A Real-Life Real Estate Bubble

Given all the talk about the ‘bubble’ in real estate, what is the best advice for real estate investors today? Is it possible that real estate could fall in value by 10%…20%…even 50%? The short answer is that anything is possible. But, suggests True Wealth’s Steve Sjuggerud, it might help to look at what a real-life housing bubble looks like before we give that name to today’s market…

"The Florida boom was the first indication of the mood of the Twenties that God intended the American middle class to be rich."

– John Kenneth Galbraith
The Great Crash

In 1914, George Merrick switched from selling fruit to selling Miami land. Florida would never be the same again.

In 1910, only 5,471 people lived in Miami. By the time Merrick was through in 1925, he had installed some 3,000 real estate salesmen alone in the city. Merrick’s fleet of 76 busses was constantly bringing down prospective buyers who all had the same mission: to get rich on Florida real estate.

But George Merrick is only a small part of the story. In all, by 1925, there were 25,000 real estate agents working in 2,000 offices in Miami. As the population grew to 75,000 – remember, it was 5,000 just 15 years earlier – an astonishing one in three Miami residents sold real estate there.

Why was everybody hustling to buy in Florida? Author John Kenneth Galbraith explained it well in his 1954 classic, The Great Crash: "This is a world inhabited not by people who have to be persuaded to believe, but by people who want an excuse to believe. In the case of Florida, they wanted to believe that the whole peninsula would be populated by the holiday- makers and the sun-worshippers of a new and remarkably indolent era. So great would be the crush that beaches, bogs, swamps and common scrubland would all have value."

Stories of overnight fortunes were headlines across the country. "One man picked up ocean frontage for a quarter ($0.25) an acre and sold it for a million," writes Maury Klein in his book on the subject, Rainbow’s End. "Another reluctantly took 1,200 worthless acres on a debt and couldn’t sell it at $10 an acre, until the boom delivered him a whopping $1.2 million. A returning soldier traded his overcoat for 10 worthless acres near the beach and soon found it worth more than $25,000. A poor woman who had bought a Miami lot back in 1896 for $25 sold it during the boom for $150,000."

"Getting rich is easy," everyone came to think during the boom. Just buy land in Florida and you’ll be rich in a few weeks. The illusion seemed true. In fact, the assessed value of property in Miami went from $63.8 million to $421 million in just four years (1922-1926). Money was growing on trees (palm trees, right?). Did it matter if there was any value to the underlying asset? Nobody cared. And as the boom was reaching its peak, following a trend that would have made Tech and Telecom investors of the late ’90s proud, nobody even bothered to do any research anymore…they just bought with the expectation of getting rich straight away.

"An enterprising Bostonian," says Galbraith, "a man by the name of Mr. Charles Ponzi, developed a subdivision ‘near Jacksonville.’ It was approximately 65 MILES west of the city. (In other respects, Ponzi believed in good, compact neighborhoods; he sold 23 lots to the acre.) In instances where the subdivision was close to town, as in the case of Manhattan Estates, which were ‘not more than three fourths of a mile from the prosperous and fast-growing city of Nettie,’ the city, as was so of Nettie, did not exist."

Then, as quickly as it began, the bubble burst. And it was painful. In 1925, bank clearings in Miami were in excess of a billion dollars. In 1928, they were $100 million – one-tenth of what they were just three years before. The boom was over. And like the Nasdaq, speculators with hopes of easy riches were crushed.

My friends, this was a real estate bubble.

I can see many similarities between Florida real estate in the 1920s and the Nasdaq bubble of 1998-2000. But I really don’t see much similarity in real estate today, do you?

First of all…we don’t have any ‘cities of Nettie,’ though we do have people speculating on pre-construction developments. We don’t have people buying sight-unseen like Florida land circa 1925.

And most importantly, we don’t have the "euphoria" that we had then – a defining characteristic of speculative bubbles. While some people think that real estate "always goes up," some are still very afraid that "it’s too expensive and is about to fall." I don’t know how many people fall into each camp. But for a speculative bubble to develop, EVERYONE has to believe that this is the sure path to riches – just like people believed about stocks in 1998-2000.

We’re not there yet.

I would define a bubble as "when prices become un-tethered from fundamentals." Right now, real estate fundamentals, as measured by the amount of rent you can collect on a property versus its value, are fine. You can earn 6%+ in net rent on a rental property. Maybe more (even much more) if you’re lucky or good. Where else can you get paid that kind of income? Nowhere…

No, I don’t think we’re in a real estate bubble. If prices double from here, and the word on the street is that "the easy way to get rich is to buy real estate"…then we’ll be in a bubble. That will be the time to get worried.

We’re just not there yet.

So for most investors, the best advice is simply not to worry about your real estate, in particular your rental properties. We are still a long way from the bubble stage.

