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November 12, 2004

Bubbles in Real Estate
by Hans F. Sennholz

With stock prices down considerably since 2001 and apparently heading lower, many Americans have taken a liking to real estate. They have bought homes in record numbers as easy credit and low interest rates have enabled many to buy rather than rent a home. And just like stock prices during the 1990s, the value of homes keeps rising as does the debt incurred to buy them. According to Federal Reserve data, American homes now are worth some $13.6 trillion, which is 92% more than a decade ago, while mortgage debt more than doubled to $6 trillion. With all that money rushing into real estate, does it blow bubbles, as it did in the stock market, or does it reflect chronic inflation and dollar depreciation, or does it manifest rising incomes and growing ownership aspiration?

Searching for an answer to these questions, we must raise and answer yet another question that enfolds the former: is the capital market that guides and drives economic activity allowed to function freely or is it controlled and manipulated by government regulators? In other words, is an unhampered market rate of interest allowed to direct the employment of capital and labor and thereby shape present conditions, or is the rate commanded and managed by mighty controllers? The answer is obvious: it is set by the governors of the Federal Reserve System who thereby modify all interest rates and manipulate the capital markets. In recent years they chose to keep interest rates far below market rates and thus guide economic activity along lines that differed greatly from those an unhampered market would have directed. They caused massive increases in money and credit and brought about what economists call "maladjustments" which are the very mainspring of economic recessions and depressions.

Maladjustments in real estate differ visibly from the afflictions of stock and bond markets which are national or even international in range and scope. Landed property is an inherently local asset that is affected by a great number of local demand and supply factors. The housing market in San Jose, California, has little resemblance to that in Grove City, Pennsylvania, although both are affected by the same Federal Reserve monetary policy. Some places may suffer stagnation or price declines while others experience feverish booms. There may be bubbles in some parts of the country while stagnation and recession hold others in their grip. Yet all prices undoubtedly are much higher than they would be in absence of chronic inflation and dollar depreciation.

The Office of Federal Housing Enterprise Oversight informs us that average housing prices rose 38.3 percent from 1997 to 2002. This knowledge may be of interest to economic historians but of little use to real estate investors. They are intrigued and lured by local conditions and the possibility of earning high returns through debt financing when prices soar. A home buyer may put down ten percent of the purchase price and borrow the rest; a price rise of ten percent would double his investment. An annual price increase of just five percent would yield a return of 50 percent on his investment, year after year. While the mortgage loan continually depreciates in purchasing power, the owner's equity rises in step with the rising price of his house. In fact, in less than ten years a ten percent annual bubble rate will shift one-half of the value of his house to him, without having made a single loan payment. Surely, he will have to maintain the property and pay an interest on the mortgage loan, which may be less than the rent he would have to pay if he were to rent the house.

This leverage of debt financing also works in reverse. When the bubble bursts and housing prices readjust, many new owners soon lose their entire investment. A ten percent fall in prices wipes out a ten percent owner equity; a thirty or forty percent decline, which is rather common in a bubble crash, not only stamps out his investment but also may inflict additional losses - unless he walks away from his house and thereby shifts the losses to the financial institution that granted the loan. When the decline is severe and many owners choose to unload their losses on creditors, the crash may jeopardize the solvency of financial institutions that financed the bubble.

Despite such occasional reversals our age of inflation has made ownership of a home the most effective way to increase personal wealth. While inflation tends to raise interest rates by adding the anticipated depreciation rate to the basic time-preference rate, it also lowers the debtor's risk premium which may offset the higher depreciation rate. The owner's equity increases in step with the rising price of the house, which simultaneously reduces the risk to the lender. Before the age of inflation a home buyer needed a down payment of 30 to 50 percent of the purchase price; the age of inflation gradually reduced this rate to 20 or 10 percent, but sometimes 3 percent or less. The lender's price risk is minimal; the buyer may just sit back and let the bubble increase his equity.

Politicians and government officials look with favor on home ownership as they themselves do benefit from such favors. Home buyers enjoy big tax breaks. They can deduct property taxes and the interest on their mortgages from their taxable income. And when they sell their homes they may exclude up to $250,000 in capital gains from taxable income; married couples may deduct $500,000. And they can do this again and again as long as they live in the home for two of five years before selling.

