From the Editor - August 05

The commentary below is from our monthly newsletter and is provided here as a convenient reference for our readers.

Is There a Housing Bubble?

Our readers have doubtless seen increasingly discussed in the news the idea of a “housing bubble.” Is there a housing bubble in America? As with most things in life, the answer is complicated. The signs pointing toward “bubble” status are certainly there. The fact that almost 25% of the homes over the past 12 months were purchased, not as primary residences, but as investment properties, is a real concern. These buyers have little motivation to hold their properties if (or when?) housing values begin to fall. A mass exodus by speculative homebuyers would spur volatility (mostly in the downward direction) in the real estate markets.

Another concern is the growing use of interest-only mortgages. What once would have seemed absurd to the typical homebuyer is increasingly accepted. One can postulate several different reasons why an individual would want to purchase a house using an interest-only mortgage. Regardless of the reason, most of these buyers are counting on the fact that real estate goes up, not down. What happens if or when housing prices reverse their trend? Interest-only homebuyers have little incentive to hold on to their properties, since they have paid little if anything toward the principal.

Then consider the fact that the average credit rating of individuals receiving mortgages is declining. The implication is that mortgage companies are lowering their standards for who is eligible for a loan. Again, not very good news if either the real estate markets or the economy in general goes south (naturally, the two are connected).

Also consider the somewhat surprising news that mortgage companies are considering making a 40 year mortgage commonplace. There are some who speculate that the 40 year mortgage could one day replace the 30 year mortgage. Monthly payments are lower, but 40 years is a very long time, unless you happen to be a tortoise (but if you are, you don’t need a house—you just carry yours with you). From a purely practical standpoint, 40 year mortgages do make sense if real estate prices continue to rise. Otherwise, in some areas of the country it becomes impossible to make monthly payments on a home (e.g., Boston and San Francisco).

On the flip side of the equation, consider a comparison of housing prices in 1950 versus today. After you subtract out inflation, you find that house prices are 30-40% higher than they were in 1950. A clear sign of overvaluation, right? Well, perhaps not. You also have to consider that the average house today is more than twice as large as the average house in 1950! So, on a per square foot basis, housing prices today are actually cheaper than they were in 1950 (after adjusting for the effects of inflation and the size of houses in general). If you happen to live in Boston as several of our readers do, this comparison doesn’t mean much—the average price on a national basis has no meaning in Beantown, where prices are through the roof. But on average, the comparison is an interesting one, and suggests that housing prices may not be as out of line as the press is making it appear.

After carefully reviewing all the data, we at The Prudent Investor come to the expert conclusion that we don’t know if the real estate market is in a bubble or not. It definitely is in certain areas of the country. But how widespread the overvaluation really is we find much harder to quantify. In the Charlotte, NC area housing prices have spiked in a few areas, but overall have seen quite slow price appreciation for the past decade (average of 3% annually). One would be hard-pressed to call housing prices in Charlotte “bubble-like.”

This debate/discussion over housing pricing is one we definitely follow with great interest at The Prudent Investor. Approximately 25% of our investment portfolio is tied directly or indirectly to the housing market. For the moment we are comfortable with this, but we are certainly watching the climate closely. We feel very good about at least four of the five stocks in our portfolio that are connected with real estate in some fashion (NFI, IMH, TARR, KBH, with question marks at present over CAA). We believe they represent strong potential to continue to perform well, even in a sideways stock market as we are in now. Time will be the ultimate judge of whether our decisions were the right ones.