Are We In A Bubble?

At this point in the market cycle, this might seem like a really stupid question. But a question that is related to this is, “Is now a good time to buy?”

It’s a big country, and each little area has some unique factors. But here is how you sort through the fog of B.S. to figure out if prices are reasonable.

First, what is the P/E ratio of housing in your area? The P/E ratio, or Price to Earnings ratio, is used to measure the price of shares in the stock market. It tells you how expensive a stock is with respect to earnings. In housing we redefine terms a bit to get this. We define Price as the price of buying a house, taking into consideration the payments on a 30 year fixed rate mortgage (the only sane mortgage to ever be involved with), taxes, and insurance. Earnings we define as the amount that we can earn by renting that house out. That’s it. Traditionally, people are willing to pay a little more to own a home than to rent a similar home because people like owning their own homes. So an average Housing P/E Ratio might be something in the range of 1.2 to 1.3. But this P/E ratio shouldn’t change much in your area. I currently rent because this ratio has been out of whack where I live (Greater Los Angeles) for quite a few years. The last time I did the math, it would have cost me 2.5 times as much to buy as to rent. Go ahead and adjust for taxes, pride of ownership, etc.; buying is not worth 2.5 times as much as renting to any sane person. The reason people were willing to bid prices up to the point where the ratios got this ridiculous is that they thought housing prices would go up by 20% per year, tuning this year’s ridiculous price into next year’s bargain. This leads us to the next factor to consider.

Second, somebody has to have money to pay for a house. What are house prices doing with respect to earnings in your area? If earnings in an area are increasing by 4% per year and home prices are increasing by more than 4% per year, at some point in the future nobody will be able to afford a home. Draw the graphs; do the math; that is a fact. People have to pay for homes. If average home prices are increasing faster than average wages, then something may be wrong. If you look at a graph of home prices vs. wages, and those graphs moved together for years or decades, and then they moved apart, you can take an educated guess that they are going to move back together again. As a matter of fact, you might get pretty close to the future price of homes in your area by figuring out where home prices would be if that relationship had not deviated from its long term pattern.

Third, are there any natural limits to population growth in your area? Strict building codes and geography can both limit growth. Limited growth potential may push prices higher, but to repeat, somebody has to pay for the houses. So if you live in a very desirable area with limits to growth, prices may increase, but wages must also increase. This is why the areas that are currently in price freefall are the ones surrounded by tons of open land. The places in the country where homes are tanking the fastest are Las Vegas, Phoenix, the Southern California Inland Empire, the inland areas of Orange County and San Diego County, and the entire California Central Valley all the way north through Stockton and Sacramento. All of these areas have steady wages, and all the land in the world to develop. There are no restrictions on growth.

One more thing to watch out for is the “My community is special because…”. I don’t know where you live, but I can tell you that it is not special. “People like to live:

-- in the Southwest”

-- in California”

-- in Southern California”

-- in Los Angeles”

-- near the beach”

-- near me because I am so fantastic…”

All of these points are true. But they were true last year, and 5 years ago, and 15 years ago, and 35 years ago. Why do any of these things justify prices that suddenly go through the roof? Did some brave new American explorer just discover California? No. Nothing has changes except the insanity of mortgage lenders. This time is not different, and your area is no more special than it has been for the last 40 years. And fyi, during the last housing crash of 1989 to 1994, homes in super spectacular areas like Beverly Hills, the Los Angeles Westside (including the beach areas), and Santa Barbara fell by as much as 50%. That is a fact. Did people suddenly decide they hated nice weather and the beach? No, a bubble popped.

That’s it. Does this sound overly simplistic? It is not. The home sales industry tries to muddy the issues, just as the car sales industry does with the car salesman’s “Four Square” logic, but renting is a substitute for buying, and somebody has to pay for homes. If these ratios are skewed toward higher prices, then it is a bad time to buy, and maybe a good time to sell.