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1983
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1992
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1994
1995
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1997
1998
1999
* part of year


FIGURE 9.4 U.S. Vacancy Rate Is Climbing
Source: U.S. Census Bureau




bad news for landlords. It is also bad for homeowners who are not land-
lords. Potential buyers of homes are constantly evaluating the alterna-
tives of buy or rent, thus the prices of all homes are influenced by the
rental market.

Clue #4: Mania-Like Behavior in Some Areas
Irrational markets are at least as much psychological as they are eco-
nomic. The real estate market shows at least two signs of mania beyond
the statistics. First, many markets show frenzied buying that accompa-
nies bubbles. Second, there is a widespread belief that real estate prices
cannot fall.
My friends Tom and Florentien just bought a house in the Boston met-
ropolitan area. I ran into Tom one evening and I asked how he was doing.
He said, “I™m exhausted. I had to get up at 5 a.m. and take a one-day
business trip. Now I™ve got to go make a bid on a house.” I inquired fur-
Real Estate 209



ther about the pressing need to make a bid immediately. Couldn™t Tom go
home and make a bid the next day? The answer was no.
The Boston real estate market is”as of July 2004”still in a total
mania. In Tom™s case, the property went on the market on Saturday and
he knew that in order to have a chance he needed to bid by Tuesday. As
soon as a reasonable property comes on the market, multiple potential
buyers flock to make aggressive bids. The winning bid generally is above
the asking price.
In the case of the condominium adjacent to ours, the winning bid came
in above the asking price and the deal closed within hours of the unit
coming on the market! Through some inside connection, the buyers
learned of the hot property and quickly made the owner an offer she
couldn™t refuse.
This behavior is crazy. Buyers are forced to make huge decisions with
very little time for consideration. The mania is not nationwide as many
markets are more subdued. Nevertheless, there are many places where
this buying frenzy is common. Such behavior is typical of bubbles.
The second sign of mania is the belief that real estate prices cannot
fall. When people envisage bad times in real estate, they imagine a
plateau for some period of time. It seems impossible that real estate
prices could actually decline. In Chapter 3, we met the trustees of my
condominium who thought buying more property was a “can™t lose
proposition.”
This belief in housing price rises is shared by professional analysts.
Dr. John Krainer is an economist who works for the Federal Reserve. He
wrote an excellent article entitled “Housing Price Bubbles.”9 In his con-
clusion, he writes, “Following the observation that declines in nominal
house prices are unusual, I hold the house price fixed at its current level.”
Dr. Krainer does go on to analyze the possibility that housing prices
could decline. Nevertheless, it is telling that he begins by assuming that
prices will not fall. When markets are at their irrational tops, people con-
sider declines to be impossible.
210 Applying Science and Art to Bonds, Stocks, and Real Estate



If it looks like a mania and feels like a mania, it™s probably not a duck.
The housing market shows the psychological signs of overvaluation.



Is There a Housing Bubble?

No.
I do not believe there is a bubble in U.S. housing prices. However,
there are substantial risks to housing prices and they may fall substan-
tially.
If housing prices could decline a lot, why is this not a bubble? In a true
bubble, prices become so far out of line that it would be impossible for
them not to fall. In the tulip mania, for example, it was possible to buy a
house for the price of a single tulip bulb.10 Because tulip bulbs can be pro-
duced in massive quantities with a bit of sunshine and water, it is impos-
sible for bulbs to continue to sell for the price of a house.
Similarly, U.S. tech stocks in the late 1990s reached impossible levels.
Cisco, for example, had a P/E in excess of 100, a figure that could not be
justified by fundamentals. While irrationality can last a long time,
Cisco™s stock simply had to fall. I went on record with, “if Cisco™s stock
price does not decline, I will tear up my Harvard Ph.D. in business eco-
nomics, because a continued high stock price would disprove everything
I have learned.” (Many other people went on record as well.)
So a bubble is such a degree of irrational pricing that only one out-
come is possible. There are warning signs in U.S. housing prices: It is
true that housing prices cannot grow faster than rents indefinitely, and it
is also true that the long-run growth in housing cannot exceed the growth
in population. Thus, the boom times in housing will end. The valuation
levels, however, do not justify the label of a bubble. It is possible, there-
fore, that a decline in housing prices may be avoided.
U.S. housing is expensive but not so high as to ensure a collapse. In
addition to the unsustainable trends and the bullish psychology already
covered, however, there are additional risks to the housing market.
Real Estate 211



