Measuring the bubble: A real estate unreality index

With the bubble fresh in our collective memories, it is hard not to conclude that real estate is a vast bubble waiting to burst. But calling real estate a bubble is not sufficient; the question is how big is the bubble and how far into cloud-cuckoo land have investors gone? Unlike tech stocks, real estate is solidly grounded in the physical world, and this gives us a rough and ready measure of just unreal things have begin. Here is a three stage “unreality Index” against which to consider the state of the real estate market today:

Phase 1: Rental income can’t cover underlying finance costs.

Quite simply, it is a bubble when the maximum rents chargeable for a property are less than the cost of financing the property’s purchase at current market prices. By this definition, much of California has been in a bubble for a very long time. But while this is good news for renters, it does not necessarily mean that housing values are a bubble about to burst. A home can be a solid long-term investment even if short-term rents are out of whack with mortgage payments. And the impact of this bubble phase bursting is small as few homeowners actually rent out, and really don’t know or care what rental rates are. A Phase 1 bubble is thus not likely to burst and if it did, the deflation is typically modest.

Phase 2: Home buyers expect equity value to rise quickly.

Once upon a time, people bought homes because they needed a place to live. If the value of the house also went up, fine, but that was beside the point. However today, ever more homebuyers have reversed expectations. They consider their house an investment first and a home only second. They are counting on the rise to fund their next home or retirement.

This second bubble phase is worrisome because it leads people to engage in risky strategies like all-interest loans, treating paper appreciation as an equity piggy-bank, and speculative home-flipping. A burst bubble has real impact in such situations, and thus begins to put the real estate in a market where the dominoes are lining up, and more likely not just to fall, but also to take down others with them when they do.

Phase 3: Debt-based investment buying becomes popular.

This is the phase when people rush to buy additional properties identical to what they already own, and in the same geographic area. Buyers are so smitten with the steady Phase 2 appreciations that they get greedy and decide to put more of their financial eggs in the same basket in hope of making a killing. This of course violates the principle of diversification, creating a situation where the dominos are crowded ever more closely together and the slightest perturbation can send the whole sequence crashing down, wiping out the prudent with the reckless.

This third phase is thus truly terrifying. It is the level of unreality that Charles MacKay featured in his famous 19th century book, Extraordinary Popular Delusions and the Madness of Crowds. It is the nuttiness of Tulipomania and the South Seas Bubble. But even this level of folly does not necessarily mean a bubble will burst — it just merely means that people have lost their senses. I have a very bad feeling about what lies ahead in the next few years, but maybe we will get lucky and real values will grow into inflated, unrealistic expectations.