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Tuesday, July 11, 2006

RE: There Is No Bubble In Seattle

Last week, Gregory Wharton posted the grand culmination of his 15-part Seattle real estate bubble extravaganza. I wanted to wait until he posted the last chapter, but it's been over a week, and I think the points he made in his most recent posts should be addressed sooner rather than later. I said in my first post about his series that "I may not agree with all of the conclusions he comes to, but at least he is giving the subject a genuinely thoughtful analysis." I stand by that statement. I appreciate Mr. Wharton's thoughtful approach, but I do of course disagree with his primary conclusion that Seattle is not currently in a bubble market. In this post I will lay out the reasons that I am not convinced by Mr. Wharton's argument. I'm not going to spend time (right now) making the case why I do believe that Seattle is in a bubble, but rather the scope of this post will be limited to refuting Mr. Wharton's argument that we are not.

This is a pretty lengthy post, so let's get right to the point. Here's Mr. Wharton's money quote (emphasis mine):

So, even though prices have been increasing, sometimes at breathtaking rates, in Seattle there have been solid economic reasons for them to have done so. That doesn't necessarily mean that prices will continue to rise at their recent rates (an issue I will address in the final chapter to come), but it also means that a bubble-deflating crash to fundamentals isn't impending. For those who have been priced out of the market, now facing still-stagnant wages and rising interest rates, that will likely be unwelcome news.
Let me stop right there. I want to take this argument one piece at a time. Clearly I agree that prices have been rapidly increasing. No argument there. Obviously prices don't go up unless there's some reason, but are the reasons for the price increases truly "solid economic" ones? These are the four "solid economic reasons" that Mr. Wharton claims are driving Seattle real estate prices up at a "breathtaking" rate:
  • The reduction of risk in real estate compared other markets
  • The inherent value of improved property versus the increasing cost of new construction
  • The restricted supply of permission to build versus steadily increasing demand for real estate assets
  • The reduced cost of money increased the purchasing power of capital when leveraged
I'll address each one, slightly out of order.

The reduction of risk in real estate compared other markets
"Reduction in risk" is a canard, and is more a psychological reason than a "solid economic" one. Even the title of the post where he explained that bullet point was titled Swooping Buzzards: The Fickle Flight of Capital (emphasis mine). In it, he said:
Following the collapse of the Tech Stock Bubble beginning in early 2001, a substantial amount of investment capital fled from the equities markets and into U.S. real estate. Some of this was institutional investment funds, but by far the most important portion of it was money committed by individual investors. As the stock market fell and individual Americans felt the bite on their 401(k) plans and mutual fund statements, they began withdrawing their money and investing it first in their homes, then later in real estate generally. The perception that "home values never go down" and "you always need a roof over your head" combined with uncertainty in the equity markets to generate a flight of capital toward real estate.
So the "reduction of risk" basically comes from the fact that everyone believes there is a reduction of risk. I fail to see how that is either "solid" or "economic."

The restricted supply of permission to build versus steadily increasing demand for real estate assets
He claims that there is a "restricted supply of permission to build:"
In Seattle, there are large cost premiums on real estate associated with land-use regulation. At least a quarter of the price paid for the median home in Seattle is directly associated with this cost.
I don't doubt that regulation is a primary contributing factor that makes Seattle homes more expensive than those in say, Duluth. However, what Mr. Wharton does not explain is why this factor would contribute to the surge in prices that we have seen since 2001-2002. Have Seattle building regulations become more restrictive in the last 5 years? The 2002 study he refers to throughout his post is based on data from 1999, when the median priced home sold for less than 54% what it does today. So how can regulatory issues be a "solid economic factor" driving prices so high so fast in the last 5 years?

