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To borrow a phrase from the late Supreme Court Justice Potter Stewart, financial bubbles are like obscenity: You can't define it, but you know it when you see it.

I've now officially seen it. For me, the light went on when friends here in Madison announced they were considering purchasing a duplex as investment property. Now, lots of folks have done well in the real estate business. Over time, rental property has generally appreciated while providing its owners with a steady stream of income and sometimes a roof over their heads. As Will Rogers famously observed, real estate is a sound investment since they don't make it anymore.

True. But when people with little expertise in real estate see it as a no-lose, road-to-riches proposition, we've left the investment arena and entered the realm of speculation.

By almost any measure, residential real estate prices are dangerously detached from economic reality. According to Yale University economist Robert Shiller (yes, the same Robert Shiller whose book "Irrational Exuberance" correctly forecast the demise of the New Economy bubble), house prices are in the throes of perhaps the greatest speculative frenzy in U.S. history.

By Shiller's calculation, the average domestic house price has risen in real (inflation-adjusted) terms by about one-half percentage point per year since 1890. Over the last two years, however, US residential real estate has averaged annual real returns of 8.1%, a 16-fold increase from the long-term average. The 12% inflation-adjusted rise over the 12 months through April may be the largest annual gain ever recorded. House prices relative to rents also are at historic highs.

Global phenomenon
To be sure, the real estate bubble is not unique to America.

House prices also have gone through the roof in South Africa, Ireland, Spain, Britain and Australia. In each case, a contributing factor has been easy money policies pursued by major central banks intent on cushioning economic damage caused by the popping of the stock bubble in 2000. But stock investors simply took their fresh-honed speculative skills to the real estate market.

Last year, 23% of all homes purchased in the United States were intended as investments rather than to be owner-occupied. More than one-third of all first-time buyers and one-quarter of all home buyers didn't make a down payment. During the last half of 2004, almost one-fifth of new-home purchases were financed by interest-only loans. Fully one-third of mortgages this year have been negative amortization loans, in which the borrower pays less than the interest due for a period of time.

In some especially hot markets, real estate has changed hands several times even before being occupied as speculators "flipped" properties for short-term gain.

With the question of whether there is a housing bubble resolved beyond a reasonable doubt, the only remaining issues are how and when it will end.

Bubbles can have surprising longevity, as evidenced by the five-year vertical climb in technology stocks during the late 1990s. But property prices already are falling in Australia and Britain. In the United States, where regulation has been looser, a possible day of reckoning may take a bit longer.

Correction could snowball
Actually, compared with downside volatility in stocks, a correction in house prices could be unspectacular, especially at first. Whereas a bear market on Wall Street usually shaves about 30% off the average stock price over 18 months, nominal declines in real estate nationwide could be limited to about 3% annually for a period of several years. But even at that seemingly innocuous level, the economic consequences might be severe.

Some real estate investors would quickly find themselves "upside down" (debt higher than property value) once property values begin falling. The resulting fire sale of properties would resemble a margin call in stocks, with selling begetting still-more selling. And consumer spending could take a severe hit as adjustable-rate mortgages re-price in a year or two and as homeowners feel less wealthy.

The best-case scenario is that house prices will level off for an extended period, allowing incomes and other economic fundamentals to catch up.

An exhaustive study of real estate price cycles by IMF economist Thomas Helbling provides some hope in that regard. Helbling examined the aftermath of 75 housing booms in 14 rich countries between 1970 and 2001.

The good news is that busts were not an inevitable consequence of large gains in property values. Depending upon how a boom was defined, a bust followed only about half the time. The bad news is that when a bust did occur, recessions and prolonged periods of below-trend growth were a virtual certainty. On average, real estate busts caused house prices to fall by 27% in real terms over a four-year period.

Helbling's work suggests that while the US and the world economy may yet dodge a very dangerous bullet, the consequences of taking a hit could be very painful.

Tom Saler is an author and freelance financial journalist in Madison. He can be reached by e-mail at tomsaler@aol.com.

Article from: www.jsonline.com