Are We Heading Into a Real Estate Bubble? Six Factors to Consider

The 2007 housing crash should not have caught people by surprise, there were numerous warning signs and red flags available to the average investor. The United States had recently undergone a very similar bubble and crash cycle with technology stocks just a few years earlier, so investors were not in uncharted territory. For those who have been watching there have recently been spikes and rapid declines in both gold and Bitcoin prices and investors will likely be seeing similar cycles in other asset classes in the coming years. We may be on the cusp of a real estate bubble now, if not on a national level, certainly in certain markets, so it is wise to be vigilant for some of the warning signs. I have provided some thoughts below on six factors to watch that may indicate we heading into bubble territory

1. Workplace Chatter: Prior to the tech stock crash in 1999 people riding public transport and around the water cooler were giddy talking about the huge returns they were making in technology stocks. It seemed like everyone became a stock picking genius overnight and people discussed quitting their jobs to become full time day traders. This same type of euphoria about real estate investments also permeated workplace conversations in early 2005 and 2006. This type of public chatter is your first sign of trouble on the horizon. Lesson: When everyone at work or on public transport is talking about the virtues of a particular investment, whether it is real estate, bonds, gold or Beanie Babies...it is time to go against the herd.

2. Get Rich Books Become Bestsellers: Before the 2000 stock market crash there was a series of books about how the stock market would only go higher. One title that stands out was by James Glassman and Kevin Hassett entitled Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market, published in 1999. After several years of a bull run in stocks, the authors asserted that stocks were actually undervalued and would only climb higher, encouraging readers not to miss out on this investment opportunity. In reality, the Dow Jones Industrial average was at its zenith of 11,750 in January 2000, only to fall below 7,300 by October 2002. This same best selling book phenomenon occurred with real estate and the proliferation of real estate television reality shows about selling properties and flipping houses giving the impression that on one could be a real estate millionaire overnight. Lesson: Pay attention to trending business books to see if they begin to be dominated by a particular asset class. Particularly, if the books promote how easy it is to make money in the asset class, the truly smart money will sell and move to cash. There are always deals in the aftermath of a market crash.

3. The Numbers No Longer Add Up: When we first started investing in real estate we could buy a property that had rents that would cover the monthly mortgage (including property taxes and insurance) with a small amount of profit as well. In a just a few years the prices of houses rose so much that the cost of the monthly mortgage was twice the monthly rent. About two years later this ratio was become three times the rent. Rents would naturally rise over time and begin to catch up, but these ratios were absurd for investors. Buyers should have asked themselves why they should purchase a property when they can rent it for 1/3 of the price. Some homebuyers said they wanted to buy a house now, because they did not want to become priced out of the market, this fear fueled a further rise in home prices. Lesson: When irrational behavior takes over in the market and your numbers no longer make sense, it is time to sit out for a while. Investors who trust their gut when things don't seem right are likely to be successful in the long run. This is also a time to avoid taking on leveraged debt, which can quickly exacerbate any mistakes and may even wipe out a decade of investing progress. All markets will go through a price correction and return to a more normal historic trend line providing an opportunity to invest again.

4. Oddly Creative Financing and Slipping Due Diligence Standards: As the housing bubble was inflating the long standard 20% downpayment was replaced by 10% down and then 5% down. It culminated in 0% down and even cash back options at closing. When an investor has no skin in the game, they are far less likely to be concerned if the asset falls in value. At the same time traditional loan documents that required verifying the applicant's income and other assets were replaced by loans that took the applicant's word without verification, frequently called liar loans. Other loan products that did did not verify the applicant's job or income were nicknamed "ninja" loans for no income, no job, and no assets. When the financial industry is nicknaming its products after liars and ancient assassins it is time to start looking for the exits. Homebuyers also slipped in their own due diligence. Buyers were waiving home inspections and some were including elevator clauses with their offers agreeing to pay $5,000 above the highest competing bid. It may make sense for a seasoned investor who is buying an investment property at a steep discount to waive an inspection, but it is not a wise practice for the mass of traditional homebuyers. Lesson: Watch for slipping due diligence standards both on the part of lenders and on buyers as well. These are a hallmark of irrational exuberance and should encourage investors to start tightening their own standards to protect themselves.

5. "This Time is Different!": This refrain of the foolish is frequently heard just before a bubble pops. Prior to the housing crash many business news programs often said there had never been a housing decline across the entire nation they also justified the rapid rise in prices saying this time it is different as we are seeing more people shifting from being renters to becoming homeowners, a trend they expected to continue above historic levels. They noted that all prior housing crashes were contained to a certain geographic area or to specific real estate asset classes such as office buildings, warehouses, or residential housing, but never all at the same time across the country so there is nothing to fear. The notion that this time it is different makes people think they are seeing something unique and it tends to encourage risk choices. Since real estate gurus, the mass media and my friends on the subway are all saying houses will continue up in value and we will never have a nation wide crash I should be fine with adding an elevator clause or skipping a home inspection to lock in this deal. Lesson: Gold will always just be gold, stocks are just equity shares in a company no matter how interesting that company may be, and real estate is land combined with a structure made of materials such as wood, metal and concrete. Good due diligence practices are always important to follow regardless of the investment and despite what the newscasters say, it is never different this time.

6. Beware of the Hubris: I was living in Abu Dhabi as the global crisis was unwinding and the smaller and less wealthy emirate of Dubai had to be bailed out by the deep pockets of the emirate of Abu Dhabi. Dubai had racked up debts building the world's largest skyscraper, the world's first island shaped like a palm tree, among other world's first projects in a time of tremendous hubris. Similarly in the United States, just before the global financial crisis, Lehman Brothers had paid record prices for real estate assets and had a leverage ratio of 31 to 1 ($31 dollars of debt for every dollar of equity) which means even a modest decline in the value underlying assets would severely damage the firm and it led to Lehman's demise. Prior to the 2000 technology stock crash companies that had yet to post a profit were paying millions of dollars for comedic Super Bowl ads that had little to do with marketing their underlying business. Lesson: Every major bubble expansion has a certain element of hubristic excess that precedes the crash. Keep an eye out for periods when asset appreciation is fueling excessive and unnecessary spending and follow Warren Buffett's advice,'Be fearful when others are greedy and greedy when others are fearful'

I wish everyone the best as they chart their real estate investing future and keep an eye out for trouble ahead.

Nathan Carter

*The above article is neither tax advice nor legal advice (because I skipped the bar exam and moved to Lebanon). Please consult an attorney, certified financial planner, or a tax professional for any related questions.