USA Real Estate Bubble IF Any Will Crash

Stephen Chung

Managing Director

Zeppelin Real Estate Analysis Limited

July 2005

A friend from the USA has emailed me an article which author-analyst thinks there is now a real estate bubble in the USA. Apparently my friend does not feel there is one judging from his tone but nonetheless he asked for my views. The following is abstracted from the reply I gave him:

 I (i.e. your humble author) have been reading much about USA and even global real estate bubbles in the local and foreign media. Judging whether there are bubbles is always a difficult task and almost always involves a bit of subjectivity which in turn relates to the analyst's past experience, investment behavior, and / or even personal values.

 Being thousands of miles away from the USA, I am handicapped in not being able to really 'feel' the market sentiment e.g. whether people talk about real estate in typical lunches, dinners, or family-friend gatherings etc. Nonetheless, based on the information and data I have read to date, I am inclined to think there is a bubble in some of the real estate markets in the USA. But then again, having bubbles does not automatically translate into immediate dooms (and bubbles can last quite a while), and having NO bubbles does not automatically mean that prices will ONLY go up. Yet I do think some form of crashes will happen assuming things continue along the current path and that there are real estate bubbles. This may include other markets such as those in Europe but I will guess the USA ones will have more global impact. Apart from the usual rationale, some of my reasons for expecting a crash are as follows:

a) Americans are new to variable rate mortgages and I doubt if those using them really understand its nature = a double-edged sword unless they instill-buy some form of cap on the interest rate in the mortgage agreement. The panic (when and if a crash occurs) will be higher than IF they had just used fixed rate ones. [Note: this is because fixed rate mortgages offer some degree of financial payment certainty at least till the expiry of the term, while variable rates may imply immediate significant jumps in regular mortgage payments which could be more than what the household budget has allowed for].

b) A crash does NOT have to have a 'banana republic-type economy' to happen = e.g. the Hong Kong real estate bubble in the late 90s*. If you look into the overall wealth of Hong Kong in the 7 years from 1997 to 2003, you would notice that little had actually changed i.e. people were still generally employed [it was the 'threat' of being laid off that counted] and people still had some HK$3,000B placed with the banks [granted say 1/3 might not be really Hong Kong's own money being an open economy but that still left a big sum]. They were just not spending much, let alone buying real estate. Hence, bubble nay-sayers citing how healthy the USA fundamentals are, assuming if so, are misled.

c) A crash (at least in real estate) needs to involve only a small portion of the overall real estate market stock to be 'traded' in 'desperate' pricing to set off the event = how deep and long-lasting the impact depends on a variety of conditions including the 'sensitivity' (degree of response, reaction and interaction etc) of market participants to such market events i.e. how easily (or not) panicked or manipulated they are. In short, the perils of so-called 'market price'. You may not agree to it and you may decide not to sell your home at that particular 'market price' at the time, but should you wish to refinance or upgrade or relocate etc, you are bound by what the market is willing to offer at the time. Based on the article emailed, it does NOT occur to me that spending 10-30% of your disposable income on housing mortgages or having a mortgage to home value ratio of 35% to 70% is overly worrying, BUT those families who leverage themselves to the fullest (e.g. having 100%+ mortgages, owning 2+ homes etc) are a catalyst to a crash, and it will be their desperate transactions, when and if occurred, which will set the market price and the market tone.

d) Americans spending beyond their means and doing it with borrowed money (e.g. from China) = despite all economic theories and financial wizard strategies that have evolved since memory seeking to create new paradigms, common sense tells me that such a condition cannot last forever. Something has to give, be it via an economic crisis, a financial crash, or even some form of war (if history is any guide).

Hope this would be of interest and use.

Note* = Hong Kong real estate prices dropped BY (not to) almost 70% from the 1997 peak levels to the mid 2003 troughs. Prices have since recovered some 60% on average. This steep drop was in part due to the HK$ to US$ peg (HK$7.78 = US$ 1.00) but that alone could not have explained the whole story. 

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