patrick.net

West Coaster, the situation is slightly different because Americans tend to run for the exit while the Japanese would like to keep mistakes private.

The mechanism for the credit boom/bust cycle is the same though.

Live rich and die broke. Perhaps people are trying to carry debt into the coffin. What a great way to socialize the cost!

Just one thought, with P/E ratio above 30 in the Bay Area, it is quite difficult for prices to stay flat. Even if rent increases 20% while prices stagnate, the P/E ratio will still be 25 - a rather high number to justify without expected appreciation.

Fake P, it is all relative. I agree that there should be a premium to own. The question is how much premium. If prices are to stagnate, a P/E of 15 is already a bit high as an investment. Now, paying a P/E of 25 (or higher) to own is quite a bit of premium if there is no expected price appreciation.

The rule-of-thumb is that a good real-estate investment should not cost more than 100 times the monthly rent, which translates to a P/E of 8.3.

Jack, you are assuming that the current housing boom in the Bay Area has nothing to do with the credit bubble. :)

I surely remember 1999! Back then, I actually thought that real estate was a great investment in the Bay Area because of the rental growth and P/E ratio! Too bad I was still in school. :)

I hope that the economic environment here can justify steep rent increases. This way, the P/E ratio will drop (hopefully) and I will feel better.

"PeterP is the one who has predicted an October crash time frame. He gets all the credit for that..."

... but gets laughed at when it does not happen ... :(

Anyway, I still think it will.

BTW, IMHO, Netrugu's posts are the most informative. I really learned a lot from them. :)

While we are doing predictions, May dataquick numbers will be out soon...any predictions? Out of the two areas we are looking at for first signs of a boom (SD and LV), I think...

SD will be slightly up over last months average (484K). SD is a big family place and May is the last big month for families that want to get their kids enrolled in the local schools in time.

I hear some LV data is in that shows prices up, but that's according to an Assn. of Realtors. I think May salestrak data will show new and resale prices down for the first time in recent history.

I think No. Cal will still be going up but with a slight % decrease.

Now you have someone to make fun of in a few days if I'm wrong ;)

Fake P, if you can make people remember me for a thousand year I do not mind. You will have to make me more famous than Irving Fisher though.

Historically, October is a volatile month for the financial industry as money managers re-position themselves near the end of their fiscal year.

This year, several developments are of particular concern, in particular:

* Exceptionally low implied risk-premium in both derivatives and debt instruments

*The FED has been raising interest rate but the bond yield is not responding.

Such developments suggests that the industry (esp. hedge funds) may be resorting to excessive risk-taking in order to maintain return.

When the re-positioning occurs in October, the extra volatility may just be the trigger that causes liquidity to dry up. This will start the nuclear reaction.

Peter P - Thanks for clarifying your prediction for October. I'll wait for the cataclysmic economic event in October which will herald a crash in Bay Area residential real estate.

My prediction is similar to that of Jack. For the next 3-4 years, I don't predict anything worse than low appreciation in most areas and maybe minor drops here and there. I don't see a crash happening in the Bay Area. I said many times that if the bursting of the Internet bubble, and the loss of 200K jobs didn't do it, then it would take something really exceptional to bring down the real estate market here. Some over-extended buyers getting into trouble just isn't going to make that much of a difference here.

Face Reality, the internet bubble bust actually helped this housing bubble if you believe for a second that it has nothing to do with the underlying demand for housing as a sheltor (as opposed to housing as an asset).

We will see. :)

One note about the internet bubble and the housing bubble in the Bay Area:

It has been said that the housing boom did not end even after the internet bubble bursted in 2000. There are several possible explanations:

1. The housing market in the Bay Area is robust enough to withstand the shock of the internet bubble bust.

2. The internet bubble bust helped inflating the housing bubble

I argue that (2) is the likely scenario because:

1. Housing P/E shot up only after the internet bubble bust. Until 2000, this housing bull market was accompanied by increasing rent.

2. As an asset class, homes compete with stocks for capital. With excess liquidity created by the FED, stock market money find its way into the housing market after the internet bust.

