will be so willing in the future.

Posted by: Michael Herdegen at August 9, 2005 5:57 PM

Yes, the million dollar home could cost 750,000 in 2008...befire going to 1.5 million in 2015. That's not a bubble bursting either.

Posted by: oj at August 9, 2005 7:27 PM
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