Prices may slow their rise, or as indicated in the New York and California markets, they may even contract some. Then again, they may continue to rise. How’s that for an accurate forecast? Truth is, nobody can foretell what will happen. But since there is underlying fundamental value, it seems smartest to ride it out – particularly if you don’t have too much debt.

Could real estate fall 10% in value? 20%? Even 50%? Sure, it’s possible. Anything is possible. But, in my opinion, we’re not in a real estate bubble. People don’t expect to get rich next month in real estate…by buying this month. Nor would they if they tried.

Regards,

Steve Sjuggerud,
for The Daily Reckoning
November 19, 2002

P.S. On the other hand, the same low interest rates that have everyone screaming "real estate bubble!" have created an interesting opportunity in mortgage REITS. In fact, for the last year I’ve been recommending to readers of my advisory letter, True Wealth, that they keep their funds parked in this un-sexy sector.

Talk about boring. We’re buying these tax-free investment vehicles because their only assets are mortgages – mortgages backed by government guarantee. Although these REITS trade like stocks, a trillion dollars of government guarantees stand behind them.

So, they’re not very exciting. In fact, there’s hardly any risk at all. But we make 16-25% a year in dividends alone…and one of these REITS is up over 440% in the last two years alone. REITS are throwing off so much cash these days in dividends, we call this strategy "portfolio repair."

Editor’s note: Steven Sjuggerud, PhD. is an international currency expert and a member of the Oxford Club advisory panel. Dr. Steve is also the editor of True Wealth and president of Investment U, a self-directed coaching program for mastering the best investment strategies for capital protection and maximum long-term profits.

The Labor Dept. reports that 40% of all goods and services are cheaper now than they were a year ago. Eyeglasses, meat, poultry, eggs, fish, communications of all sorts, personal care, commodities, new cars, furniture, clothing, tools, appliances – they’re all in outright deflation.

"Deflation is real," says MONEY magazine.

So in-your-face is deflation that even Ed Yardeni couldn’t miss it. Uh oh. Does that mean deflation is already over? Yardeni rarely notices a trend unless it is too late to profit from it…or it never happens.

Writing in Barrons a couple of weeks ago, the chief investment strategist for Prudential Securities introduced a War & Peace Model of deflation. Prices rise during wartime, he noted; they typically go down when the war is over.

Let’s see. Yes, they fell after the war of 1812, and again after the Civil War…and after WWI. But what’s this, Yardeni’s chart seems to disprove his hypothesis – prices rose after WWII and have been going up ever since!

Ah ha! It was a ‘cold war,’ Yardeni asserts, and now that it’s over we can expect falling prices, "a consequence of increasingly competitive markets resulting from peace, free international trade, industrial deregulation, technology and productivity."

But don’t worry, he continues, because there are two kinds of deflation, "sweet and sour." In the sweet version, "companies offset the competitive pressure on their prices with productivity gains."

In the sour version, intense competition depresses profits, "forcing companies to slash their payrolls in desperate attempts to cut costs and boost productivity. Consumer confidence falls as the jobless rate rises. Consumer spending is depressed by the worsening employment situation and perceptions that there is no rush to buy when prices are falling."

Not that we prefer it, but our guess is that the second sort of deflation is the one we’re headed towards. Americans are deeply in debt; paying it back is never a ‘sweet’ time.

Consumers’ spirits have been sustained by rising real estate, easy access to mortgage money, zero percent auto loans, and low retail prices. But now, the top end of the housing market is getting pinched (more below…)…auto sales have eased off…and retail stocks are falling as consumers begin to wonder whether they should wait for lower prices.

Of course, we also expect the ‘sour’ deflation simply because Yardeni and so many others forecast the sweet variety.

Here’s Eric with more news from Wall Street:

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Eric Fry in New York…

– "Deprived of bad news to ignore, stocks stalled, then sank on Monday," joked Smart Money’s Igor Greenwald. It’s true; the FBI issued no new terrorist warnings yesterday and no major blue chip company announced disastrous earnings. So the ever-hopeful swarms of dip-buying investors could find no grim news whatsoever to blithely ignore. The Dow dropped 92 points to 8,486, while the Nasdaq retreated 17 to 1,393.

– Government bonds bounced a little, while gold and the dollar both slipped a little.

– As predicted in this column several weeks ago, large pension plan liabilities are becoming an increasingly severe problem for some of America’s biggest – and most highly regarded – companies.

– Billion-dollar pension shortfalls are popping up all over the place and biting a few companies on their corporate rear-ends. Just last week, SBC Communications, Inc. announced that the withering value of its pension investments, coupled with rising medical costs will shave $1 billion to $2 billion (give or take $1 billion) from next year’s earnings.

– The day after SBC’s shocking mea culpa, Honeywell International reported that the cost of replenishing its depleted pension plan coffers would reduce earnings by $235 million to $335 million in 2003.