If (2) has been the reality and (1) has been the psychology, this bubble can be perfectly explained.

I find myself in the strange position of agreeing with both Peter and Jack.

I think that we're certainly in a bubble - the disconnect between rents and purchase prices defies any other explanation (nor have I even *heard* an explanation in this thread for that fact by any but the pro-bubble camp). Presumably, the only alternate explanation would be "rents haven't caught up yet". O really? When are we going to see 10% year over year increases in rent? 'Cause right now they're still generally trending down.

On the other hand, I don't think the current numbers show anything other than a market that's gone from white-hot to just red-hot.

With the exception of the peak of the Internet bubble (and arguably even then), house prices have been out of whack with rents in the Bay Area for decades. It's nothing new. It doesn't make sense to own a house in the Bay Area for the purpose of collecting rent. It doesn't make sense now and it didn't make sense in the past as far back as I can remember, but so what? This is not the purpose of owning real estate here, and it's not how you make money here.

In speaking with "old timers", I've been told that in years past, the "renter's discount" was on the order of 20% - higher than most areas of the country, to be sure, but still within bounds of some other areas of the country.

It's now about 60%, based on my recent (abandoned) search for a home purchase. (Note, this is south bay. east bay is mysteriously more balanced, for some reason.)

C'mon. SIXTY FREAKING PERCENT? That's GOT to have unbeleivable expected appreciation factored in, or it doesn't make sense.

Rents have to MORE THAN DOUBLE to make up the gap. That's over seven years of 10% year over year rent increases with 0% housing appreciation, for those of you without calculators.

I would say that a P/E ratio of 10 is marginally doable for investment and a P/E ratio of 20 is very high. Such high ratio is usually associated with highly desirable areas with expected future appreciation.

Any ratio higher than 25 is a red alert for speculative activities.

Face Reality, do not confuse the ratio of price/income and price/rent. The first one is tied to a very complex political/cultural system and the second is tied only to expected appreciation.

Both London and Hong Kong are notoriously speculative. They are no very good "role models" for us.

According to your logic, Salt Lake City is a super bargain! At least they are growing their tech industry and we are shrinking ours.

And Tokyo crashed big time, by the way.

When I was small my Dad taught me that the ratio between mortgage payment and rental payment is almost entirely about anticipated future appreciation.

If prices are anticipated to be flat our current ratio of 30+ will be ridiculous and it will revert to a reasonable level below 20. Unless rent goes up big time, prices will have to drop at least 30%.

The current ratio can be justified *only* if _expected_ appreciation remains high while prices _actually_ stay flat for years. I do not know how this is possible at all.

AFAIK, North Bay is not nearly as bubbly as South/East Bay. If you compare the mortgage-payment/rent ratio the change will be even less because of lower interest rate.

I do think that North Bay is not going to drop nearly as much as South/East Bay.

Interesting. As I said, not so bad as in the South Bay. (Though I wonder about your $600k figure. How big a house? Have you checked prices recently?)

In Campbell/Cupertino area, a $700K house will rent for as little as $1650. Don't beleive me? Check Craigs' list. I was stunned as well. Prices about the same in San Jose, they're more in line in Fremont.

All that tells me is Marin isn't the bubble the south bay is - but Marin is quite possibly one as well - check out your "little" difference:

$235k / 12k = 19.58
$600k / 23.4k = 25.64

That's a 25% increase in price/rent ratio. Hardly small, though you're easliy forgiven for having thought it so - I thought it was small too until I worked the numbers.

BTW for Campbell:

$700k / $19.8k = 35.35

Ouch.

BTW - I should mention - rents in the Campbell / Cupertino area are *scary* low right now, and I fully expect them to bump *substantially*, for a least short while, once the housing market cools - if only to get in balence with the rest of the bay area. So I know using them is creating a more bleak picture than elsewhere (like Fremont, or, apparently Marin). But hey, it's where I live.

What does “complex political/cultural system” mean?

For instance, half of Hong Kong's population live in government housing. Most people do not own cars. There is no sales tax and no capital gain tax. The income tax is closer to 15% than 35%. These all contribute to a higher median home price to median income ratio.

