The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (24 page)

All three of these fundamental economic drivers contributed to each other and contributed tremendously to the rise of real estate prices over more than a century. Adding to this feedback loop was the increasing popularity of vacation homes. As cities became more and more congested, people sought refuge in quieter, far-away places. Vacation houses were cheap, but over time more and more people with more and more money were chasing the more desirable vacation spots, which of course just drove real estate prices up even more.

Beginning in the early 1970s, those three key factors of population growth, urban migration, and wage increases all started to slow down substantially after more than 100 years of high growth. Nonetheless, real estate prices continued to climb. The late 1970s and early 1980s were a time of relatively high inflation, so at first the price increases in real estate did not reflect much change in real value, just higher prices due to a cheapening dollar (inflation). It is important to also note that income growth—a strong fundamental driver of nonbubble real estate prices—did not rise much during this time. In fact, since the 1970s, real wage growth has been essentially flat for more than a generation. So the primary driver of rising real estate prices in the 1970s was inflation, certainly not income.

Then, in the early 1980s, things changed. As inflation declined, real estate prices began to take off due to something else:
low interest rates and a booming economy
. During the high inflation of the late 1970s and early 1980s, mortgage rates had been as high as 18 percent, so when interest rates fell, the cost of borrowing money decreased a lot. And not only real estate got a big shot in the arm from this. Lower interest rates and easy credit for consumers in the 1980s helped launch the beginnings of our rising multibubble economy, of which the real estate bubble was just one.

The beauty of all this cheap, easy credit was that lots of money was available to make all kinds of purchases, real estate included, with a lovely perk: Instead of spending one’s
own
limited and hard-earned cash, home buyers and consumers got to play with the bank’s money. And, my goodness, is other people’s money a whole lot easier to spend!

Naturally, as more and more people bought homes and other properties, real estate prices went up and up. This created a bubble-inflating feedback loop: When home prices went up, people were then able to refinance their mortgages and pull out some of the increased equity in their homes—making it possible to go shopping for
even more stuff
, including more real estate, not to mention all sorts of other bubble economy goodies, from new cars to vacations to home improvement projects and more.

Cheap loans, easy credit, and rising real estate values became a wonderful win-win for the banks and consumers. Soon the banks and other lenders were aggressively seeking more and more mortgage buyers, especially mortgage refinancing, which began to grow rapidly. In fact, by the early 2000s, homeowners were routinely using their rising home equity like personal ATMs, withdrawing essentially “free” money that helped pump up the rest of the rising bubble economy.

Without the low interest rates, the easy access to credit, and the overall rising bubble economy, real estate prices would not have risen much over the past three decades, because during that time we had nearly no growth in real wages (adjusted for inflation). It has been almost all pure bubble growth.

Conventional wisdom says that, despite the recent downturn, rising real estate prices are bound to return, even if that takes a while. And prior to its happening, home values will certainly not fall too much lower. The worst is behind us. It is just a matter of time before we get back on track to the assumed “natural growth” of real estate values—just like we’ve had for more than 100 years.

Conventional wisdom not only believes we will “get back on track” soon, they also believe that the main problem that caused the real estate drop and financial crisis in 2008 was a lot of subprime mortgages going bad, and that it was not due to any other problems.

Now that we have begun to solve those subprime-related problems, CW expects to see real estate gradually recover. They acknowledge that the economy faces some temporary headwinds that are keeping the real estate rebound from happening sooner. But, in time, demand will pick up and all will be well again, as the overall U.S. economy continues to recover.

One reason CW feels so very confident in this point of view is that they fully believe that
low interest rates will last forever
. Low interest rates are what helped make home buying so affordable, and low interest rates will continue forever, ensuring that real estate remains the fabulous investment that it has already proved itself to be for so many, many years.

CW sees no fatal future flaw in this logic—primarily because they desperately do not want to see it. They don’t want to face the fact that future inflation is coming and interest rates will rise. They want to see low interest rates forever.

Over the long haul of time, real estate has been a great investment, not just for a few decades but for many generations. More recently, especially between 2001 and 2006, real estate profits had become enormous, morphing into a supercharged investment. Not only could you earn a cool 10 to 15 percent or more (in some cases even 25 percent) per year in increasing equity, you could
leverage
that investment with other people’s money at super low interest rates.