– Fortunately for their pensioners, SBC and Honeywell are both capable of topping off their existing pension shortfalls – for now – without declaring bankruptcy. But not all companies are so lucky, which is where the Pension Benefit Guarantee Corp. (PBGC) comes in.

– David R. Francis of The Christian Science Monitor recently examined the financial health of the PBGC, the government agency responsible for safe-guarding America’s corporate pension funds. To preview: the PBGC could be in much worse shape, but it probably SHOULD be in much better shape.

– For starters, 360 of the 500 companies in the Standard & Poor’s 500 Index are underfunded by about $243 billion, according to a recent study by Credit Suisse First Boston. And as we’ve noted a couple times recently, this massive funding liability could weigh heavily on S&P 500’s profits and cash flow over the next several quarters. That’s the bad news. The OTHER bad news is that the ultimate guarantor of all these woefully underfunded pensions is not exactly flush with cash. So what happens if two or three more big companies head off to "corporation heaven" before getting a chance to replenish their underfunded pensions? The PBGC rides to the rescue…if it can.

– This venerable government agency covers pensions, up to a limit – $42,954 per year for a 65-year-old worker retiring this year. "Over the past 15 years," says Francis, "defined-benefit pension plans have declined in importance. There were 112,000 such plans in 1985 and only 35,000 last year." The number of defined-benefit plans may be shrinking, but 35,000 is still a big enough number of plans to create big problems for the PBGC, and also, maybe, for taxpayers.

– "So far," Francis says, almost reassuringly, "the PBGC is in good financial shape. As of June 30, it had a surplus, measured on an actuarial basis, of $4.8 billion. That’s down from $9.7 billion at the end of fiscal 2000. This surplus is likely to shrink further with the current wave of corporate bankruptcies. The agency was paying the pensions of 268,000 retirees at the end of fiscal 2001. By now, that number has probably risen to close to 400,000."

– In other words, the $4.8 billion could well be down to about $3 billion or less by now. But that’s not very comforting, given the estimated quarter-of-a-trillion- dollar liability facing the 360 S&P 500 companies alone. What – we wonder – is the funding status of the OTHER 34,640 pensions that the PBGC safeguards?

– Not to worry, says spokesman Jeffrey Speicher, the PBGC has enough cash to pay benefits for "the foreseeable future."

– First of all, the future never seems to be quite as foreseeable as the folks who use the phrase "foreseeable future" assume. Secondly, even if the future were foreseeable, we doubt we would foresee the PBGC’s continuing solvency, without having to hit up the taxpayers for cash at some point. As the PBGC is a government agency, it can’t actually go bankrupt. But it could stroll up to Capitol Hill one day with its hat in hand to ask for a very, very large handout.

– But don’t worry, that wouldn’t happen until sometime in the UN-foreseeable future.

———

Back in Paris…

*** Richard Bernstein, at Merrill Lynch, figured out that he could make a pretty good leading indicator out of his colleagues’ forecasts.

When Wall Street strategists – such as the aforementioned Ed Yardeni – tell you that you should have more than 62% of your money in stocks, for example, Bernstein says it is a very good time to sell out. By contrast, when the strategists become fearful, and tell investors not to have more than 50% of their money in stocks, it is generally a good time to buy.

Currently, Bernstein’s reading for stock market exposure is up to 69.2% – close to an all-time high. Meaning, Wall Street strategists are as bullish as ever.

Sell!

*** "Sales of Luxury Homes Across U.S. Slip," reports a Bloomberg headline, "A Sign the Housing Boom May Fizzle."

In New York City, sales for the top 10% of apartments dropped 18% in the third quarter. Sales of $1 million-plus houses in California fell 10%. In Washington, D.C. suburbs, there are 4 times as many high-end houses on the market as a year ago.

Bloomberg was silent on the market for $1 million-plus homes in West Virginia. Maybe they don’t make mobile homes that expensive.

*** Long-time Daily Reckoning sufferers know that we regularly include updates and insights on matters that have nothing to do with investing. But since the DR is a free service, we permit ourselves these little gratuitous reflections from time to time.

Money isn’t everything, we remind ourselves.

And so, the family news…Edward, 9, may be the worst student of the bunch. We tried to help him with money – by hiring a tutor to work with him on his written French. But despite the best efforts of paid professionals, his most recent report card was a disaster.

The French schools do not try to spare students’ feelings. The pedagogues are not interested in developing self- esteem; what matters to them is performance. Edward was ranked last in his class and knew it. So bad was his report card that Elizabeth went to see the headmaster to ask if there were any hope for him.

"He is not dumb," said his teacher. "He just can’t sit still and won’t pay attention. When the rest of the kids get out their notebooks and go to work…he gazes out the window. Or worse…he starts talking."

What is a parent to do, dear reader? If only money could solve the problem…!

Of course, Sophia was not a very good student either. But now she’s in college – in West Virginia, no less – and getting A’s!