What do you mean by making serious money? Does it mean making 500K in home appreciation or 500K in stock options? Salt Lake City does have a lot of high-tech opportunities and it is still growing.

If you ask people in Hong Kong or Tokyo they will say that their prices are higher than SFBA because they perceive more opportunity to make money there. Thinking that SFBA can be as expensive as Tokyo before it crashes is absurd.

Also, do you know what is the rent in Tokyo for the $1M apartment?

Face -

Tokyo is much the same as New York. But only if you compare Manhatten, as opposed to, say, the wilds of Queens.

The geography of both Tokyo and NYC are very different than here. It's important not to compare the premium places, but the median places, where most of the population actually dwells. (And I have no data on that for Tokyo - I'd be interested in hearing if you do).

It's also important to compare salaries, both at the high (three sigma) end, and the median. Excluding the crappier parts of uptown, Manhattanites make quite a bit more than the residents of, say, Campbell. Sadly, the salary figures I've seen only break out NYC incomes by Bourough, not neighborhood, so I don't have the hard data to back up that claim :-(

Jack -

As a currently dedicated Renter, I'm here to tell you that LOTS of cashflow positive rentals exist in the south bay. I've lived in a few.

Here's how to get one:

Step one: Ten years ago, purchase a home or condo.

:-)

It was also possible to get a positive cashflow rental going during the dot-com bubble, though if you tried that, you probably had to either cashout or refi to hold the property for the last three years ;-9

Prop 13 - every landlord's friend. One of the things that is *certainly* driving the current housing boom is that you'd have to be NUTS to sell a cashflow positive rental in California - Prop 13 is a HUGE windfall. Noone in their right mind would sell a home with property taxes in the low four digits when you can clear even a modicum of rent to cover costs. I'm suprised this isn't mentioned more often here. Since tax costs remain fixed, you can only count on the profit growing by leaps and bounds as the years go on, even with only marginal rent increases. Of course, if you start now in a negative position, good luck riding out the next seven to ten years until you get positive position.

Prop 13 is certainly a factor in whatever happens next to the housing market. I suspect it may be enough to make the bubble deflate more gently, but I'm truely unsure. And I don't think it's enough to stop it from deflating completely. Just more slowly.

(Note - beleif in the existence of the bubble doesn't mean I think it'll pop. A balloon with a slow leak is just as flat as one that pops.)

"IF rents go up by 10 per cent a year for several years, you probably wont really leave,it will be because it will be WORTH IT to renters to pay that much to live here."

Only if every comparable rental goes up 10% as well. This would require a complete rebirth of the Tech/VC/IPO industry. But if people realize that easy money can again be made in the stock market, won't they pull money out of the housing market?

People may be able to pay the premium for fixed rate but they may not be able to pay down the principal. IO loans are more of a problem than ARM loans.

"Things are not out of balance. This IS the balance."

I do not blame you. One camp believes that market is always right. The other camp believes that market is always wrong. I belong to the second camp.

Jack says: "Things are not out of balance. This IS the balance."

OK, we completely part company here. Balence implies a steady state, or, at a minimum, one that evolves slowly. Is that what you meant? And if so, *any* data to back it up?

Jack says: "IF rents go up by 10 per cent a year for several years, you probably wont really leave,it will be because it will be WORTH IT to renters to pay that much to live here."

For tech workers, probably (but check out that outsourcing fad for a different future.) But who the heck is gonna flip my burgers? Those poor guys can't barely make it now. In this group include *any* unskilled or poorly skilled labor. They can't all live in Merced, can they? (P.S. Merced's up 43% in the last 3 years too.)

At any rate, my point is that the market simply won't eat that in rents. Therefore they won't go up - people will relocate (it ain't THAT nice here). Most of us weren't born here anyway. Causing rents to fall, after a brief rise.

At least we agree that cashflow positive rentals are not possible to construct in today's market.

Pop quiz - do you personally know ANYONE who's moved here and bought a house as a part of the move? I don't. But I know alot of folks moving the other direction.

