Six Signs of an Asset or Real Estate Bubble
The 2007-08 real estate crash should not have caught so many people by surprise. There were numerous warning signs and red flags for the average investor. The United States had undergone a similar boom and bust 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 warning signs. Here are six factors to watch that may indicate we heading into bubble territory
1. Workplace Chatter: Prior to the 2000 tech stock crash many people were giddy talking about the huge returns they were making in these stocks. It seemed like everyone became a stock picking genius overnight and people discussed quitting their jobs to become full time day traders. Tech stocks were a common topic of discussion on public transport and during breaks at work. This same type of euphoria about real estate investments also permeated workplace conversations in early 2005 and 2006. This type of ubiquitous 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 may be 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 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 real estate reality shows on flipping houses, giving the impression that millions could be made in real estate overnight.
Lesson: Pay attention to trending business books, watch for titles promoting how easy it is to make money in a particular asset class. The smart money will sell and move to undervalued assets. There are always deals in the aftermath of a market crash to pick up deals.
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 monthly profit. A few years later home prices rose so much that the monthly mortgage was twice the monthly rent. About two years later the monthly mortgage was three times the rent. Rents naturally rise over time and begin to catch up, but these ratios were absurd for investors. There is no reason to purchase a property you can rent for 1/3 of the monthly mortgage. Some home buyers 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 and led to some bad investments.
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 more likely to be successful in the long run. This is also a time to avoid becoming over leveraged with 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 2000s housing bubble was inflating the standard 20% down payment 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 concerned if the asset falls in value. At the same time traditional loans that had 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 loans that 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 find the exits. Home buyers also slipped in their 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 decision for the average home buyers.
Lesson: Watch for slipping due diligence standards both on the part of lenders and buyers. These are signs of irrational exuberance and should encourage investors to start tightening their own standards to protect themselves.
5. This Time is Different: A refrain of the foolish, frequently heard just before a bubble pops. Prior to the housing crash business newscasters often said there had never been a housing decline across the entire nation, which they used to justify the rapid price rise, 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 type of real estate such as office buildings, warehouses, or residential housing, but never all at the same time across the country, telling viewers there is nothing to fear. The notion that this time is different makes people think they are seeing something unique and it encourages risky decisions.
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, this time is never different.
6. Beware of Hubris: I was living in Abu Dhabi during the global financial crisis and watched as the smaller and less wealthy emirate of Dubai had to be bailed out by the deeper pockets of Abu Dhabi. In its hubris, Dubai racked up excessive debts building the world's highest skyscraper, a peninsula shaped like a palm tree, and an impractical set of islands shaped like the world. At the same time in the United States, 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 underlying value of assets would severely damage the firm. This hubris 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 investment bubble has signs of hubris and excess that precede the crash. Watch for these signs and follow Warren Buffett's advice,'Be fearful when others are greedy and greedy when others are fearful'