It used to be that only the big players, like hedge funds and big real estate developers, had easy access to leverage, and they used it well to create massive profits. It was rare for average American consumers to get access to so much leverage, and now they, too, were using it to create huge returns. And, of course, the bigger real estate investors were using leverage, too. Why spend $100,000 to earn a 10 percent return equaling $10,000 when you can put down just $10,000, borrow the other $90,000, and earn 100 percent equaling $10,000. Wow, what a bonanza!

The profits from leveraged real estate investments were absolutely astronomical, and CW absolutely does not want that to ever end.

Conventional wisdom on real estate is wrong for the same reasons that CW is wrong about all the other falling bubbles—
it’s a bubble
! As explained earlier, the growth of real estate prices since 1980 was no longer driven by fundamental economic drivers but instead by low interest rates, easy access to credit, and the rest of the rising bubble economy. Bubble prices don’t last forever because bubbles eventually pop.

Let’s go a little deeper now, to dissect the CW myth of “always rising” real estate values.

First, the idea that real estate prices always grow is just plain historically wrong. In fact, we have had many periods of slow growth, no growth, and even negative growth in real estate prices. For example, from 1930 to 1950, the growth of land prices was a dismal
negative
3.27 percent. Then, from 1960 to 1970, we had a modest growth rate of 1.76 percent. Even during the period from 1990 to 2000, land prices rose only 1.08 percent. So the whole idea of endless growth is just not borne out by the historical facts.

Second, the idea that real estate values always rise because population is always growing and land is limited enough to always drive up prices is also not correct (see the sidebar on the myth of limited land).

Finally, the striking contrast between the
lack of increase in incomes
(in inflation-adjusted dollars), compared to the dramatic rise in home prices during this time, confirms beyond anything else that real estate has been a
rising bubble
, not driven by real fundamentals. We would expect to see median home prices to rise with a corresponding rise in median incomes. However, if incomes are up 2 percent and real estate is up 80 percent, by definition you have a bubble.

The biggest flaw with conventional wisdom on real estate is the idea that interest rates always will stay low, as they have for decades. Instead, we will have rising interest rates. Rising future inflation (due to massive money printing to support the falling bubbles) will drive interest rates up significantly, and without an endless supply of low interest rates, the whole CW argument—not to mention the bubble itself—falls apart.

As interest rates rise and mortgages become more expensive, we can kiss what is left of the falling real estate bubble goodbye. On the way up, this bubble was fueled by low interest rates and easy lending, allowing people to buy houses they would not be able to afford under normal conditions. But with higher mortgage rates, more money will go toward the buyer’s interest payments, leaving less money available to pay for the property. When people cannot afford something, they buy less of it and prices go down.

Remember, at the same time that mortgage rates rise, employment will also fall further, so there will be fewer potential buyers. Fewer buyers means even more inventory for sale. Increasing supply and falling demand means falling home prices and a big real estate bubble pop.

We certainly do not blame people for believing that real estate prices should always generally go up. That is what most of us have seen, and it is an awfully nice idea to believe in. Aside from occasional dips due to recessions and one depression, home prices have generally risen, not only since most of us were born, but since our parents and even our grandparents and great grandparents were born. So we don’t blame homeowners for having faith that real estate will eventually rise again and will generally keep rising forever.

But we do blame the so-called “experts” (investment analysts, economists, government officials, etc.) who should have known better. By looking at the facts rationally, it was not all that hard for us to describe the rising real estate bubble in our first book, written in 2005 and published in 2006. Nor was it so terribly hard for us to predict that the real estate bubble would be the first of our six big colinked bubbles to blow, putting downward pressure on the others. This took insight and analysis, but mostly it took a
willingness
to see it. Without a willingness to see it, the
correct
macroeconomic view is a lot harder to see.

The correct macroeconomic view is that real estate prices
do not
just go up automatically and endlessly without cause. There are real economic forces that push real estate prices up, and if those forces are absent and if real estate goes up anyway, then we have a rising bubble. But bubbles do not rise forever. Eventually, bubbles pop. It is as simple (and as painful) as that.

The popping real estate bubble is an excellent example of what all the other falling bubbles will look like when their time finally comes. At first, we maintain complete bubble blindness for as long as possible, until the rising bubble begins to level off and fall a bit. Then begins the excuse making, aimed at rationalizing what is assumed to be just a temporary downturn. Next, when things don’t dramatically improve, there is more minimizing of the facts and more happy talk about the good old days soon returning. The denial-fest continues and the cheerleading carries on, right up until the moment of the final pop. At that point, it all seems so obvious and the “experts” pretend they have been expecting it all along.