Broadly speaking, there are three asset classes: stocks, bonds, and real estate. Cash, or money market funds, are really just a type of bond – very short term and very safe. While investors can gain access to all three with mutual funds, most own real estate directly. For many, real estate is their biggest, and often their best investment.
There are three main reasons real estate has generally been a successful investment for most people: 1) by buying a home, investors are effectively paying themselves rent 2) a mortgage is essentially a forced savings program paid into each and every month 3) because of the nature of the investment, real estate investors tend to avoid the poor decisions they make when they invest in other major asset classes.
Unfortunately, this last factor may be changing.
The main reason investors should worry about real estate bubbles is this: most experts say that real estate bubbles are simply impossible – at least on a national scale. In a recent article posted on bankrate.com, David Lereah, chief economist for the National Association of Realtors, was quoted as saying, "There is no national price bubble. Never has been; never will be."
This may go down as one of the most infamous quotes in investing history, up there with respected Yale economist Irving Fisher, who in 1929, shortly before the great stock market crash, proclaimed that “stock prices have reached what looks like a permanently high plateau".
With investing, there is no such thing as “never”. The fact that something hasn’t happened in the past does not mean it can’t happen in the future.
People like real estate. They trust it. They can live in their investment. After a sharp bear market and numerous Wall Street scandals, the same can’t be said about stocks. Much of this good feeling was capped off with recent massive gains in real estate prices around the country, notably in certain hot markets.
The sentiment could be summarized by a short piece on CNBC to plug her show by the vivacious and orange-tinted Suze Orman:
“Hi everybody I’m Suze Orman. Now have you noticed that the markets really haven’t gone anywhere over the past year or so? What should you be investing in? I’m here to tell you that I still believe the number #1 investment for you is real estate…”
We have two reasons for being skeptical about Suze’s claim. For one, she has been wrong in the past - some have poked fun at her for being a big proponent of “the Cubes” or QQQ (recently changed to QQQQ), the Nasdaq 100 Index ETF back in the stock bubble years - an investment choice still down around 70% from the high. Two, we disagree with her because we think real estate doesn’t really beat the stock market over long time periods because of the nature of homes vs. stocks.
Recent memory aside, home prices do not climb much faster than inflation over time. There is a sound economic reason for this – homes can be built out of materials that are highly correlated to inflation. Even the cost of labor used to build a home is closely tied to inflation. Home prices are capped at a slim margin over the cost of building a new home, and the cost of building a home tends to move with commodity prices and labor costs.
This is not to say fortunes can’t be made in real estate - notably with coastal homes that are in limited supply or from buying in an out-of-favor neighborhood before it becomes popular. But for many, homes are the ultimate commodity investment - it works mostly because so much money is plowed into it (divert 30% of your income each month into anything and it will be worth a small fortune someday).
The reason we recommend real estate in general as an asset class over real commodities is that real estate can be rented for income, and income producing ability (now or in the future) is the true definition of an investment over a mere speculation like hoarding copper.
Investors often look to real estate when stocks let them down. The last true real estate bubble in America took place in the early to mid 1920s – the great Florida land grab. What really kicked off the rampant speculation by individuals was a sour stock market. From peak to trough in 1919 to 1920, the Dow suffered a 47% drop – one of the fastest and most furious in history.
Early gains made by speculators in Florida’s development led to wild stories of easy riches that sucked in more and more money – into dumber and dumber investments (sound like the tech boom to anyone?). Before long, hucksters were selling underwater land as the next multimillion dollar hotel location to greedy investors looking to flip their way to instant wealth. The expression, “If you believe that, I’ve got some swampland in Florida for you” lives on to this day.
Investors also like leverage. Borrowing makes the relatively low risk world or real estate investing as exciting as . . . well, tech stocks. Today it is not uncommon for someone with very average credit and only a moderately stable income to plunk down $25,000 on a $500,000 home. If the home climbs 20% to $600,000 (which it has been doing for years now, so why should it stop...) the investor turns $25,000 down into $125,000 safely. Try doing that in stocks!
On the other hand, somebody who borrows $475,000 (to buy a $500,000 house that cost $300,000 a few years ago, and could be worth that much again) could lose his job and be unable to make the payments—that will climb if interest rates go up. It’s pretty hard to turn $25,000 into a negative $175,000 with stocks.
