Home Inspection Business

Is the Real Estate "Bubble" Going to Burst?

A lot of hoopla has been floating around the news media lately about the "bubble" theory of real estate, that is, the theory that the real estate market is going to burst. In my opinion, this theory has no merit.

First, understand that there are three basic premises that undermine the discussion of a real estate bubble:

1. There is no national real estate market
2. The real estate market doesn’t explode or crash
3. The market has limited relevancy to the shrewd investor.

The Real Estate "Market" is a Compilation of Local Economies

When people speak of the real estate economy, they are using nationally- based statistics. For example, Fortune Magazine reported recently that since the early 1960’s, average residential real estate values have never had a down year. This statement is true, but while these numbers are measurable, they do not reflect the intricacies of local real estate markets.

The stock market is based on the national, even the world economy. The real estate market is based on local, and, in many cases, micro-local economies. For example, California foreclosures were down 7% in 2003 from 2002, but up 17% in San Francisco (due, in no small part, to the fizzle of DOT COM companies). And, within a particular city that is doing well, there may be certain neighborhoods doing poorly for a variety of reasons, such as over-building of new homes. So while statistics, calculations and economic factors are relevant, so is common sense - take a look around and see what's really happening. Talk to real estate agents, investors and lenders in your area for a better picture of what is going on.

Real Estate Markets do not "Crash"

We all remember October 19, 1987, known as "Black Monday". The stock market lost 22% of its value in one day - what investors call a "crash". History points to times which real estate values have taken 22% hits in certain cities and in pockets within cities. However, no real estate market dropped 22% in one day, one week or even one month. In fact, the real estate "crash" of the late 1980’s took several years to bottom out in most markets.

As Money Magazine reported recently, "high prices themselves don't necessarily indicate a bubble. For that, you also need excess supply. Factors that inhibit supply -- zoning laws that limit building, for example -- may prevent a bubble from forming". And, according the National Association of Realtors, the supply of homes is not exceeding demand in most cities. Combine limited supply of houses, low interest rates and a baby-boomer generation in its prime house-buying years, and it is not likely we will see a wholesale collapse any time soon.

WHAT ABOUT RISING INTEREST RATES?

A lot of people are worrying about how rising interest rates will affect the market. Certainly, a rapid rise in interest rates may affect prices, since the higher the interest rate, the less house a buyer can afford. But, interest rates alone do not determine prices, but rather supply and demand. So long as a particular area has more buyers and than sellers, the values will remain strong. And, large migration trends, such as the retiring big-city baby boomers moving to the warmer climates, will greatly affect the supply and demand of housing in certain parts of the Country.

Finally, keep in mind that even if a real estate market is reaching a peak within a particular area, it doesn’t necessary mean it will necessarily collapse. The fact that real estate values in your city have climbed at twice the rate of inflation last year and only half the rate of inflation this year doesn’t mean the bottom is falling out. And, just because your city’s average real estate values or home sales went down, doesn’t mean it went down everywhere in the city. Case in point, Denver, Colorado – excess supply of high-end homes has driven down values, but the low-end "starter" homes (the bread and butter of real estate investors) have suffered no loss. The problem is, people see headlines like "Average Real Estate Prices Falling" and they panic. Declining values of $1,000,000 homes skews the average, so you can't pay attention to broad numbers. You need to look specifically in the price range and location of houses you are buying.

The Market Has Limited Relevancy to the Shrewd Investor

If you buy and hold for the long term (15 + years), you aren't likely to lose. Real estate values generally go up in the long run, with few exceptions. The same is probably true of the stock market in the long run, but there's one problem: there's no guarantee any company you invest in will be in business in 15 years - not even Xerox, IBM or AOL!

If you buy and flip properties quickly, the market appreciation or decline is not all that relevant to your profit. I had this discussion when I appeared CNBC recently; if the local real estate market is "hot" you can sell a property quickly, but you can't buy it as cheap. If the local real estate market is weak, you can steal properties, but you have to account for a longer hold period when you resell. It is relevant to know where your market is CURRENTLY going (up or down), but don't worry so much about the "bubble" bursting - real estate markets don't collapse (or explode) in 3 to 6 months.

On the other hand, if you are buying properties with negative cash flow with the expectation of the values increasing over 2-3 years, shame on you! What if the values decrease? What's your backup plan? Can you rent it for break-even cash flow? Can you sustain negative cash flow until the market rebounds? If so, then don't sweat it - you'll also pick up a whole bunch more properties at the bottom of the real estate cycle. If not, then you are a speculator, not an investor, and you are at the whim of factors beyond your control. Such activity is very risky, to say the least.

The bottom line is, the real estate market may go up, and then again, it may go down. So what? Don't bank on appreciation, buy properties below market, and have a "plan B" if it doesn't work out. Do this, and the you will see that the "bubble theory" is full of hot air.

by Attorney William Bronchick