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Housing Bubble? Too Early To Call!


The sudden surge in the housing market here in Southern California has caught most people by surprise—and is already starting to cause worry in some circles. Double-digit price increases, tight inventories, and bidding wars across the region sound too much like what was happening at the height of the last real estate bubble—the aftermath of which continues to reverberate throughout the economy. But concern over another housing bubble is largely premature – the numbers tell us a different story.

It’s hard to believe that only one year ago reports in the media were still focused on when the housing market was going to bottom out. One news article called the slowing of price declines a hopeful sign of recovery. Other doomsayers were talking ‘double dip’ following a second wave of foreclosures that would dump untold millions of units onto the market. California’s Attorney General was pushing a series of foreclosure reforms dubbed the Homeowners Bill of Rights that she said were essential to healing California’s housing market. Looking back, given the current rebound in the market, it all seems silly.

The problem is that both the media and policymakers were taking prices as the primary indicator of the direction of the market, which they are not. Prices lag the cycle. What leads the market is inventories – and inventories have been on a downward trajectory for well over two years. Here in California, there was roughly 7 months of supply on the market two years ago; today supply has dropped to 3 months —nearly as tight an inventory as during the height of the housing bubble in 2005. The recovery was in the works well before prices started to rise at their current heady pace.

Still, if you dig away at the stats, this really isn’t anything like 2005.

Yes, median prices are up—but not by that much. The most recent report from DataQuick shows the median price in Los Angeles was up to $350,000 in February, 17% higher than in February of 2012, when the median price was $300,000. But remember, median price does not control for the quality of the housing stock being bought and sold. Price increases could mean that the price of all homes is going up, or that the average quality of the homes being sold today is higher than what it was one year ago. Indeed, the latter explains well over half the current price increase because the number of foreclosures in the mix (foreclosures typically sell at a discount) is down considerably from one year ago. Other ‘quality’ adjusted numbers such as those from Case Shiller put the increase at less than 10%. Rapid, but not exploding.

As for buyers, in 2006 the market was being driven by an incredible availability of credit—just about anyone could get any loan to buy any house. Today, credit remains tight. Additionally, in 2006 investors bought to flip. Today, they buy to rent. It’s an entirely different strategy, built on fundamentals, not on riding a wave.

And what are those fundamentals? The amazingly cheap cost of housing relative to rent in Los Angeles today. In 2000, the median price of a house in Los Angeles County was $206,000 and interest rates were running at 8%. The monthly cost of that house, assuming for simplicity a 100% loan to value mortgage and adding property taxes, was a little over $1,700.  At the same time, the average monthly rent for an apartment was $1,000, making the home cost-to-rent ratio 1.73. At the peak of the housing bubble in 2006, that ratio had risen to 2.9, incredibly high and indicative of how misaligned prices had become because rent was so much cheaper.

Los Angeles County: Home Ownership Cost Vs. Rental Cost
  2000 2006 2011 2012
Median Household Income $42,189  $51,315  $52,280 $54,894
Average Asking Rent $1,001 $1,356 $1,412  $1,458
Median Home Price $206,275 $539,406 $324,338 $338,850
Monthly Home Payment + Property Taxes $1,729  $3,917  $1,960  $1,890
Price-To-Income Ratio 0.49 0.92 0.45 0.41
Price-To-Rent Ratio 1.73 2.89 1.39 1.3

Today, rental markets are tight given all the movement into rental housing following foreclosure—10% higher than in 2006 despite double-digit unemployment. And as home prices and interest rates have dropped sharply, the home cost-to-rent ratio has hit at an all time low of 1.3. It’s no wonder investors are leaping in. Median prices would have to get back to $470,000 before the ratio reached 2000 levels.

Could prices rise to this level? Maybe. But certain pressures are likely to cool things off. First, credit is tight, so as prices increase, demand will fall because price-to-income levels will rise and limit potential buyers. Secondly, rental markets will cool with more buyers and slow investor demand. And, thirdly, as prices rise, many formerly ‘underwater’ owners will be able to sell their properties, which will increase inventories. Banks are still processing quite a few properties and that will continue to add to supply. Finally, builders are rushing in to build units to meet the unexpected demand.

But remain wary. Today’s recovery could turn into another bubble if we forget to pay attention to fundamentals and instead focus on that age old, yet disastrous, investment strategy—the trend is your friend.


CATEGORY: Real Estate

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