All the new house purchases I know of are 1) trading up, or 2) two income tech workers taking out ARMs and *shudder* IO/ARMs. (No speculators, I don't run in that crowd.)

We only have a limited supply of dual income tech workers. I suspect that we'll run low soon. (Sooner than October, I think.)

"Rents are around $5K-$6K for a $2M apartment.

Salaries there are pretty similar to salaries in the Bay Area, so if you think life’s hard here, just try to imagine what it’s like to make it there. "

The P/E ratio in Tokyo is still very high, so it will continue to drop for many more years. Families there do not have two SUVs. Most of them do not even own vehicles.

I never said that Bay Area is hard, but I refuse to buy when the P/E ratio is 30+.

Jack said: "My point was that positive cash flow rentals have not existed for a long time here. (Which could also be an argument against a steep correction–looking at housing as simply an investment in SF Bay Area is THE big mistake that everybody is making.) Hey! its just a thought!"

This is probably worth exploring:

OF COURSE a house isn't an investment. Only silly people think that. Sadly, most of the US is silly. What it actually is is a major long term capital expense with significant carrying costs, with a fairly decent chance of a few points of appreciation over inflation, over a long term (30+ year) period. There've only been three departure points from this long term trend: the 1950s, and now for the upside, and the 1930s for the downside.

The reason why we're currently in a period of significant risk is that almost *everyone* to purchase property in the last few years in this area has become an unwitting speculator. Work with me on this:

Why are all these people buying houses with ARM loans at the bottom of a interest rate cycle? Because they're planning on either selling their homes or refinancing within five to seven years. (>80% in bay area)

Why are all these people buying houses with IO loans, previously virtually unknown since their role in the Great Depression? They don't expect to hold the loans (or at least the mortgage) when the principle comes due. (>60% in bay area)

What is this, except speculation? They're speculating that 1) Houses will continue to appreciate and 2) that credit will continue to be readily available. And they're making a committment to flip within 5-7 years. Some as quick as 3, but I don't have any data on average length for IO Loans. I sure hope most people are smarter than that, but hey, they bought pets.com too.

If they're wrong on either count, then their "investment", leveraged well over 90%, on average, will become a guarenteed ticket to bankruptcy.

So - let's ask the question: How many forclosures do YOU think it will take to tank the market? This is not rhetorical. I think everyone has SOME number, even the biggest bulls. I'm not sure of my number, I'll have to think about it, but I suggest everyone try to come up with that number. And then watch for it.

All that it'll take is a flat market and moderately restricted credit. Won't even need interest rate hikes, thanks to the IOs. 10% down market, even with generous credit, will also do the trick, thanks to all the 100% loans.

Please, convince me I'm wrong. I want to be wrong. Really.

Reminder:

It does not take much turnover for prices to tank. Old-timers can stay in their houses. They do not care and they will not be affected.

"PeterP…can you explain what you mean by “extra volatility” in the equity markets that could cause havoc. What/where is the volatility."

October is close to the end of a fiscal years. There are a lot of year-end reporting for companies. Moreover, many funds close their books around that time. The reshuffling of positions can lead to increased volatility.

Most importantly, October is cursed. :)

I have to repeat:

Being able to refinance in 3-7 years is a very big assumption.

Being able to do so with a 100% financing, non-amortizing loan is an even bigger assumption.

"I think the ratio of price to the income and wealth of an area is a lot more important than the ratio of price to rent."

The standard deviation of both ratios are important. We are experiencing a high-sigma event.

Very smart, Netrugu.

Y2K is not a financial event and there is no reflexivity between market and participants. In short, its outcome is independent on expectation.

A bubble bust is *always* a self-fulfilling prophecy.

I mean that Netrugu is smart about posting an argument to protect ourselves from it.

1-2 price % declines are significant. What we have in SD and OC is a steep run-up thru the end of 2004 followed by flat or decreasing prices. If prices continue to be flat, as they have been since December, it won't be long until the yr/yr goes flat as well...just takes time to reflect in the numbers (lucky for the Realtors who can continue to misleaded people by quoting yr/yr statistics).