Some Bubble-Speak
by Jim Scott

I can usually count on at least one person each day inquiring as to when the current real estate bubble will pop. There is a base assumption that it is not so much a matter of if but when. Some of us remember 1990. The average price per square foot in North Mission Hills was $228 and that by 1994 it was $168. Market corrections are normal and maintain the overall economic health of the marketplace. Without cycles, market distortions can become permanent and eventually causing that particular market to self-destruct. The business cycle is exactly like nature's method of maintaining forests—a good forest fire is healthy in the long run. Before you run for the phone, I am not suggesting there is a looming real estate disaster. The current high inventories and inconsistent marketplace are business as usual. This is not to say there is smooth sailing ahead. The market will be buffeted by external economic and political events through the end of 2005 and many knowledgeable voices are arguing to the contrary.

Accordingly this discussion cannot ignore the sheer volume of studies, articles and other reports on the impending price implosion in residential real estate. The argument goes basically like this; prices of homes have risen far higher than the increase of the aggregate income of consumers. Therefore the ability to purchase homes has lessened leading to a decrease in demand. This in turn forces prices down. Economists from HSBC just issued a report wherein they argued persuasively that “Expectations of future house price appreciation are spectacularly, and unrealistically, high” and that “This bubble-psychology has manifested itself in very rich valuations,”

The argument noted above is convincing. The study shows how past price corrections have always followed period when prices outstripped incomes at the latter stages of a bull market in real estate. Granted our pricing structure is certainly influenced by global issues, the national and state economies as other influences outside the County. Most scholarship and studies are national in scope and do not necessarily apply directly to this market. San Diego has other issues to consider.

Which brings me back to the issue of the residential bubble. A recent study by economists from the Federal Reserve Board argues contrary to the HSBC report. They said that “…it appears that home prices have risen in line with increases in personal income and declines in nominal interest rates,...” A more telling conclusion is that “the supply of housing in those states appears to be inelastic, making prices there more volatile….much of the volatility at the state level is the result of changing fundamentals rather than regional bubbles.” In other words, the inability of the market to meet demand by increasing the supply of new housing will continue to prop up the current pricing levels. As long as it is painfully expensive and difficult to produce new housing in San Diego prices will remain at their lofty levels. The only cloud is the prospect of even higher interest rates.

Since rates have moved up since the beginning of the year, the Fed report may seem at first blush to be wrong. But the market has long factored in higher rates. Consumers anticipated the increase and jumped in the market in record numbers early in 2004. The current lull is nothing more than a market respite, not the beginning of a correction. The current inventory levels, widely perceived as a harbinger of ill winds, are really nothing more than seasonal variations. Compared to the past winter, they may appear to be unreasonably high. In fact, they are normal. Any property that is appropriately priced should sell quickly. Demand for property is undiminished; sellers may need to adjust their expectations to get their home in escrow.

 I am more concerned about the apartment and commercial markets. Because of the prices paid, the success of these investments relies on the ability to raise rents over a period of time. In observing our local market in apartments for example, it is apparent people are placing bets that rents will increase at a rate substantially over inflation. Commercial property investors are assuming the local economy will continue to produce additional jobs that will drive demand for office, retail and industrial space.

These investor's assumptions are perhaps predicated on another supposition. It may appear buyers are grossly overpaying for commercial property but there may be other issues. Foremost are two factors; population increases and job growth should remain positive over the medium term and second, land and infrastructure limitations are destined to rule this market over the long term just as in the residential sector.

This means commercial investors are betting long that supply will really dominate the future market, not demand. In other words, we are running out of land and the means to support development infrastructure. Population increases will outstrip the County's ability to create shelter and commercial space over the next ten years. So get out the checkbook.

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Read Jim's back articles at www.sqre.com or call him for selected back issues, 619 920 9511

I welcome your comments; my email address is jimscott@sqre.com.

You can reach Jim Scott at his office, conveniently located in the heart of Mission Hills, at 1111 Fort Stockton Drive. Founded in 1982, Scott & Quinn is the oldest full service real estate firm in Mission Hills and is still locally owned and operated. Jim has been a homeowner in Mission Hills since 1976. He is married and has two boys. He can be reached at 296-9511, extension 100. Scott & Quinn features professional property management as well as 15 sales associates. Click here to see Jim's past Market Reports .