Breaking The Real Estate Bubble Myth

Bubble? What bubble?

At the root of the Real Estate Bubble Myth is the fact that interest rates are on the rise and the inexplicable truth is that, all of a sudden, everybody is so worried and concerned about it. Interest rates have been steadily on the rise both in the United States and, by reflection, in Canada since mid-2004, so I will leave to psychiatrists and psychologists the arduous task of explaining the newest, interest-rates phobia. I will, however, delve into the reasons as to why interest rates have been on the rise for these past 18 months.

Interest rates are the most important mechanism of Monetary Policy used by Central Banks to expand or reduce the available pool of capital at any given time. Central Banks use this mechanism to control the level of aggregate demand for goods and services, a primary cause of economic fluctuations. By reducing the money stock the cost to the banks for using the available capital is raised and passed on to consumers with a mark-up factor. This, in turn, discourages consumer spending on goods and services and, conversely, stimulates consumer saving. The effects are widespread and reverberate throughout the economic basket including, of course, real estate. What, however, pays to bear in mind is that it is not so much the amount of the increase that is important but, rather, the time given for the economy to adjust. The effect of a one percent interest rate hike in one month is going to be very different – and much more dramatic – than the effect of a one percent rate hike in six months, and this is a fact very well known to both the Federal Reserve System and the Bank of Canada.

So much so, in fact, that David Dodge, the Governor of the Bank of Canada, as well as Alan Greenspan, the outgoing Chairman of the Federal Reserve Bank and Ben Bernanke, the nominee for the Chairman position are all proponents of gradual interest rates increases. Prof. Bernanke in particular, in fact, has gone even as far as postulating an inflation-targeting approach designed to keep inflation in check at 2 percent over two years. All number-crunchers out there, therefore, consider this: the posted annualized U.S. rate of inflation calculated monthly for November, 2005 using the Consumer Price Index published by the Bureau of Labor Statistics is 3.46 percent, so all the Feds are talking about is a -1.46 percent inflation-targeting reduction programme over two years. That amount should be easy enough for everyone to absorb and it certainly does not look nearly as ominous as the doomsayers are all too fond of depicting.

Contrary to the belief of many ‘bubbleologists’ and the uneducated guesses of ill-informed consumers, a rise in interest rates is actually a welcome variable for the economy and, moreover, it is specifically the tool needed to keep a bubble from bursting. An economic bubble as it is widely known – or perhaps it isn’t – occurs when speculation causes prices to increase, thus producing more speculation and subsequent price increases. The bubble bursts when prices of goods are so absurdly high that consumers either refuse or cannot afford to purchase, thus sending demand tumbling down. As real estate markets in North America have seen more than a fair share of speculation in recent times, it follows that a cooling-off trend through higher interest rates will have the beneficial effect of consolidating market wealth achieved thus far. The bubble would be likely to burst if no pressure were applied on speculation, thus increasing prices even further and causing demand to lower and finally collapse. Allowing the economy to get an even footing through a slowdown of capital appreciation and, at the same time, allowing real wages to catch up is exactly the tonic needed for a healthy foundation. Higher interest rates, moreover, promote domestic saving and attract foreign capitals thus reinforcing both the Greenback and the Loonie, another beneficial factor in finance albeit not in trade.

So, what is the prognostication for 2006? Real estate consumers need to look no further than at the prices large developers are asking – and collecting – today for new construction slated for completion by the end of 2006 and beyond. Prices for residential condos in the planning stage or just under construction sold ‘on paper’ today are about 10 percent higher than prices of equivalent existing resale units, which goes a long way to point out where big players think the real estate market is heading. The basis of this buoyance is that consumer confidence is stronger than ever. Just before the Holidays, in fact, the Feds reported that the Index of U.S. Consumer Confidence has risen to 103.8 from 98.3 in November, the second highest level since August, 2005 when the Index reached 105.5, a reflection of lower energy prices and an improved job market environment. Moreover, preliminary estimates already show an 8.7 percent rise in Holidays spending in the United States and a 7.6 percent rise in Canada over the same period last year. There is no valid reason to believe, under the circumstances, that consumer confidence applies to everything but real estate and that an economic bubble would affect only real estate markets and nothing else. Furthermore, Real Estate Boards across Canada and the United States report that inventory levels are ‘seasonally normal’ – an indication that the anticipated glut of housing due to the inability of homeowners to meet mortgage payments has failed to materialize thus far. In fact, those who worry that adjustable-rate mortgages are a potential financial time-bomb ready to explode should be informed that while there has been a surge of new adjustable-rate mortgages over the past twelve months, especially in the United States, they account overall for less than 10 percent of the total existing inventory of mortgages held by banks. Furthermore, many adjustable-rate mortgages have allowed consumers to fix rates up to 10 years, and it is only borrowers of sub-prime mortgages that face monthly-payment adjustments after three years – which therefore means that the problem, if there is a problem, will come due in 2008, not in 2006. Interest rates increases have absolutely no impact whatsoever on the vast majority of mortgagors who have locked in already.

In conclusion, therefore, it certainly appears that the Real Estate Bubble theory belongs more to Greek mythology than the reality of our times. There is in progress right now a reduction of real capital values, which will continue for some time as the direct consequence of the markets taking a breather. This trend is expected to settle real estate markets to new, more commensurate pricing levels before appreciation will surge upwards once again. Where the difference will be seen more likely than not is in the annualized rate of appreciation: gone are the times of twenty percent capital appreciation increases from year to year. As interest rates are steadily, gradually increasing, expectations in economic circles range from a conservative 5 percent to an optimistic 10 percent housing appreciation in value by this time next year. But there is no question that real estate markets still have a way to go to make up for years of decline. Those who theorize the collapse of the housing market by comparing it to the stock market are fundamentally incorrect. At its core the housing market, like the stock market, is all about supply and demand. However, the difference is that investors base their decisions to buy into stocks on future potential whereas investors base their decisions to buy into housing on inherent value. Moreover, externalities as varied as immigration, internal migration trends, marriage trends and cultural precepts as well as generation gaps affect real estate markets whereas they are totally missing in stock markets. As such, real estate markets just do not ‘crash’ like stock markets. There is not going to be in real estate the infamous Black Monday – October 19, 1987 – when the Dow Jones collapsed 22 percent in value in one day. When people buy into stocks there is no guarantee whatsoever that the companies they are buying into will be still in business five, ten, fifteen years down the road. Real estate markets, conversely, are far, far safer.

In the absence, therefore, of external negative influences the likes of wars, terrorist attacks or devastating virulent pandemics – which, on the other hand, would affect the entire economy – and until such time as consumers exhibit confidence and purchasing power the way they have been doing thus far, there is no reason to fear bubbles of any kind anywhere in real estate. Hence, do not expect to hear a popping sound any time soon.