Are We On The Brink Of Another Bubble?

gum Over the last few weeks, several of my clients have asked a seemingly simple question: Are we in the midst of another housing bubble?

Additionally, I have been forwarded a number of articles supporting the “bubble theory” – an important issue for investors planning their personal business strategies.

For these reasons, I am shifting gears this week, bypassing my usual focus on legislation and regulation, in order to provide some bubble-related perspectives for Real Estate Mogul’s readership. And what I am discovering should prove to be both timely and helpful for today’s real estate investor.

The Recent Spike

To maintain a broad and objective perspective regarding the possibility of a new real estate bubble, I have spent recent weeks supplementing my own knowledge of price-related policy changes with an investigation of several other timely and well-informed sources, including:

Multiple hours of recent Q&A with various housing-focused Wall Street analysts
A series of “industry insider” articles regarding the potential for another bubble
A review of recently-released housing data from numerous third-party providers

graph In the latter part of the second quarter of 2012, the GSEs altered their REO valuation methodology – something I wrote about at length in my newsletter for the Distressed Property Coalition. The new methodology, which was adopted for short sales in late 2012, offers opportunity for more reasonable pricing, as well as inflation particularly in distressed areas. Whether we are talking REOs or short sales, the data was difficult to explain at first, because of the disparity of pricing in certain areas.

As more data on the institutional purchases became available, and as I held more meetings with housing officials, it became clear that the recent increase in housing price spikes were due to (i) changes in this valuation methodology and (ii) massive purchases by institutional buyers. Accordingly, there is no doubt that the spike is real, and it does not seem to be particularly organic – especially within distressed markets, where we have seen prices soar nearly 10% in a single quarter.

Does this mean we are on the verge of another bubble?

Although it could be tempting to view these recent developments as indicative of a new bubble in real estate prices, I don’t think that is the case.

The primary flaw of the “bubble theory” is a lack of any historical context. Without proper context, a 10% spike in prices across a distressed area may seem like a crazy number. However, it is notable that home prices previously declined 18.9% (across the board) during the first quarter of 2009 – and the decline was twice as severe in some distressed areas. While the recent dramatic rise in prices should certainly be evaluated, it is important to remember where we are coming from, and where we were at the height of the bubble.

According to the S&P/Case-Shiller index, today’s national average home price is relatively unchanged from 2003 levels. Perhaps more importantly, home prices are essentially unchanged 2009 levels and lower than some of the immediately subsequent periods heading into 2010. At the height of the bubble (mid-2006), the index rested around 190 before eventually dropping to the 130 level (2009). Today we sit around the 135 level.

Up, Up & Away!

What does all this mean? Compared to where we were, home prices are still at a reasonable level despite the recent uptick. In fact, before the recent uptick, prices had briefly dipped below the 2009 level.

Moving away from the data and taking a broader view of the recent history of the last housing bubble and our current circumstances, there remains little support for the bubble theory. The essential key to the last bubble was an environment of easy mortgage credit. That is clearly not the case today. Any interest rate hike (the rate has nowhere to go but up) would flatten prices. And mortgage payments today are also comparable to rental prices. Taking all this into context, there does not seem to be an argument that we are in identical or even similar circumstances to the time preceding the last bubble.

Shifting back to the institutional buyers, many bubble theorists point out that these buy-and-rent models may be in danger of failing. I tend to agree with this premise. However, if the models break down and the funds blow up, one would tend to expect that such developments would cause a sharp decrease in home prices, not an increase. These firms each hold several billion dollars in residential assets, and if their models fail, the market would essentially have billions of dollars of distressed properties for sale. Since when does a glut of distressed properties result in inflated prices?

The recent spike in prices is shocking, but compared to the last bubble in real estate pricing, it still appears to be a good time to invest. And if institutional buyers are your chief concern, it seems to me that they are more likely to cause a crash if they fail rather causing than a bubble if they perform.