Is the Real Estate Market a House of Cards?

2006 Volume 9 Issue 1

In 2005, prices for homes climbed to dizzying new heights. Does this trend in prices represent a bubble? Will the bubble burst? Are these higher prices sustainable? What will be the economic impact?

Photo: Karolina Michalak

During 2005, the housing market has been a frequent news topic. Why all the interest? First, the price of housing, particularly in some “hot” areas of the country, has seen annual double digit growth over the last five years-up to 50 percent per year in Las Vegas! Second, the housing affordability index has been dropping. This index is a measurement of those who can qualify for a mortgage on a median priced house given current interest rates, a 20 percent down payment, and the median income in the area. For example, the average cost of a house in California as of November 2005 was $545,910, and the median salary was $54,140-less than half the salary needed to qualify for a mortgage. In Southern California the gap was even bigger. The median salary of $52,580 was $74,240 below the salary needed to qualify for the median priced house.[1] These figures indicate that less than 14 percent of households can purchase the median priced house-down from 18 percent a year earlier. As housing prices increased and the affordability index fell, market participants began to question whether the high prices could be sustained or if a housing price bubble existed.

Why Should Businesses Care?

If there is a housing price bubble and it does burst, why should business people care-other than be concerned about a drop in the value of their own homes? The economy is driven by consumer spending, which makes up approximately two-thirds of all spending. Consumers who have seen the price of their houses double in the last few years feel “rich” even if they do not plan to sell. If consumers feel rich, they spend. In addition, homeowners have taken advantage of the low interest rates and high real estate prices. They have converted their real estate investment into cash either by refinancing and pulling cash out or borrowing with a home equity loan against the higher value. If consumers see the price of their houses stagnate or fall, they may cut spending and thereby impact economic growth.

This article explains an asset bubble, analyzes the causes of a possible bubble, and examines the implications of a bubble.

What is an Asset Bubble?

An asset bubble exists if prices are high today because investors believe they will be higher tomorrow-not because fundamental factors justify the rise in prices. History provides several examples of asset bubbles-and the big pop.

On March 10, 2000, the NASDAQ stock index, which lists many technology firms, hit 5,049, followed by the pop heard round the world. The market plunged downward, reaching its bottom of 1,114 on October 9, 2002. The “experts” cite many causes of the technology bubble, including the belief of many market participants that a “new economy” had emerged in which technology ensured that recessions were a thing of the past and productivity gains would continue at levels that formerly had seemed unattainable. Though many technology companies had yet to produce a profit, overconfident investors felt that this was a temporary condition and that the inevitable profits would ensure that technology stock prices would continue to rise. By January 2006, the NASDAQ index had regained less than half its peak value.[2]

On December 29th, 1989, the Nikkei 225 Index, which reflects the value of Japanese stocks, hit its all time high of 38,916, and then, “pop!” The Nikkei slid downward for more than a decade, reaching its bottom of 12,698 on June 18, 2001. Again, the experts cite many causes for the Nikkei bubble, including financial institutions exhibiting aggressive behavior and inadequate risk management, monetary easing and low interest rates, regulations encouraging increases in real estate prices, and investor overconfidence and euphoria.[3] After a decade of deflation and banking reform, the Nikkei hit a five-year high in January 2006, about 33 percent of its peak value.

Photo: Fleur Suijten

However, asset bubbles are not a recent phenomenon, nor are they limited to stock markets. The Dutch Tulip bubble of the 17th century was one of the most dramatic examples. After tulip bulbs were introduced into Europe, they became the prized possessions of the rich. As the price of tulip bulbs increased, speculators began buying the bulbs from sailors and selling them to the wealthy. By 1634, bulbs could be bought and resold within a few days for a significant profit. In 1636, the Amsterdam Stock Exchange began trading interests in bulbs, and notaries began specializing in recording tulip transactions. It is estimated that a bulb at the peak of the bubble sold for $34,584 in today’s dollars. Eventually, some investors began to liquidate their interests in tulips, supply increased dramatically, and during a six week period in 1636, tulip prices fell by 90 percent. To limit the chaos that followed, the government nullified all tulip contracts and declared tulip speculation a form of gambling. Tulip prices never recovered after the bubble burst, and today rare tulip bulbs sell for $0.30 to $0.40 apiece.[4]

A House of Cards?

Are we experiencing an asset bubble in the U.S. real estate market? There are some interesting parallels to previous asset bubbles-particularly low interest rates, aggressive behavior by financial institutions, and high short-term profit potential, which encourages speculation.

The U.S. economy entered a recession in 2001, and the Federal Reserve (Fed) lowered interest rates-monetary easing-to spur the economy. As mortgage rates fell to 40-year lows, more households qualified for mortgages, and the demand for houses increased. Increased demand helped to inflate housing prices.