The prices of manors and mansions have soared above all other housing prices. When the stock market began to retreat and disappoint in 2001 many underperforming funds sought refuge in real estate and thus caused housing prices to take off. The nouveaux riches of the stock market now sought safe harbors in real estate and those speculators who could not afford such luxury could at least borrow against the equity in their houses and raise their standards of consumption to manor levels. A "refinancing" mania gripped the real estate market and lifted the level of mortgage debt. To take advantage of the current low rates, many debtors chose "variable-rate" mortgages that are readjusted frequently. If interest rates should ever return to market levels and cause real estate prices to decline, many such refinanced houses would not be worth the debt standing against them. In the meantime, most homeowners rejoice about their rising equity which they calculate in nominal prices. If they would compute prices in inflation-adjusted dollars, their profits would be much lower or even turn to losses. In some parts of the country nominal prices continue to rise moderately while inflation-adjusted prices actually stagnate or even decline.

National statistics tend to understate the risk of loss for many homeowners. They obscure the extreme price swings in individual towns and cities and blur the particular forces that may reduce or compound the maladjustment. During the 1980s, for example, several West Coast cities enjoyed feverish high-tech and defense-spending booms. Real estate prices soared. A few years later when high-tech production spread to China, India, and many other places, stagnation settled over many places and prices fell noticeably. In the Silicon Valley they slid some twenty percent.

In recent years many communities also have been affected by soaring U.S. trade deficits driven by Federal Reserve easy-money policies and mounting U.S. Treasury budget deficits. As trade deficits rose to more than $500 billion annually, that is to more than five percent of GDP, American manufacturers of many consumers goods faced growing pressures of foreign competition and were forced to contract. Many communities soon experienced economic declines and rising unemployment especially in parts and sections of town occupied by the laboring population. While the construction of mansions continued at full speed and middle class refinancing generated new life in old neighborhoods, heavily-populated urban areas occupied by welfare recipients and unemployed laborers ceased to grow. Apartment rents may have kept on rising but the prices of such dwellings rarely did.

Throughout the industrial Northeast many communities, large and small, even endured real depressions as militant labor unions relentlessly boosted production costs and unemployment soared to deplorable levels. The strongholds of labor unions, such as coal mining, the steel industry, the automobile industry, the aerospace industry, trucking, and shipyards, stagnated throughout most of the 1980s and 90s. In Grove City, Pennsylvania, ugly labor strikes, too numerous to count, finally drove the largest employer out of town and state. In Youngstown, Ohio, high unemployment and deep depression settled on the community when the last steel mill was forced to close its gates.

The local demand-and-supply factors that often drive the real estate market may at times be overshadowed by national forces. They surely were overwhelmed during the Great Depression of the 1930s and the six recessions that descended on the country since then. Another recession could do it again. If foreign central banks should tire of financing U.S. trade deficits the U.S. dollar would plummet in foreign exchange markets, American goods prices would rise, and interest rates would readjust. An international flight from the dollar undoubtedly would delimit the Fed's power to manage interest rates. Rising rates would impact on the housing market and reveal the maladjustments that resulted from many years of rate manipulation. Rising rates would expose ill-designed housing built in wrong quantities, wrong qualities, and wrong neighborhoods. Of course, the monetary authorities would do everything in their power to flush the troubles away. Unaware of any inexorable principles of economics and infatuated by the coercive powers of government, they are likely to compound the difficulties and make matters worse.

Even if foreign creditors should never tire of financing American trade deficits and U.S. Treasury debt, the maladjustments are calling for correction. The ocean of debt in which many Americans are swimming cannot brook a major rise in interest rates; it may soon force a readjustment. Similarly, the financial bubble engendered grossly inflated price-earnings ratios which call for early readjustment to unimpeded levels. In short, powerful forces consisting of the value judgments and choices of the people are working tirelessly to correct the maladjustments also in real estate.

* * * *

It is well nigh impossible to estimate the magnitude of income and wealth which false interest rates and misleading credit markets redistribute every day. It is unearned lucre that is taken from millions of savers and creditors and bestowed on all kinds of debtors, including millions of mortgagers. Surely, most Americans are both creditors and debtors but rarely equal in both accounts. Most may be vaguely aware of the transfer process; some may take advantage of it, but only a few may be knowledgeable of the causes that drive the process. Economists are keeping their eyes on the prime movers, the Federal Reserve System and the U.S. Treasury which wield vast powers over American money and credit. But their voices are barely audible in the din of official pronouncements.

Most Americans trust their political leaders and their media spokesmen who wax eloquent about the wisdom of Federal Reserve policies and the benefits of Federal spending. They sense the growing importance of government and especially its primary role in the allocation of inflation lucre. Discerning the important role of politics in their economic lives, many Americans now participate in party politics and join in bitter feuds about government favors. They all would redistribute the lucre, few would abolish it. They may even favor and support inflationary policies that blow bubbles in real estate and create incomparable opportunities. Unfortunately, they pay little heed to the great economic and social harm done by such policies.

Hans F. Sennholz
www.sennholz.com

Copyright © 2002-2007 Hans F. Sennholz

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