The reduced cost of money increased the purchasing power of capital when leveraged
Translation: low interest rates, baby! Yes, interest rates have been at historic lows, and no one I know has attempted to argue that this is not one of the primary driving forces behind the drastic price increases we have seen across much of the country, including Seattle. This reason is at least "economic," although considering that interest rates are on their way back up, I'd hardly call it "solid." As Mr. Wharton points out, looser lending standards are also largely to blame for skyrocketing prices.
Low interest rates also encouraged lenders to come up with new ways to keep up their profit margins. The simplest way to do that was to expand the pool of people they were willing to loan money to. Another issue was that, even though the monthly payments were getting more affordable, higher prices in the housing market meant higher down payments to meet conventional equity requirements (20% of purchase price). Americans were able to buy more financing with their monthly payment amounts, but they didn't have a proportionately higher reserve of cash to cover the higher down payments. Lenders obliged by offered a wide new range of options for buyers to enter the market without having to raise a lot of cash for equity. Hard money seconds, promissory notes, home equity loans, and a wide variety of other financing methods proliferated in response.
However, for this to be used as evidence that we are not in a bubble, it would have to be unlikely to reverse course. Interest rates are already on the rise. So far, banks are still broadening the pool of suicide loan packages, but does anyone seriously believe that trend will continue? When the financing industry inevitably begins the return to tighter lending standards, won't that drive prices down the same way the opposite trend drove them up?

The inherent value of improved property versus the increasing cost of new construction
I left this for last because I believe it is really the best thing Mr. Wharton has going to support his conclusion. Unfortunately, "the best" just isn't good enough, in my opinion. Here's the crux of his argument:
The size of a median home in Seattle is currently 1,720 square feet. In 1999, average construction cost for market-rate homes targeted at the median range was about $110 per square foot. Right now, construction cost in the same segment is running, on average, at about $160-$170 per square foot. Some houses are built for more, some for less, but a majority are now falling into that price range.
Doing a quick calculation, I see that the median home of 1,720 square feet has a construction hard cost replacement value of about $284,000. Adding in 15% soft cost, the comparative value of new construction for the median Seattle home is $326,600 not including land. That is certainly less than the median home sale price of $427K, but not by so much that we should immediately think we're seeing a bubble in real estate prices.
I already addressed the fact that I'm not convinced his construction cost figures are entirely accurate, but for the sake of this post, let's just assume that they are. I believe that even if those figures are accurate, it still doesn't mean that we aren't in a bubble—prices are still likely to go down in the future.

The easiest way to explain my argument is by way of analogy. It's a pretty cheesy one, but I think it gets the point across nicely.

Let's say there's some portable consumer electronics device that plays digitally-stored music, costs $200 to produce, and sells for $400. Let's call it an iHip. Thanks to some great press and a word-of-mouth frenzy, the iHip is a huge success, and it is on everyone's "must have" list. Despite the fact that portable music can be had in any number of ways, iHips are the preferred choice. Well, say that the cost to produce iHips goes up to $250, and the sales price follows suit, increasing to $450. No big deal, people still buy iHips because they're so darn hip and popular. Plus now existing iHip owners can sell their used iHips for that much more—if they wanted to get rid of their iHip, that is—which most of them don't, because it's so gosh darn cool.

Five years later, 65% of the population owns an iHip, in spite of the fact that the cost to produce iHips has shot up to $800, and they now sell retail for $1,200. One day a prominent tech writer points out that portable music can be had for a fraction of what people are spending on iHips, and really iHips aren't all that cool to begin with. Most people poo-poo him publicly, but privately they realize that he may have a point. People who bought their iHips start thinking about how much they could make if they sold theirs at today's prices, and how far that money would go toward other portable music options like a simple CD player or even satellite radio. Slowly but surely, demand for iHips decreases, while the supply of used iHips increases. Eventually, there are so many used iHips on the market, that they no longer command top dollar. In fact, despite the fact that brand new iHips still cost $800 to produce, used iHips are selling regularly for $400-$500. Production of iHips slows to a trickle, but as people switch to other portable music options in droves, the inventory of iHips for sale keeps going up.

Replace "iHips" with purchased homes, and "CD players or satellite radio" with renting (or simply selling, in the case of "investment" properties), and you can see why I don't buy the argument that high construction costs = sustainable high prices for all homes. When the other three bullet points begin to turn around (as they most certainly will and in some cases already are), the above-described scenario seems to me not only possible, but probable.