A recent real estate broker’s guidebook on New York and Florida (that looks like a stock analyst’s report) noted some startling price trends: 2-4 family townhouses in Brooklyn were up 174%, studios in New York City up 20%, lofts up 35%. More startling was the time frame of the big returns: 1 year.
Everyone is so sure that real estate will continue to move onward and upward that the cost of buying a home is now at record highs in relation to the cost of renting the same property. In some hot markets it costs just 50% or less of what it would cost per month to buy to simply rent. It is entirely possible that an investor would do better renting the house they want to buy, and parking the difference each month in an index fund – at least for shorter periods of time of 1 – 7 years.
More sobering is the thought that the relationship between renting and buying could become exaggerated quickly if rates rise (which increases the costs of home buying) or if rents fall (which could happen in a recession). Suddenly homes may not be just 25% overpriced, but perhaps 40%.
Is 25% overpriced a bubble? It is when the average home only has about 50% equity on the books. In other words, if homes fell 50% in price, there would be no equity left in residential real estate, and the outstanding mortgage debt would exceed the market value of the property.
This is startling because homes are now our greatest asset. Today, total household wealth is higher than ever, largely because appreciating home prices have made up for any losses in stocks.
Saying that only some regional markets are overpriced is like saying only some stocks were overpriced in the 2000 stock bubble. Therefore, buying – even on margin – is safe. Florida, New York, California, New Jersey, Massachusetts, Connecticut, and Las Vegas represent more than 50% of the total market cap of all U.S. property, so it’s hard to say the bubble is only localized. Exxon Mobil (XOM) wasn’t overpriced in 2000, but Cisco (CSCO) was.
Brokers used to let customers buy stocks on up to 90% margin because stocks were a sure thing. After the crash of ’29 people realized the error in their logic.
Maybe real estate won’t crash. Maybe prices will just stay at the current levels until fundamentals catch up. Maybe we’ll never learn the risks of 5% down. Let’s hope so – an economy partially fueled by home equity loans can’t take a bear market in home prices.
Better if we think a bear market in real estate is something that doesn’t exist.
Broadly speaking, there are three asset classes: stocks, bonds, and real estate. Cash, or money market funds, are really just a type of bond – very short term and very safe. While investors can gain access to all three with mutual funds, most own real estate directly. For many, real estate is their biggest, and often their best investment.
There are three main reasons real estate has generally been a successful investment for most people: 1) by buying a home, investors are effectively paying themselves rent 2) a mortgage is essentially a forced savings program paid into each and every month 3) because of the nature of the investment, real estate investors tend to avoid the poor decisions they make when they invest in other major asset classes.
Unfortunately, this last factor may be changing.
The main reason investors should worry about real estate bubbles is this: most experts say that real estate bubbles are simply impossible – at least on a national scale. In a recent article posted on bankrate.com, David Lereah, chief economist for the National Association of Realtors, was quoted as saying, "There is no national price bubble. Never has been; never will be."
This may go down as one of the most infamous quotes in investing history, up there with respected Yale economist Irving Fisher, who in 1929, shortly before the great stock market crash, proclaimed that “stock prices have reached what looks like a permanently high plateau".
With investing, there is no such thing as “never”. The fact that something hasn’t happened in the past does not mean it can’t happen in the future.
People like real estate. They trust it. They can live in their investment. After a sharp bear market and numerous Wall Street scandals, the same can’t be said about stocks. Much of this good feeling was capped off with recent massive gains in real estate prices around the country, notably in certain hot markets.
The sentiment could be summarized by a short piece on CNBC to plug her show by the vivacious and orange-tinted Suze Orman:
“Hi everybody I’m Suze Orman. Now have you noticed that the markets really haven’t gone anywhere over the past year or so? What should you be investing in? I’m here to tell you that I still believe the number #1 investment for you is real estate…”
We have two reasons for being skeptical about Suze’s claim. For one, she has been wrong in the past - some have poked fun at her for being a big proponent of “the Cubes” or QQQ (recently changed to QQQQ), the Nasdaq 100 Index ETF back in the stock bubble years - an investment choice still down around 70% from the high. Two, we disagree with her because we think real estate doesn’t really beat the stock market over long time periods because of the nature of homes vs. stocks.