Increasing prices eliminated some potential buyers from the market even with low mortgage rates. Financial institutions stepped in by pushing adjustable rate mortgages (which lower salary requirements with lower initial payments) and by offering creative mortgage financing featuring such things as no down payment, zero percent interest for the first year, negative amortization (the monthly payment is less than the repayment of principal and interest) and interest-only loans (no repayment of principal). Interest-only mortgages accounted for 17 percent of all mortgages in the second half of 2004.[5] Creative financing allowed more households to qualify for mortgages, increased the demand for houses, and helped to inflate housing prices.

Returns in the stock and bond markets since 2000 have been low or negative, and volatile. At the end of 2004, stock and mutual funds were worth 21 percent less than five years earlier.[6] However since 2002, house prices in California have risen 71 percent. High housing returns versus returns on other investments attract speculators.[7] It is estimated that 23 percent of the homes purchased in the U.S. during 2004 were bought by real estate investors, many of whom hoped to resell the homes quickly at a profit. An additional 13 percent of the purchases were second homes. Housing experts report that people who do not live full-time in a home are inclined to sell quickly if prices stagnate or decline.[8] If supply increases rapidly, there will be downward pressure on home prices.

Will the Bubble Burst?

Some evidence suggests that there is an asset bubble in the housing market. The question is, will it burst? There are two views on that question.

The bubble will burst: Some factors that suggest it could.

  1. Creative financing-Creative mortgage instruments have made borrowers vulnerable, not only to rising interest rates (as monthly payments on adjustable rate mortgages increase), but also to stagnating or falling prices (as market prices fall below mortgage balances with negative amortization or interest-only mortgages). Short-term interest rates, the index for many adjustable rate mortgages, have increased steadily since the Fed began raising interest rates in June 2004. Market watchers have yet to observe a significant increase in mortgage defaults or delinquencies, except in the sub-prime category in which the delinquency rate, while still low, doubled in 2005 to 6.23 percent. However, the negative impact of creative financing may be obscured by the large number of bankruptcies declared in October 2005 prior to the tightening of bankruptcy laws.[9] A clear picture may not be available for some months to come.
  2. High household debt-Creative mortgage financing has been a major driver in the housing boom. Mortgage debt in the U.S. has nearly doubled since 1995.[10] In addition, because of relaxed lending standards, more than 50 percent of new home buyers in California during the last two years spend more than a third of their pretax household income on mortgage payments-the maximum recommended by the Department of Housing and Urban Development. An additional 20 percent spend more than half their pretax income.[11] If these households have payments that increase over time and their incomes do not increase at the rate of their payments, the number of delinquencies and defaults may rise quickly.
  3. Spillover effect-Two-fifths of the jobs created in the U.S. since 2001 are related to the housing market, including jobs in construction, real estate brokers and appraisals, and mortgage lending.[12] If the real estate market stalls, these jobs could be lost. If these jobs are lost and not replaced by jobs in other sectors of the economy, the number of delinquencies and defaults may rise.
  4. Interest rates-The U.S. government continues to run a budget deficit that must be financed. Demand for Treasury securities by foreign investors and governments has allowed the Fed to raise interest rates at a measured rate. However, if foreign demand slows, interest rates may rise quickly and to undesirable levels in order to attract additional funds.[13] Higher interest rates could increase bankruptcies and defaults on mortgages.
  5. Global asset bubble-The total value of residential property in developed countries increased by more than $30 trillion over the past five years to over $70 trillion, equivalent to 100 percent of those countries’ combined GDPs. Some markets are beginning to slow, with the market in Britain reflecting the sharpest drop. Real estate markets in the southern hemisphere countries-Australia, New Zealand, South Africa-also appear to be slowing.[14] If weaknesses in housing markets slow growth in the global economies, the U.S. economy could be impacted. A slowing of the U.S. economy could increase delinquencies and defaults on mortgages.

What bubble?: Other factors suggest the housing market will not crash.