In Mr. Wharton's first post in the series, he said the following:
It turns out that Seattle real estate prices are unsustainably high in many cases, maybe even ripe for a serious correction, but outside of the condo-flipper market there is no bubble...yet.
Obviously Mr. Wharton and I have differing definitions of a real estate bubble. To me, "unsustainably high" prices is the definition of a bubble. I find myself confused about just what he means by "unsustainably high" when in his conclusion he plainly stated that he believes "a bubble-deflating crash to fundamentals isn't impending." How can prices be "ripe for a serious correction," if he believes that there are "solid economic reasons" for prices to be as high as they are? What is there to correct?

All in all, I believe Mr. Wharton's series uses good research and rational thinking to lay a solid foundation, only to come to a conclusion that is not supported by the very arguments he has laid out.

So let's hear from you. Do you agree or disagree with me? Are my arguments sound and reasonable, or did I miss a crucial piece of the puzzle? Has the bubble been debunked, or is it still hanging over our heads? Inquiring minds want to know.

(Gregory Wharton, Seattle Real Estate Professionals, 07.03.2006)
Please read the rules before posting a comment.


Anonymous said...

Didn't King County pass a variety of laws that would impact real estate recently? Things around how much land can be re-developed? Something like 30% needs to be left un-developed. I thought this came into effect in the last 2-3 years.

Anonymous said...

Tim, I think you have done what you claimed to do - you debunked Wharton's argument that we're not in a bubble.

This, of course, does not establish whether or not we're actually in a bubble. It just means that Wharton's argument does not follow. And I agree with your opinion that Wharton has the risk and interest rates issues backwards. Lower risk and lower interest rates are valid reasons why prices have risen, but this does not establish good reason for prices staying high. Due to the "reversion to the mean" idea, these issues do seem to be in favor of prices falling.

An additional comment about construction cost: In an industry with a secondary (resale) market, such as iHips or houses, there is no direct link between construction cost and prices. The manufacturer can control new prices, but not resale prices. Raising new prices (for whatever reason) reduces construction volume, which indirectly affects the resale supply.

Conclusion: manufacturers can control prices only if there is no oversupply. If everyone can find what they want on the resale market, then prices still will not rise even if manufacturers produce nothing. However, if there is a resale shortage, manufacturers can raise prices until demand falls into equilibrium with the desired production volume.

What does all of this have to do with construction cost? Almost nothing! The only relevant point is: as construction cost rises, manufacturers will be squeezed by the resale market. They will raise prices (by choice or by force) until such point that demand falls. In a rising housing market, this seems relevant - the resale market is undersupplied. However, in a soft market, construction costs no longer affect prices at all. New production may drop precipitously as costs rise, but that's all. Eventually, the manufacturer will be priced out of his own market.

Eleua said...

but it also means that a bubble-deflating crash to fundamentals isn't impending. For those who have been priced out of the market, now facing still-stagnant wages and rising interest rates, that will likely be unwelcome news.


Your analysis of this load of bull is right on (IMHO). He seems to hoist himself on his own petard, and actually provides somewhat of a good argument that the market might be due for some pain.

In the above italicised passage, he notes that wages are stagnant and interest rates are rising. I know I've pimped my blog over and over, but this swerves right into the meat of my argument on why prices must come down.

If PNW incomes were skyrocketing, I would have to concede the day to the bulls, but they are not. If inflation is rising, and the cost of borrowing money is rising, then just where are people going to get the money to keep the market afloat? I show how home prices must be kept in line with incomes, or you end up with an affordability crisis that just can't be ignored.

Another point on contemporary bullish housing analysis is how it is eerily similar to all the bull-analysis of stocks back in the go-go days of the late '90s. Remeber, back then, it "was different," and we had a "new economy." Within weeks of the WSJ pronouncing that the NEW ECONOMY was indeed a proper noun, stocks got smashed. The NEW ECONOMY was defenestrated in favor of classical fundamentals.

Sorry to keep saying it over and over, but I think the point survives.

Your iHip analogy is spot-on. People want iHips because they think they are investments and cool. Who wouldn't want to make money being cool?