Recent memory aside, home prices do not climb much faster than inflation over time. There is a sound economic reason for this – homes can be built out of materials that are highly correlated to inflation. Even the cost of labor used to build a home is closely tied to inflation. Home prices are capped at a slim margin over the cost of building a new home, and the cost of building a home tends to move with commodity prices and labor costs.
This is not to say fortunes can’t be made in real estate - notably with coastal homes that are in limited supply or from buying in an out-of-favor neighborhood before it becomes popular. But for many, homes are the ultimate commodity investment - it works mostly because so much money is plowed into it (divert 30% of your income each month into anything and it will be worth a small fortune someday).
The reason we recommend real estate in general as an asset class over real commodities is that real estate can be rented for income, and income producing ability (now or in the future) is the true definition of an investment over a mere speculation like hoarding copper.
Investors often look to real estate when stocks let them down. The last true real estate bubble in America took place in the early to mid 1920s – the great Florida land grab. What really kicked off the rampant speculation by individuals was a sour stock market. From peak to trough in 1919 to 1920, the Dow suffered a 47% drop – one of the fastest and most furious in history.
Early gains made by speculators in Florida’s development led to wild stories of easy riches that sucked in more and more money – into dumber and dumber investments (sound like the tech boom to anyone?). Before long, hucksters were selling underwater land as the next multimillion dollar hotel location to greedy investors looking to flip their way to instant wealth. The expression, “If you believe that, I’ve got some swampland in Florida for you” lives on to this day.
Investors also like leverage. Borrowing makes the relatively low risk world or real estate investing as exciting as . . . well, tech stocks. Today it is not uncommon for someone with very average credit and only a moderately stable income to plunk down $25,000 on a $500,000 home. If the home climbs 20% to $600,000 (which it has been doing for years now, so why should it stop...) the investor turns $25,000 down into $125,000 safely. Try doing that in stocks!
On the other hand, somebody who borrows $475,000 (to buy a $500,000 house that cost $300,000 a few years ago, and could be worth that much again) could lose his job and be unable to make the payments—that will climb if interest rates go up. It’s pretty hard to turn $25,000 into a negative $175,000 with stocks.
A recent real estate broker’s guidebook on New York and Florida (that looks like a stock analyst’s report) noted some startling price trends: 2-4 family townhouses in Brooklyn were up 174%, studios in New York City up 20%, lofts up 35%. More startling was the time frame of the big returns: 1 year.
Everyone is so sure that real estate will continue to move onward and upward that the cost of buying a home is now at record highs in relation to the cost of renting the same property. In some hot markets it costs just 50% or less of what it would cost per month to buy to simply rent. It is entirely possible that an investor would do better renting the house they want to buy, and parking the difference each month in an index fund – at least for shorter periods of time of 1 – 7 years.
More sobering is the thought that the relationship between renting and buying could become exaggerated quickly if rates rise (which increases the costs of home buying) or if rents fall (which could happen in a recession). Suddenly homes may not be just 25% overpriced, but perhaps 40%.
Is 25% overpriced a bubble? It is when the average home only has about 50% equity on the books. In other words, if homes fell 50% in price, there would be no equity left in residential real estate, and the outstanding mortgage debt would exceed the market value of the property.
This is startling because homes are now our greatest asset. Today, total household wealth is higher than ever, largely because appreciating home prices have made up for any losses in stocks.
Saying that only some regional markets are overpriced is like saying only some stocks were overpriced in the 2000 stock bubble. Therefore, buying – even on margin – is safe. Florida, New York, California, New Jersey, Massachusetts, Connecticut, and Las Vegas represent more than 50% of the total market cap of all U.S. property, so it’s hard to say the bubble is only localized. Exxon Mobil (XOM) wasn’t overpriced in 2000, but Cisco (CSCO) was.
Brokers used to let customers buy stocks on up to 90% margin because stocks were a sure thing. After the crash of ’29 people realized the error in their logic.
Maybe real estate won’t crash. Maybe prices will just stay at the current levels until fundamentals catch up. Maybe we’ll never learn the risks of 5% down. Let’s hope so – an economy partially fueled by home equity loans can’t take a bear market in home prices.
Better if we think a bear market in real estate is something that doesn’t exist.