Double, Double Toil and Trouble, Do We Really Have a Bubble?

With apologies to Shakespeare, this is a good question these days. A bubble has traditionally been defined as a situation where the price of an object rises because of an expectation that it will keep rising, not because the rise is based upon fundamental economic factors. The “tulip craze” was such a phenomenon in early 17 th Century Holland .

Obviously, there is concern about the potential impact if there were a bubble in real estate values. If there is one and if it were to collapse, the effect would be significant. Consider the drop in stock market values a few years ago. That was a bubble and its popping had severe repercussions throughout the economy.

In an article I wrote six months ago, I stated my opinion that the declines in housing values I have seen were due to the introduction of other negative factors, not just the fact that housing prices had risen rapidly. In the 1970s a huge increase in oil prices affected oil patch states. In the early 1990s the loss of 200,000 aerospace jobs in the Los Angeles area caused value declines of about 10%. Third, a couple of years ago the dot.com implosion affected values in Silicon Valley . Let’s look at the current state of affairs.

In the six months since I wrote that article, prices have continued to increase. Housing prices in my neighborhood up over 80% in the last seven years so this is something I think about a lot. So it was with interest that I read a report from the Federal Reserve Board of New York that discusses this issue in detail. The report is at

The authors, Jonathan McCarthy and Richard W. Peach studied the mountains of housing data that are published by the trade organizations and various governmental bodies. They find that traditional measures, accepted as gospel, may be inaccurate. For example, the indices may not give proper effect to the increase in housing quality over the years. Paying more for a better home is different than paying more for exactly the same home 20 years later.

The indices also do not measure accurately the fact that people don’t just buy houses, they buy houses and land. In fact, where I live, the land is always more than half of the value of the total package. Inflation in total value is more a function of increase in land value than in the value of the structure that sits on it. In more rural areas, large amounts of land are available whereas in urban areas, the land is simply not as available. Those urban areas are precisely where demand is highest and thus the volatility in those markets is highest.

They also show that the affordability of homes is based upon personal income and interest rates. Over the last 20 years, the combination of these factors has increased faster than the prices of homes. This means that, in general, homes are more affordable today than some periods in recent history. In fact, the percentage of family income that is required to support a home today is still reasonable by historic standards.

Thus the authors maintain that there is no bubble, that the current increase in prices is healthy and are consistent with the strength of the economy. I would characterize it this way: the growth in personal income and the reduction in interest rates have meant that families can afford to buy more expensive homes, and the market has willingly obliged them.

Having said all of this, there is also no question in my mind that certain people are acting as if there were a bubble. I hear stories from many different markets and in some of them you can find individuals who are acting stupidly. Most of the buyers may be acting rationally, making sound decisions about their housing. Yet a block away another buyer may be paying too much for a home because his agent says, “If you just add a pool and fix it up, you’ll be able to sell if for $300,000 more in six months.”

That non-thinking is what gets people in trouble. A year from now, when that prediction does not come true, they may find themselves in over their heads and having to sell at a distress price. A year from now, they will tell their story at cocktail parties and it will not sound anything like what really happened. They’ll say that the bubble burst, but what really happened was a result of their own poor judgment.

These are times to be careful, but those who exercise prudence are going to be in good shape.