Is Real Estate the Next Bubble?

Investors who rode the performance wave of technology stocks in the late 90�s only to see the bubble burst in March of 2000 are probably wondering whether or not real estate is the next bubble. Real estate has not quite achieved the returns of tech stocks, but many homes in the Baltimore-Washington region have jumped 25% in the last three years and vacation homes in prime markets have doubled in the last five years. So the comparisons are not without merit.

The performance has been terrific, but does this mean we are in a bubble? If so, how can we take advantage of current real estate values?

Is Real Estate Really Overvalued?

Stock experts in the 90�s claimed that there was no bubble. As tech stocks ran up in value, analysts abandoned traditional methods of profitability analysis, because these firms had no current profits. Instead, they tried to substitute measures that would predict future profitability. Federal Reserve Bank Chairman Alan Greenspan viewed this as �irrational exuberance.� Mr. Greenspan�s comments were early, but he was right nonetheless. As for real estate, Mr. Greenspan pointed out in congressional testimony last summer that investors cannot buy and sell real estate as efficiently as they can stocks and bonds. So it�s harder for bubbles to occur in real estate.

History supports this notion. According to Fannie Mae, the nation�s largest residential real estate investor, annual home prices, on a national basis, have not declined since the Great Depression. However, regional downturns have occurred, such as in the oil patch of the early 80�s, the rust belt in the mid-80�s, and California and New England in the early 90�s. The first two events occurred due to regional recessions; the last occurred due to overbuilding. Economists do not expect either a national or regional recession. Since there is a low inventory of homes for sale in the Baltimore-Washington area, one would assume that housing is not overbuilt. So the conditions for a bubble do not appear to exist.

Donna Barkman of Coldwell Banker in Ellicott City says that conditions have been right for a boom in real estate. She points out that there is very little land for sale and a low inventory of homes. In addition, low interest rates have allowed people to buy more expensive new homes while maintaining similar mortgage payments. She says that the market is not as strong today as six months ago due to the uncertainty surrounding the war. But she feels that buyers will be ready later in the spring. As rates rise, buyers may have more negotiating room, but she doesn�t see housing prices retreating.

Conditions have been even better for vacation real estate. Properties on the Atlantic Coast have appreciated between 50% and 100% in the last ten years. This price appreciation was first fed by strong demographics as baby boomers entered their retirement years. The strong stock market and the quick profits from technology stocks helped turbocharge values. Then low interest rates fueled the market in the last few years. Tim Rhodes of Coldwell Banker in Bethany Beach, Delaware points to the low supply of high-end homes near the beach and strong demand holding prices firm. However, further back from the beach, new housing starts have increased the available supply. A weak economy could lead to falling prices in this area.

Realistically, the declines in the equity markets to date and the inevitable rise in interest rates will rein in the real estate market. Already we are seeing weakness in new home sales on a national basis. However, strong demographics and moderate economic growth reduce the likelihood of a substantial decline in real estate values. Here at BWFA, we are not in the housing bubble camp absent a deep recession. But we are a nation at war and in these turbulent times a recession cannot be ruled out.

Should We Take Advantage of the Real Estate Boom?

BWFA is a strong proponent of diversification of assets and we are constantly rebalancing client portfolios to reduce concentrations in sectors that have performed well recently and allocating the funds to sectors that have underperformed. Should our clients trim their real estate holdings and allocate the funds to the equity markets? In theory, yes.

There are circumstances where it might make sense to trim our exposure to this sector. Homeowners who are looking to downsize as they enter retirement might want to do so now to ensure they sell in a strong market. Investors in vacation properties may also feel that locking in capital gains that could be used against capital losses in the stock market would allow for the efficient transfer between asset sectors. But, for most of us, our primary residences and vacation homes are more than investments. They fulfill a primary need for shelter, and we have emotional attachments not found in the stock markets. We are not prepared to trade them for short-term financial gains. In addition, real estate has historically been an excellent hedge against inflation.

For most of us, simply holding our real estate is the best course of action.