Say What?

Did he really just say that? Say it ain't so. Oh man. Bummer. Party's over, turn out the lights. Say it however you like, but last week's comments from the master bubble blower and national chief financial officer was another in a series of warning 'bells'. Fed Chairman Alan Greenspan said he saw signs of "froth" and local bubbles in housing, but no national bubble. Even at 78 Mr. Greenspan still wields considerable power when it comes to liquidity creation. Mr. Greenspan has been in "easy money mode" for over 3 years now, and as a result, the real estate market has done exactly what it should have...become artificially inflated by low interest rates and a lax credit process.

Banks have been forced to 'find what to do with' all the liquidity the FED provided, so standards had to be lowered to force the money out into the system and generate big upfront fees. Appraisers are on board with the program so they continue to get the business.

Even after 2% (200% relative increase) has been tacked onto the FED Funds rate the market doesn't believe. The 10 year treasury is at the same place it was when the FED started raising rates a year ago, and the real estate market has not even tapped on the brakes. So, last week The FED chairman decided harsher and more direct words were necessary to forewarn the speculators and homeowners, that this cannot continue, and probably shouldn't continue. Greenspans comments were followed by no less than 2 of his fellow FED Governors making similar comments.
A recent Fortune cover story discussed the frenzy of housing speculation. The story detailed several “investors” as they raced around the hot markets to purchase homes or even just contracts to purchase homes under construction. Other anecdotal facts that point to increased speculation include “the number of chapters of the National Real Estate Investors Association has jumped from 44 in 2002 to 170 currently.” The number of homebuyers in Phoenix that labeled themselves as investors doubled since last year to 2,703 and they purchased 18% of all the home sold in Phoenix last year. Eighty-six books on real estate investing were published last year, three times as many as in 1998. According to the article, only 1.6% of mortgages were interest-only in 2001. Three years later in 2004, a whopping 31% were. One investor said he was not worried that he was losing $3,500 per month on his investment houses since he is not renting them all out because he is “in it for the appreciation.”

The FED seems to be heeding the warning signs of previous asset bubbles and trying to jaw bone the rampant speculators and the banks that provide the financing to beware, as they slow the liquidity and raise the cost of money at the prescribed measured pace. In fact, Fed Governor Furgeson had this to say last week "Clearly central bankers would benefit from a better understanding of asset price movements --- particularly more extreme movements - so that we do not mistakenly facilitate in some way potentially harmful outcomes," Ferguson said.

It may be hard to stem the flow at this point, since so much money has been made and many 'exciting' deals are firmly in the pipeline, so the warnings seem to be falling on deaf ears, especially so since the real estate bubble concept has been talked about for so long now that most do not subscribe to the possibility of it existing.

We all are experiencing the appreciation, using the equity to fund our lifestyles, and counting it as part of our net worth. Its great having an appreciating asset that you not only can live in but you can live off it too. Home equity has been and continues to fuel the American consumer and the all the new real estate tycoons. But, as rates rise, even at a measured pace, the cost to carry those inflated assets rise. The values of those assets will surely slow in their appreciation, and in fact might even go down in value. Similar to bond yields and bond prices, there is an inverse relationship between rates and prices. As interest rates on the funds used to purchase the assets rise, the cost to carry the asset rises. Those forces will combine to undermine the real estate market and values of real estate.

Finally, unlike many other financial assets, real estate has an economic value. It is an asset that has a very important use. Their is a cost to that use which is paid in the form of either rent or carry costs of the house. While the appreciation of that asset is nice, the costs associated with the utility of that asset are critical to its valuation.

In many areas, the costs to own a home has doubled and tripled over the last 5 years. Clearly that cannot continue as the end user of the home will not be able to afford to live there. Speculators and investors must either rent or sell their appreciated assets in order to realize the profit. Valuations have gotten to a very uneconomic and overly inflated level, which will undoubtedly prevent the realization of those profits. And dare I say may even cause the unthinkable...a loss of capital in a real estate investment.