I'm with "DEFLATION GUY" and think that once the paradigm shifts, people will actively avoid buying RE, in hopes of holding out for lower prices. Just the same, people holding RE will be very motivated to sell, to avoid lower prices. This deflation scenario would increase the amount of homes on the market by several fold, while pulling buyers away. It would be a bull nightmare.

The Tim said...


You're probably thinking of the Critical Areas Ordinance (CAO), which was passed in October of 2004, well into the current boom in real estate values. One could possibly argue that increases since late 2004 have been influenced by the CAO, but given that major home price inflation was well underway before the CAO was passed, I don't think it can really be blamed for the present situation.

Shadowed said...

Aren't existing properties exempt and/or grandfathered from the CAO as well? I thought it only affected new development.

Eleua said...

Americans were able to buy more financing with their monthly payment amounts, but they didn't have a proportionately higher reserve of cash to cover the higher down payments. Lenders obliged by offered a wide new range of options for buyers to enter the market without having to raise a lot of cash for equity.

So, Americans can borrow more, but they don't have the skin in the game that they once did? This smells like massive default, to me.

Where did we get these new buyers? My guess is they were the former renting class, that now thought they could move up to the big time and become a homeowner. Now that we have chased the upper tier of renters into the lower class of homes, where does the next wave of buyers come from?

More importantly, what happens if shareholders of the holders of mortgage paper ever get religion? What kind of financial vetting will have to take place to get money for a house? What is going to become of your standard sub-prime borrower? Will they get money to stay in the game?

Even better, what happens when lenders require that a hard 20% be put down on a home, regardless of credit or financing?

I don't see how this does not ends in tears.

Anonymous said...

National City Bank is reportedly going to sell it's mortgage business and it's sub-prime unit First Franklin.

First Franklin does a whole bunch of business in our market. A whoooole bunch of biniz to local mortgage brokers.

This only happens when the markets continue to do well.

Anonymous said...

I've thought about the "requiring 20% down" issue a lot.

If lenders started requiring 20% down again, then the number of mortgages they issue (and hence their revenues) would drop significantly.

Mortgage lenders are in business to produce profits.

Will mortgage lenders really start requiring 20% down again if it means lower revenues? (and in turn a lower stock price, layoffs, etc.)

Eleua said...

Will mortgage lenders really start requiring 20% down again if it means lower revenues? (and in turn a lower stock price, layoffs, etc.)

They will balance those concerns against the money they lose on short-sales and defaults.

It will only take a few defaults to offset the revenue of hundreds of mortgage origins.

Additionally, due to the secondary market, the people that write loans are not usually the ones that hold the loans to completion.

If you are the CEO of "Fly-by-Night Mortgage," you only care about originations. You will sell them to me at "Sucker Capital Management" and be done with it.

This works until your borrowers (now mine) default, and now I don't have the payments from their mortgage and I am left foreclosing and going through that money hemmorage.

Guess what? When you go to sell your next bundle of mortgages, I will demand a higher interest rate (lower purchase price of your bundle), and say that unless you want this trend to continue, you had better look into the financial viability of your clients.

The reason: I don't give a damn about how many mortgages you originate, only the viability of the revenue stream I am buying from you.

Anonymous said...

If I'm reading correctly, people on both sides of the bubble existence argument seem to agree on one point, a drop to fundamentals would mean a substantial price reduction.

The core of the non-bubble argument rests with the axiom "ya' gotta live somewhere". Explain to me how even stagnating prices are not highly unstable in a speculative market - especially one that is financed so creatively.

darth_s said...

It seems that the "createive" lending industry is on very shaky foundation now. It can roll over any time.

Anonymous said...


Is ther any visibility into the number of defaults in the Seattle area?

This would be a key indicator to watch and see if there is a correlation to a tightening of lending standards.

Eleua said...

Explain to me how even stagnating prices are not highly unstable in a speculative market - especially one that is financed so creatively.

They are unstable. Once a bubble gets blown, it depends on rising prices to sustain itself. You don't hold a money losing investment for break-even. You can only make money on a money loser, by selling it to an even greater fool.


I posted this on the Sunday Thread, but it fits your question.

Question: If you KNEW that RE prices would increase by 10% for the next five years, how much money would you put into buying a house?