  1. Limited land-There is still much open space in the U.S., but most people don’t want to live where it is located! They prefer economically vibrant areas where housing is often constrained by limited unused land and rules and regulations passed by governments and neighborhood associations. Limited supply in high demand areas could protect home prices from significant losses.[15]
  2. Demand for housing-The demand for housing will stay strong. Financial security and empty nests have increased baby boomers’ demands for second and vacation homes. The children of baby boomers-a mini population boom-are beginning to enter the housing market. Immigration continues to increase the U.S. population. Foreign ownership of housing, for investment returns or living space, continues to grow. All of these factors will keep demand high and reduce downward pressure on U.S. real estate prices.[16]
  3. Control of inflation-Many economists and market watchers believe that the Fed has developed the tools and expertise necessary to control inflation. If inflation is under control, then interest rates should not climb dramatically. Historically, the number of prospective home buyers has not been significantly reduced until mortgage rates exceed 8 percent, and few expect mortgage rates to approach that level.[17]


Will the bubble pop, or will we simply hear a hiss? Headlines as early as July 2005 warned that the peak of the housing market was near. As late as September 2005, UCLA’s Anderson Forecast warned that the peak was near and that the resulting slowdown would weaken economic growth-and possibly cause a recession-for the next two years.[18] However, even UCLA has now changed its song. In the latest report, the Anderson Forecast states that there is evidence of some slowing in certain regions, but no convincing evidence of a slowdown “in the big picture.” Although UCLA still sees slowing and some job loss over the next two years, it is predicted to be minor.[19]

The annual double-digit price increases are probably coming to an end, but large price decreases and a significant economic downturn seem unlikely. In some less desirable areas, prices may stagnate or decline slightly-less than 5 percent. In desirable areas, prices are not expected to decline, but will appreciate at a slower rate-in the 5 to 8 percent range. U.S. real estate basics have not changed. The three most important factors are still location, location, location.

[1] “Realtor Group Sees Gap in Income, House Prices,” The Los Angeles Times, 2 November 2005, C-2.

[2] “The Cost of All Those McMansions,Business Week, 6 June 2005, 44.

[3] Okina, Kunio, Shirakawa, Masaaki, and Shiratsuka, Shigenori. “The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons,” Bank of Tokyo Discussion Paper No. 2000-E-12, May 2000.

[4] Hirshey, Mark. “How Much is a Tulip Worth?” Financial Analyst Journal, 1998.

[5] “Housing Market Has Lost Touch with Reality,” The Economist, 28 May 2005, 36.

[6] “So Long to the Wealth Effect,” Newsweek, 17 October 2005.

[7] Sing, Bill. “Peak for Housing Said to Be Near,” The Los Angeles Times, 28 September 2005, C-1.

[8] Corkery, Michael and Haughney, Christine. “Investors Hold the Key to Housing Boom’s Fate,” The Wall Street Journal, 17 August 2005, B-4.

[9] Eisinger, Jesse. “Consumers May Be Starting to Bend, Judging by Those Subprime Mortgages,” The Wall Street Journal, 30 November 2005, C-1.

[10] “Why Home Owners Could Get Pinched,” Business Week, 19 July 2005, 36.

[11] Green, Chuck and Wedner, Diane. “Mortgages Take a Bigger Bite,” The Los Angeles Times, 4 September 2005, K-1.

[12] “The Global Housing Boom,” The Economist, 18 June 2005, 13.

[13] Crawford, Peggy and Young, Terry. “The Twin Deficits: A Looming Crisis?” The Graziadio Business Review, Volume 7, Issue 2, 2004.

[14] “The Global Housing Boom,” The Economist, 18 June 2005, 13.

[15] Hagerty, James. “What’s Behind the Housing Boom,” The Wall Street Journal, 21 November 2005, R-4.

[16] Leonhardt, David. “Be Warned: Mr. Bubble’s Worried Again,” The New York Times, 21 August 2005, BU-1.

[17] “Higher Rates Won’t Hammer Housing,” Business Week,10 May 2005, 33.

[18] Sing, Bill. “Peak for Housing Said to be Near,” The Los Angeles Times, 28 September 2005, C-1.

[19] Haddad, Annette. “Hot Housing Market Still ‘Cruising’,” The Los Angeles Times, 7 December 2005, C-1.

About the Author(s)

Peggy J. Crawford, PhD, joined the faculty of Pepperdine's Graziadio School in 1997 after serving on the faculties of the University of Houston, Fordham University, and George Mason University. She has published in a variety of journals on topics such as leasing, mortgages, closed-in mutual funds, the depreciation of the dollar, the trade and federal deficits, and the price of oil. She has served as a consultant for such firms as Sprint, AT&T, various state CPA societies, and the Washington Redskins (her favorite client!).

Terry Young, PhD, has over 15 years of business experience in Asia and the United States. Thoroughly versed in international economics, Dr. Young has extensive knowledge of the global marketplace, with primary emphasis on Asia. Her consulting expertise includes global sourcing, business start-ups and management in such industries as food distribution, the textile and garment industries, agriculture, electronics, and real estate development. Dr. Young's 20-year university teaching experience includes assignments at the University of Southern California, at two California State University campuses, and a full-time professorship at Pepperdine University's Graziadio School of Business and Management where she received the Luckman Distinguished Teaching Award in 1994.

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