Risk #1: Rising Interest Rates
In June 2003, the interest rate on the 10-year Treasury was 3.11%. One
year later, in June 2004, it was 4.82%. This stunning increase of more
than 50% in just one year shows how rapidly rates can rise. How far will
interest rates rise? What will the effect be on housing prices?
First, how far will interest rates rise? We learned two key facts in the
discussion on bonds that are worth repeating. First, as compared to the
last 20 years, interest rates are extremely low. Second, this is especially
true when interest rates are adjusted for inflation. Figure 9.5 shows the
real”inflation-adjusted”interest rate on 10-year Treasury bonds. This
is calculated by subtracting the inflation rate from the interest rate.
Unless the economic world has changed completely, real interest rates
will rise. This can occur via a decrease in inflation or an increase in inter-
est rates. If inflation does not fall from current levels, how far will inter-
est rates rise? Over the previous 10 years, the real interest rate (the
premium over the inflation rate) has averaged 3.3%. Consumer price



10%
Real Interest rate (10-yr - CPI)




9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
1981
1982
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2000
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2003
04*




* part of year


FIGURE 9.5 Real Interest Rates Are Extremely Low
Source: U.S. Federal Reserve, Bureau of Labor Statistics
212 Applying Science and Art to Bonds, Stocks, and Real Estate



inflation is heating up a bit. The annualized rise so far in 2004 is 3.3%. A
different method of estimating inflation that looks at year over year
changes in prices registers a slightly more benign 3.1%.
Thus, if the real interest rate returns to the average of the previous
decade, the interest rate on the 10-year Treasury will rise from 4.8% to
somewhere between 6.4% and 6.6%.
The interest rate on the 10-year Treasury bond could therefore easily
rise to above 6%. In fact, such a rise could be said to restore interest rates
to normal levels. The 3.11% rate of June 2003 looks like an irrationally
low interest rate, and the subsequent rise a return to a level with more
appropriate compensation for inflation.
What would the effect of a 6% interest rate rise be on home values?
The exact answer is difficult because it relies on so many factors. How-
ever, a simple approximation is made by assuming that home buyers will
make a mortgage payment that is a fixed percentage of their paycheck.
This assumes, for example, that a buyer who can afford a $1,000 monthly



$200,000 $179,279
$180,000 $161,899
Value of $1,000 payment,
30-year fixed mortgage




$160,000 $143,298
$140,000
$120,000
$100,000
$80,000
$60,000
$40,000
$20,000
$0
2003 low current (7/2004) 'normal'
Mortgage rates


FIGURE 9.6 Rising Interest Rates Would Hurt Housing Prices
Source: U.S. Federal Reserve
Real Estate 213



mortgage payment today would be willing to make the same payment in
a higher interest rate environment. Let™s see the effect of interest rates
with this assumption and then adjust the answer.
The analysis looks at the amount a person can borrow with a 30-year,
fixed-rate mortgage and a monthly payment of $1,000. At the low mort-
gage rates of 2003, this hypothetical buyer could have borrowed
$179,000. At the current rate, the figure drops to $162,000, and if real
rates return to “normal,” our buyer could only borrow $143,000 (see Fig-
ure 9.6). Thus, for a buyer who allocates a fixed percentage of her or his
income to a mortgage payment, a return to historical real interest rates
would decrease the feasible home purchase price by 20%.
This view suggests that a return to a more “normal” real interest rate
could push home prices down as much as 20%. Of course, the decline
could be far less as sellers are reluctant to cut prices even in soft markets,
and buyers might be willing to stretch budgets. On the other hand, inter-
est rates could swing from their 2003 irrational low to rates significantly
above 6%.
Two conclusions seem obvious: Interest rates are historically low by
almost any measure, and so rising interest rates are likely; and, they will
put downward pressure on housing prices.
It is said that the snake that bites is rarely the snake that is visible.
Almost everyone is aware of the risks that rising interest rates create for
housing prices. By contrarian logic, therefore, rising interest rates are
unlikely to topple the housing market. If there is to be a big bad wolf in
housing it is likely to come in the form of some less discussed risks.

Risk #2: Leverage
I first learned about leverage during my high school physics class. My
teacher got the biggest, strongest football player in the class to compete
against a scrawny boy. The battle was to push a door that was half open;
the football player was given the task of trying to close the door, while
the scrawny nerd tried to force it open even further.
214 Applying Science and Art to Bonds, Stocks, and Real Estate

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