Answer: Easy. As much as you possibly could (absent a better investment vehicle). If you could get 90% leverage on that investment, and you had $50K down, your $50K would increase to $298K, after RE fees. Without consideration of iterest and paydown, that is a 43% ROI - not bad for your average moron. This explains the massive 'speculative premium' that now is paid for RE

OK, now....

Question #2: If you KNEW that RE would go down by 10% per year, for 5 years, how much would you pay for a house?

Answer: Easy. As little as possible. Under the same scenario (but using 20% down, if you could find someone with 20% to put down), that same $500K house would be worth $274K, after RE fees. Your $100K was gone after the second year, and the three years following would require you to bring an additional $176K to the closing, just to unload your house.

You lose $226K on a $100K investment. That is a 225% loss over 5 years.

So, how much money are we going to be putting toward RE when the investment paradigm changes?

Anonymous said...

But the investment paradigm will only change if lenders tighten their lending requirements.

If that doesn't happen, then the PI guy will be correct. Prices will most likely rise.

Lending practices (and the tightening thereof) are the key to this bubble bursting, IMO.

Eleua said...

I don't follow the larger PNW market all that closely, as I really have no desire to live on the Eastsound (unless a fabulous place in Ballard opens up), but I do loosely track foreclosures and the like in my hometown and Kitsap County.

There are hundreds of sites that track distressed properties in the US, and most can be narrowed down to the individual town. this one will do to give you a very brief outline of what kind of condition your neighborhood is in.

For me, I know where I want to live, and I thumb through their county records to see where the vulnerability is. I also walk/jog the neighborhood and try to chat up the neighbors about all sorts of stuff. Right now, there is quite a bit of smoke, but no fire. The bull market has liquified gross errors of judgment. That will change.

Sorry I could not be more help

Eleua said...

For the PI guy to be correct, he needs:

-lowering or stagnant interest rates

-no widespread defaults

-California equity locusts to stay liquid in their 96% unaffordable markets

-complete absence of fiduciary responsibility on the part of holders of mortgage paper

A change in just one of the above will dramatically change the PNW RE market.

It's going to catch most people flat-footed.

darth_s said...

The first sight of tightening lending practices already appeared:

Remember that about 70 % of buyers in the Seattle area bought homes with No money down, especially first time home buyers. They must use piggy back loans in one way or another. As a matter of fact, all the first time home buyers that I know use piggy back loans.

Anonymous said...

Tim, I agree with your analysis but might add a few points.
1) Even IF the inflation in construction inputs raised the cost of building a new house, and that inflation raised the value of existing homes, the resulting inflated price of all homes would be fundamentally justified ONLY if the basis for the origianal inflation of materials was both fundamentally based AND durable. I believe that worldwide demand for raw materials was induced by massive liquidity injections by central banks leading to commodity inflation BUT that easy money policy was a mistake and is now being taken out of the system. WIth less liquidity and slower growth prices will come down. So the inflation was NOT fundamentally based (it was manipulated demand) and therefore it is NOT DURABLE - it will go away.
2) Flight of capital from a crashing stock market WAS a good reason for people to put money into real estate, expecially when combined with the free money extended via easy credit at subsidized interest rates. But history shows that it's called "capital flight" because it is in fact "flighty" - ie, as poeple realize real estate is not going to be a good speculation going forward that money will go elsewhere. All it takes is the few speculators on the margin to drive prices up and a few speculators on the margin leaving a market to drive prices down. Everyone one else is along for the ride. The result of capital flight from real estate will be just as dramatic as the effect of capital flight to real estate.

