As interest rates begin to rise, concern has increased about a potential housing bubble and its effects if it were to burst. As individual investors consider the likelihood and implications of a real estate bubble, three questions have to be addressed: First, does it matter if there is a bubble and it bursts? Second, what is the likelihood that there is indeed a real estate bubble forming? And third, what can be done about it? Each of these questions is addressed in turn below.
Does it matter?
The existence of a real estate bubble matters to individual investors on two levels. First, it matters on the macro-economic level, because the bursting of a property bubble will have a broad detrimental impact on the economy and the stock market. But it also matters on a micro-economic (or household) level, as the bursting of a real estate bubble can significantly hurt the average household balance sheet.
On the macro-economic level, the data is compelling. The International Monetary Fund (IMF) published an in-depth analysis of equity market and real estate crashes in its April 2003 edition of the World Economic Outlook. In this study, it concluded: "Housing price busts were associated with output effects about twice as large as those of equity price busts. The worse case output effects exceeded those of equity price busts by a substantial margin. Moreover, the slowdown after a housing price bust lasted about twice as long." The average real decline in prices in a housing market crash (30% after four years) was found to be less than for a stock market crash (45% decrease in equity prices, on average, after two-and-a-half years), but at the end of each of those periods, GDP (or "output") had fallen 8% after a housing bubble burst compared to 4% after a stock market bubble burst.
The reasons for why the bursting of a housing bubble has such a big macro-economic impact are intuitive. First, consumers, on average, have a lot more of their wealth tied up in real estate than they do in stocks, so any change in the prices of homes has a bigger impact on consumer spending than a change in equity prices. Second, consumers are more likely to borrow to buy their homes, thus amplifying the impact of price swings on their wealth by being leveraged.
The macro-economic impact is nothing more than the aggregation of the impacts at the household level. To illustrate, let's take an example of a household that has $100,000 in net assets. Of that $100,000, one-half, or $50,000, is tied up in equity on the family's home. The home is worth, say, $250,000, and there is an outstanding mortgage of $200,000 on the home. A pretty typical situation.
Now suppose that housing prices drop by 20%, and the family is forced to relocate because the head of the household has lost her job. The price of the home has fallen by 20%, to $200,000 by the time the family sells their home. They use all the proceeds to repay their original mortgage, and their equity is completely wiped out. Their net worth has just been cut in half from $100,000 to $50,000.
Does a real estate bubble matter? You bet it does.
Is there a real estate bubble in America?
Although many people currently believe otherwise, real estate crashes do occur, albeit infrequently. The IMF study cited above looked at 14 countries between 1970 and 2002, and found 20 instances of real estate bubbles bursting (defined as a housing price contraction of 14% or more), and 25 examples of equity prices crashes (defined as a drop in equity prices of 37%).
When housing crashes do occur, they are severe. The average housing price crash in the IMF study lasted four years and had a total decrease in housing prices of 30%. In addition, the study found that real estate busts were more likely to have been preceded by a boom where home prices increased sharply for a number of years.
American house prices are up 30% since the mid-1990s, the biggest real gain over any such period in recorded history, according to the Economist magazine.
As the experience in the recent stock market bubble demonstrates, identifying bubbles is an extremely difficult task. But valuation metrics similar to the ones used in the stock market apply to the real estate market. The equivalent of the P/E ratio in the real estate market is the ratio of house prices to rents. In the U.S., according to the Economist, that ratio is now at a 20-year high and more than 15% above its average value between 1975 and 2000. Another ratio used for valuation is the ratio of house prices to average household income. According to the Economist, that ratio is also at a record high, 14% above its long-run average.
These averages mask differences by market. In some markets, like New York City, housing prices and valuation metrics indicate a much more overheated housing market than in other parts of the country. The Economist predicts that housing prices will fall in the U.S. in the next few years by 15% to 20% on average -- significantly more in certain markets, and less in others.
Like the recent stock market bubble, forecasting when the bubble will burst is near impossible. Potentially, if inflation picks up and interest rates rise, that could cause the bubble to burst. Or some unforeseen external economic shock -- a big spike in oil prices, for example -- could also occur and cause the bubble to burst. But robust, fundamental economic analysis suggests that a bubble is building in the U.S. real estate market, and like all bubbles, it will sooner or later burst.
What can be done?
Unfortunately, as the recent Motley Fool article "Who Cares about the Housing Bubble?" pointed out, there is little that individual homeowners can do to protect themselves, other than plan conservatively. Potential ways to hedge financial exposure are all problematic. One option could be to short housing stocks, such as KB Home
It is remarkable to me that the financial services industry has not developed a product to tap this potential unmet need among consumers -- home equity insurance. While I have insurance to protect the value of my house against fire or other physical disaster, I have no way to buy insurance against a fall in housing prices, something that seems much more likely to me.
Developing the product could be relatively simple. An index would have to be created that would closely match the characteristics of my home (for example, single-family homes in Denver in the $300,000-to-$400,000 price range). The price of that index would fluctuate, based on the prices of the underlying assets, and it would be updated on a regular basis. Once the index is established, any financial services firm, like H&R Block
Very few people have written on this topic. One notable exception is Robert Shiller, the Yale economist who also wrote Irrational Exuberance, the prescient book published shortly prior to bursting of the U.S. stock market bubble. Shiller has published a number of papers on residential real estate insurance, but the financial services industry has never really picked up on the idea.
Perhaps that will change, and an entrepreneurial company will come up with a viable insurance product for homeowners to protect their equity in their homes. Until that happens, the best thing for homeowners to do is to be realistic in their assumptions about the capital appreciation in their homes, and to ensure that they are prepared for a crash in housing prices. Signs indicate that a housing bubble is forming, and that it will eventually burst. And when it does, history tells us that the impact will be significant.
Fool contributor Salim Haji owns a home in Denver, Colo., but does not own any of the stocks mentioned in this article.