Real Estate Bubbles - advice to avoid bobbling

In Michael Lewis’ discussion of Ireland’s financial crash, he highlights the crucial role that real estate played in the fall. The assumption that housing prices would continue to rise encouraged people to take out mortgages that were well beyond the real price of their house. However, the issue of determining real estate’s “true” price can be extremely complex. Is it merely the price that someone will pay for it? Or pay for one like it? This, obviously, is an unhelpful answer as people frequently overvalue the price of real estate, in either in their rush to earn the symbolic title of landowner or with an improper surge of animal spirits (read overconfidence in the market). Lewis instead suggests an alternative indicator – the rent levels of comparable housing. He writes that when the price of renting a house grows disproportionally less than the price of buying the house, the real estate market is undergoing a price bubble and will eventually come crashing down.

            To test this hypothesis, let us analyze the recent real estate history of Marin County. Prior to the 2007 crash, housing prices in Marin had been rising steadily and quickly. The incredible returns on real estate persuaded many to invest heavily in its housing market, which resulted in huge losses for many of these risk takers. However, if they had been familiar with Lewis’ law regarding housing and rental costs, perhaps the fall in home ownership prices could have been anticipated. First lets look at the rise in the cost of house rentals in the early 2000s. A study by the Marin Affordability Housing Inventory showed that rent prices increased significantly in the decade prior to the crash – from 2000 to 2006, the median rental price rose 26%. However, during this same time period, household ownership prices rose much more rapidly – between 1999 to 2006, the median value of homes increased 75%. Just as Lewis predicted, this difference in price growth indicated a housing bubble, and in 2008 the “pop” was extreme. The median price would fall by around $200,000.

The large divergence between the growth rate in rent prices and the growth rate in housing did indeed predict a housing price bubble and subsequent crash. While the Marin market is beginning to recover, real estate investors would be wise to heed Lewis’ law describing the relation between rent and housing prices and behave cautiously when housing prices grow much more quickly rental prices.