Rossputin.com Rational Thinking About Our World

Weakness in Sydney real estate market could presage similar housing price pressure here.
http://www.smh.com.au/news/National/Bargains-galore-as-house-prices-plunge/2005/03/26/1111692684868.html
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I lived in Sydney for over a year beginning in the summer of 2002. During that time I had many conversations with my lovely Aussie girlfriend (now my wife) about buying property there either as our residence or for investment.

My view at the time was that prices were just silly and that people were chasing real estate the same way they chased internet stocks in 1999. Additionally, the Australian interest rate cycle began its upturn well before ours and hadn't had nearly the same depth of preceding rate cuts. I thought buying property was just asking for a financial spanking.

This Sydney Morning Herald report shows that I was right to be skeptical.

Real estate, even as an investment, is a less liquid and more "personal" market than almost any other. People treat buying a house like a marriage, finding it very hard to accept that it could be worth less than their highest expectations. People almost take declining real estate prices as a personal insult, something you'd never find happening with a bond future or a share of IBM. When I ran an options trading firm, I often reminded my traders "Don't get married to your position." Emotional attachment to a financial transaction simply clouds judgment.

But real estate is inevitably emotional for most people. So, even with this intellectual ammunition, I'm having a hard time convincing my wife that there may be similar risk in real estate here in the USA. She still hears about people making money in real estate in Los Angeles or in New York and wonders aloud whether we're missing the gold rush.

There are tell-tale signs of a market top although timing is never reliable. One is when you hear "the public", i.e. people who are not experts in a particular market, talking about how upset they are that everyone else is making money in the market so they've decided to get in too. A related sign is a proliferation of TV and newspaper reports about that market. Here's an interesting and relevant NY Times article about real estate speculation from March 1, 2005. It's called Speculators Seeing Gold in a Boom in the Prices for Homes

Some great news about my wife's brother selling his NY co-op for a good profit after less than two years only makes my position more difficult to defend to her.

Yet I am undeterred: I believe that there is tremendous risk in owning real estate in many markets in America. Real estate is not one national market like the NASDAQ; it's an aggregation of many local markets each of which has its own economic and demographic factors driving prices. But what is national is that the Fed has raised short term interest rates for the 7th time in 9 months. Long term (10-year note) yields, on which most 30-year fixed rate mortgages are based, are nearing highs they haven't seen since the middle of last year...and hadn't touched for two years before that.

Many people have bought more house than they can actually afford, using variable rate mortgages and too much leverage (using small downpayments so borrowing too high a percentage of the house's value) to set up a situation with a manageable downpayment and affordable monthly payments. But rising rates will soon make those monthly mortgage payments unaffordable and people could easily find themselves in a position where they will be forced to sell a house and still owe the bank money after the check clears. There's no nice way out of that situation.

Many others are real estate speculators, with no intention of living in the properties they are buying. To be clear, I have nothing against speculators; they are an integral part of any market. The issue is that they're the "weak hands" in the market so that the larger part of a market they are the more vulnerable the market is to a substantial correction.

Keep in mind that in any market, prices are determined at the margin, i.e. by who wants to buy or sell that day. The people who are happy with their positions and are not trying to buy or sell have no important impact on prices. If just a few people in a given market get into the situation where they want to or must sell real estate, we could see them running for the exits, racing each other to get out. Just as those afraid of missing the upside jump in late and cause the last price increase, falling prices can cause investors who were previously on the sidelines to sell to escape further loss, exacerbating price declines.

If you want to see what these markets can look like, check out this 5-year chart of the NASDAQ-100. The NASDAQ-100 lost 80% of its value in about two and a half years, and has only recovered about one seventh of that loss. Or if you're less of a pessimist, you could look at a 5-year chart of the S&P 400 Midcap which has a brutal 30% sell-off over the course of a year but proceeded to recover the whole loss and more in the past two years.

Real estate is a quirky market but it is a market nonetheless. In every market, the fact that naturally emotional humans participate causes them occasionally to overshoot on the way up and on the way down. I think we've seen the upside in real estate in most markets and I don't want to jump in front of the freight train while it's careening down the hill. Of course I could be wrong....but for now I'm a very happy renter.

[Note: If you are interested in a fascinating book about the history of market bubbles and crowd psychology, I highly recommend "Extraordinary Popular Delusions and the Madness of Crowds", by Charles Mackay. Note that this book was first published in 1841 and does not include our 20th century stock market bubbles or crashes.]