Exactly how this all unwinds will be interesting. In my opinion, the Fed has raised interest rates for two main reaons: 1) to STOP asset prices from rising further, as part of it's anti-inflation mandate, since it knows that the longer this persists the worse the outcome will be, and 2) to get interest rates up high enough to give them room to lower them again when the shit hits the fan. They tried to raise slowly to cause minimal pain. Once asset prices begin to fall, consumer demand will weaken dramatically, and worldwide output will fall in response to reduced demand. The potential for a deflationary spiral is very real. The only question is how well will the Fed be able to fight it? Japan went to zero and it wasn't enough so they endured a decade of deflation. In my opinion, at 5.5% the Fed doesn't have enough room to lower and have the desired effect. Plus, the fed won't have the credibility when it tries. When you get a series of asset bubbles and try to out maneuver them by alternately raising and lower rates it's like chasing your tail. At some point the cycle oscillations become unstable and you run out of room to maneuver the rates. It's just like gambling where you can't win by keeping on doubling your bets every time you lose. It's a risky game the Fed is playing and a sure bet they're running out of credibility, luck, and room to maneuver.

biliruben said...

I think Wharton did a very admirable job. Kudos, Gregory.

What I take issue with:

He states there is no bubble in Seattle. The way he does this is to define a "bubble" extremely narrowly as a rise in prices not supported by "fundementals".

I don't agree with his definition, but even if did, his fundementals are transitory, making them not so fundemental.

Interest rates change. So we might not see housing prices "correct" to be in line with interest rates, but we could certainly see prices crater as interest rates rise to more historically reasonable levels, as banks realize they are not pricing in risk properly - particularly for piggy-backs, as we are seeing now.

Prices of construction costs, both hard and soft, will likely fall as demand for new housing and remodels fall. This is another transitory "fundemental" which is partially caused by the housing boom itself. Less a cause, more an effect.

Finally, the issue of psychology and his poll showing 71% think we are in a bubble. Really the only folks that matter are those actively in the market for a house within highly inflated area. If 71% of those people think we are in a bubble, I would be greatly surprised.

biliruben said...

I also looked back and see he responded to my question about whether lower demand for housing would decrease the the costs of construction.

To summarize, he thinks that their might be some elasticity in labor, but materials are driven by fuel, scarcity and interest rates, at least partially.

Thanks again, Greg.

biliruben said...

I realized that a criticized his choice of fundementals, but didn't offer my own.

The main fundementals that should influence a rational housing price would be rents and income. Housing prices are far out of whack in the Seattle market when compared to these two things.

Anonymous said...

no one I know has attempted to argue that [rock-bottom rates] is not one of the primary driving forces behind the drastic price increases we have seen across much of the country, including Seattle.

Right--and this was like pouring gasoline on the speculative fire, which I daresay happened to all W. Coast metro areas. I'm sure investor sales (local and otherwise vacation homeowners), easily approaches 30% in Seattle at peak (as elsewhere on our coast). Wanna bet that plays a role in recent appreciation?

To scoff at a bubble in Seattle, you have to similarly scoff at the data and analyses retraced over and over in blogs and conventional media. It's driven less by a willingness to understand, and more by a hope that prices will somehow continue up, up, up at the same rate seen these past years (IMO).

Eleua--I agree; incomes and lending costs have collided, even for Seattle. The investor party is over; and quite a few are too drunk to wake up and walk away. I think future sales volumes will be driven by realtors, pushing down prices to reap commisions.

Anonymous said...

The Critical Areas Ordinance only affects areas in unincorporated King County. The affect that this has on real estate values is somewhat limited. It is a property rights thing.

Anonymous said...

Arm Twister-

First Franklin is being sold because it's been losing money and they want to unload it.

Read the details on today's (july 11) Housing Bubble Blog.

Anonymous said...


I was being sarcastic. Perhaps too dry of humor.

Anonymous said...

At first I thought you must be being sarcastic but as I read and re-read it started sounding like you believed this was a good thing.

Ridiculous I know, but some of the twisted double speak I've heard lately concerning the market has finally led me to believe anything's possible!

Today I read a realtor quote " Inventory is going up, so the price of homes will be going up too as there are more nicer homes to choose from."

Twisted logic at it's finest- we are approaching new heights of ridiculousness here!

Sign of the times.

Anonymous said...

Here's another good realtor quote from a few weeks back:

"Buy a home now because your equity will never be higher than it is right now".

Holy Smokes! Way to keep the bad news positive!

Eleua said...

New Era Doublespeak:

Debt is Wealth

Prudence is Foolishness

Saving is Poverty

Consumption is Patriotic

biliruben said...

Gregory's outlook up.