Is there a housing bubble? There is plenty of chatter comparing the recent increases in housing prices to the housing bubble that kicked off “The Great Recession” in 2008/2009. Back then, everyone was getting into real estate and prices were soaring. Is there a bubble this time and will it pop?
The underlying question here is really about whether this is the right time for you to invest in real estate. Here are some more personalized thoughts on whether now is the right time for real estate.
What Caused the Financial Crisis?
Have you ever seen or read The Big Short? If not, and you’re considering real estate, you have to read it. It is a great example of a housing bubble. It’s an awesome and terrible story, and it does a great job connecting the “boots on the ground” feel of real estate investing to large financial institutions and the broader economy.
Here’s the short version in my own words. Most of the time, when you take on a mortgage, the company you worked with sells it to someone else. They may continue to service the loan, collecting payments and managing the escrow for your taxes and insurance, but they probably don’t own it. Instead, your mortgage gets shipped off to a financial institution that packages your mortgage into a bundle of mortgages that gets sold to large institutions. These are called “mortgage backed securities” or “MBS” for short.
Those packages are then split into buckets (called tranches, but I like buckets). The first bucket always gets paid before the second, which always gets paid before the third, etc. A bit of a waterfall effect. The idea here was because defaults would hit the lowest buckets first, even though the mortgages weren’t high quality, the highest buckets were very safe thanks to diversification.
Even some of the lower buckets were deemed safe. The idea behind diversification was that while some areas of the country may hurt in real estate, it was unlikely the whole country would suffer at once. This turned out to not be true. Big banks failed (or were saved) because their “safe” investments evaporated overnight. The shock to the system froze everything, and so began The Great Recession.
Financial Crisis in One Paragraph
In 2007/2008, it was incredibly easy to get a loan. If you were a mortgage officer, why wouldn’t you hand those things out like candy? You got paid to sign them and the demand from your buyers was massive. You and your company had no risk since you quickly sold the mortgages to someone else. The buyers of those mortgages packaged them up in a confusing mix and sold them again as safe to investors who were all too willing to buy. The result was poorly vetted mortgages with buyers that didn’t have the financial backing in place to pay. When things began to collapse it created a domino effect taking down first a few mortgages, the big banks, then the economy, then more mortgages.
Are We Heading for a Housing Bubble Today?
We plugged that hole. It’s much more difficult to get a mortgage today than it was in 2007. However, that doesn’t mean we’re safe from a housing bubble! Pretty much every crisis we’ve had over the last several decades has been caused by too much risk due to debt.
In the Great Recession, it was mortgages and mortgage backed securities. The dotcom bust almost didn’t get a chance to happen because Long Term Capital Management (LTCM) nearly crashed the economy in 1998. There’s another book you should read on that one called When Genius Failed (link below). In the 1980s it was the Savings & Loan (“S&L”) Crisis brought about by the Reagan Administration’s deregulation of S&Ls. The deregulation was done with good intention to allow S&Ls to compete, but the reality is they offered high rates and made big bets with their own investments to justify their high rates. When the rates didn’t pay off, the Federal Government covered the bill.
I don’t know if there is a bubble today. If there is, it is not clear if we will float down after COVID, or if something more violent will come along and stir things up. What’s more important is that you adequately manage your own risk levels. There may be a housing bubble, but you may miss a decade of increasing home prices between now and then. It is not difficult to “call” these things, but it is difficult to time them. Shout from the hills about a bubble for a decade or so and you will eventually be right!
Why Was 2008 Not Great For Real Estate Investors?
Well, it was great if you were on the sidelines and picking up deals left and right! If a housing bubble pops and you have cash, there are going to be some great bargains. For many who had already invested in real estate, they found themselves underwater on their loans. That means the value of their home was less than the loan that they had taken out. They could not sell the property without making the lender whole. The result was a big chunk of money out of pocket equal to loan value minus sale price.
If you had invested for appreciation potential and not cash flow, you might also have found yourself losing money every month with no way to exit the investment. Banks suddenly held many properties they didn’t want after defaults. If you were one of those investors smarting from the decline in home values, you probably weren’t picking up the properties for pennies on the dollar!
What Can I Do Today if I Think There is a Housing Bubble?
Don’t overextend yourself. If you find yourself looking at great numbers in your spreadsheet projections and considering how little you can possibly put down, perhaps now is not the time. In other words, don’t be like those big financial institutions from the past taking on too much debt.
However, a great deal in a good neighborhood can still make sense. Also, rents tend to be stickier than home prices so if you invest for cash flow, that could potentially help keep you afloat even if the price of the home falls.
