Is the Real Estate Bubble About to Burst?

Lately, so much has been written about ever-increasing real estate prices. Can these prices just go on increasing? Or will they abruptly stop, and then fall precipitously? The experts are divided on whether or not the bubble will burst. However, one thing is certain: the price rise can’t go on forever.

This article will look at the forces that drive real estate values and identify changing dynamics that could ultimately bring about a real estate crash.

Jobs, Interest Rates Drive Housing Demand

Let’s take a look at two factors that play very important roles in the formulation of real estate prices: employment and interest rates.

We are presently going through a period of very acceptable employment levels. Unemployment has been held down within a range that has been quite stable. Obviously this bodes well for the real estate market and for sustaining the real estate boom. If employment rates were to make a steep drop, you would inevitably find housing prices immediately softening and eventually dropping.

Real estate prices will always ultimately reflect the state of employment in the nation. Without solid employment figures, we just wouldn’t have enough people entering the real estate market because they obviously wouldn’t qualify for mortgage money. Also, housing prices simply can’t keep increasing faster than wages do. Eventually, wage increases have to catch up to housing price increases.

The other very important factor is interest rates. The low interest rates that we are presently experiencing mean that in the short run monthly mortgage payments will stay low and more people will qualify for mortgages. In fact, the low interest rates have actually increased the amount that the average borrower can pay for a house purchase. This fact alone has made a significant contribution to the heady real estate prices that we are now experiencing.

Is Borrowing Too Easy?

I recently read an article that talked about how easy it is to get mortgage money today. So easy, in fact, that a good percentage of first-time buyers were able to purchase a house with no down payment and with all of their financing costs added to their mortgage.

In addition, there is a new mortgage instrument out that permits the buyer to borrow money and make no principal payments for a certain number of years: interest-only mortgages. This new type of mortgage grants credit to people who heretofore would not have qualified for a mortgage. And, this mortgage has been labeled the “smart mortgage.” I’m sure that you can readily see how this type of easy credit puts tremendous steam into real estate values.

Lending institutions are relying on the sustainability of real estate values to assure them that their loans will ultimately be collected. The question is, can these high real estate values be sustained in the long run?

Why Are Long-Term Rates Staying Low?

Long-term rates are staying low, and have actually decreased of late, no matter how much the Fed tries to keep them in check. What’s going on here? The fact is, we are now in the midst of quite a strange phenomenon. As the Fed keeps pushing up short-term interest rates, long-term rates have either stayed steady or declined. Even Alan Greenspan, the chairman of the Federal Reserve, is hard put to explain this “anomaly.”

The fact is, low long-term interest rates give fuel to rising real estate prices. The only problem is, no one seems to know why the rates are staying so low or when they’ll start going up.

To fully understand why we are in the midst of a housing boom, we have to look at who is investing in our mortgage debt, who is providing us with so much money. As strange as this might sound, China is a major investor in the U.S. and its mortgage debt.

Since we are buying so many Chinese products, and other countries’ products as well, China and other countries have to do something with the money they are getting from us. What they are doing is putting it right back here by purchasing our debt. Much of that debt is government debt, a great deal of which is mortgage debt.

Will Foreigners Continue to Buy Our Debt?

If you take a look at an article that I wrote for The E-Commerce Times, The Dollar’s Falling! Does It Really Matter?, you’ll have a better idea of why China and other countries are buying so much of our debt and the long-term dangers of their doing so.

I guess the big question is, how long will other countries be content with buying U.S. debt? No one knows for sure. However, if we finally put our fiscal house in order and start balancing our budgets, these countries will have more incentive to continue to purchase our debt.

Also, we really have to do something about our current account deficit. We are purchasing too many foreign goods and not selling enough of our goods to foreign countries.

The above two factors, balanced budgets and bringing more balance to our trade with foreign countries, would go a long way toward keeping foreign investors interested in purchasing dollar-denominated debt.

Lesson From Down Under

Australia has had a housing boom that now seems to have subsided. Prices in some areas have gone flat and in other areas have actually dropped. One factor that might have put some control on runaway housing prices in Australia is the action by the Reserve Bank of Australia, the equivalent of our Federal Reserve, to do some “stress testing” of its banks.

What they did was create scenarios of unemployment and interest rates increasing to certain levels to see how banks would have survived this double-barreled “stress.” Though the banks did quite well, the actual exercise put a pall on their aggressive lending practices. This fact alone seems to have calmed housing markets in Australia.

If you are concerned about real estate values and feel that the bubble might burst, I’d suggest that you keep a close eye on long-term interest rates and the unemployment rate. If both of these rates start creeping up, it might be time for you to reconsider your investment in real estate.

Good Luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which deals in bringing small-cap companies public. He also is a frequent speaker on the subject of financial advice for small businesses as well as the IPO process. He can be contacted at [email protected].

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