How do you analyze potential market bubbles?

Question

Not looking to debate whether we’re in a bubble or not, just how the pros out there do the analysis to decide for themselves when it’s time to offload a live-in flip.  Here’s my situation:

- Military, using a no-money-down VA loan

- Bought a live-in flip property at $645K and invested $35K in moderate improvements

- Purchased in the Los Angeles county, South Bay Area (Redondo Beach, Torrance, etc)

- Current market value is ~$723K; lots of folks are talking about a bubble again

How would you start analyzing the market to determine if we’re nearing a market correction?  What factors, trends, statistics, etc would you consider? How do you factor in “micro-markets” such as those in Los Angeles where

Property Values can vary by large swings ($100K or more) from one street to the next?  What resources (websites, etc) would pull the data from?

Again, not looking for opinions on market bubbles.  I’m looking for how intelligent investors quantitatively analyze and determine what what a market is doing in their local area.

Doug Smith · Answer

Hi Jim,

Trying to guess what a market is going to do can be dicey at best, but there are times where a bubble is pretty obvious. We were very accurate at predicting the last bubble. As a matter of fact, we actually underestimated it. Recently, the movie “The Big Short” was on. Normally, I don’t watch TV, but I seem to always stop and watch a few minutes of that when I see it on. The movie made it seem like no one saw the last crash coming. That’s not true. Many of us did. As a matter of fact, most of the other fund managers out there were in lock step. I wasn’t alone. Here are some of the main things to look for.

DEMOGRAPHICS: I remember in 2005 watching from my office window all of the construction cranes putting up condos that would be priced well above $500,000 and many above $1 million. My big question was “Who is going to buy all of these new housing units?” New housing units in the area were well outpacing the number of new jobs and new migration to the area. In other words, we were building more houses than we had families to move into them. Real estate Is not like “The Field of Dreams.” If you build it, they don’t always come. In addition to that, the new jobs that were being created were not paying incomes that would support the purchase of the price-points of the new homes. The law of supply and demand eventually takes over and you get a bubble.

REAL ESTATE PRICES AND RENTS VS INCOMES: I touched on it earlier, but the when you see the increase in housing (and rental) prices outpace the growth in incomes over a longer period of time, it’s time to worry. The same supply and demand principals start to kick in and eventually the housing costs are more than people are able and/or willing to pay. You then can get a bubble.

When you see housing and economic numbers reported, remember two things. Journalists are not economists and they tend to have a weak grasp of what is really happening. Second, the data that is being reported is old. We started a real estate sales arm of our company and it has been a blessing in that it acts as a canary in the coal mine. We see the traffic of customers wanting to buy and the sellers wanting to sell long before the numbers are reported. There might be a 3 to 6-month lag in reporting, so seeing that activity can help you shift your focus when you need to act.

It’s sometimes very difficult to have a crystal ball, but staying objective and watching indicators such as the ones I have listed above will truly help.

Good luck. I wish you a prosperous 2020!

Brian Ploszay · Answer

Are certain markets over-heated?  Yes, but a real estate crash like the last one in 2008-09  - coincided with a crash in mortgage lending.  So I would pay attention to markets when there are upticks in foreclosures.  If prices start to "crash,"   owners can't liquidate their properties by selling.  They are under water and will return properties to banks.

Prices in Southern California make some think that a bubble is on the horizon.  For sure, average middle class families are finding it very difficult to afford houses.

The cause for the high prices is a local one.  California leads the country as the most difficult place to develop new housing.  Lots of zoning and other regulations, including NIBY movements (not in my back yard) have caused the demand to outstrip the supply for nearly 30 years.  The acute shortage of housing has caused the prices to escalate.  Those who do venture and buy housing often spend a higher percentage of their pay check(s) on mortgages than other states.

I love how markets operate.  Since California can't build more housing stock quickly (supply) potential buyers (demand) are leaving the state.  In other words, a consequence of this is that California is losing residents, primarily middle class residents, going to more affordable state like Arizona, Nevada and Texas.

Unfortunately, the shortage of housing has made former "affordable housing" become an endangered species.  A consequence of this is a surge of homelessness in L.A. Country.

Will Barnard · Answer

Hi Jim, thank you for your service.

You can mostly ignore media and the scuttlebutt on the street of pending crashes or corrections as they are just a bunch of people guessing typically. Follow closely the average days on market (DOM) and inventory levels and as they change from quarter to quarter,   you can get a better feel for where the market is heading. The affordability index is also a chart you should follow, it speaks volumes and ignores the crystal ball people.

I was of the opinion (at end of year 2016) that a pending correction was coming in summer 2017. I was wrong too which to my point, mostly ignore the talk on the street. Data speaks louder than that and is more meaningful.

David M. · Answer

Check out Bruce Norris.  He's well known for his numbers-based analysis of the CA market.  He's speaking at a local REIA meeting sometime this week (up near the 405/90) .  I know you're looking for micro analysis but looking at his state-level charts will give you a great set of metrics to use in our local area.  The challenge will be finding sources for the micro data.

FWIW, our South Bay area generally holds its own pretty well because of the schools, lots of local jobs, and proximity to great beaches.  During 08/09 my rents in Redondo didn't go down and I had no trouble finding new tenants.  Not saying it can't go down but it's been more resistant.

Btw, based on the numbers you provided you'd be taking a loss after standard commission and closing costs if you sold right now.

Marian Smith · Answer

@Jim Horne  The blog “calculated risk” follows economic reporting related to housing with a Cali viewpoint.  And occasionally you will see...maybe you can research...that a mortgage insurance issuer is raising rates on an area due to risk of overprice vs sustainable value, or whatever they call it.  Their business depends on them evaluating bubble risk in the mortgages they insure.

Jim Horne · Answer

@Doug Smith

Thanks Doug.  I love that movie but I was always suspicious that there was a bit of over dramatization.  Appreciate the tips!

Jim Horne · Answer

@Will Barnard

Thanks Will, it’s been a great career and I’ve really enjoyed opportunity to serve.

I remember you mentioning your thoughts on an LA bubble at a meetup I attended in Manhattan Beach last year and it definitely got my attention.  The area we live in is a bit of an urban island (one block any direction and the market takes a step down) with a top tier Elementary school that’s attracting a lot of folks priced out of the Manhattan and El Segundo markets that really want to own a place.  That’s definitely putting some upward pressure on prices in our area, especially for homes purchased from retiring or aging homeowners that have been updated like ours.  Thanks for the pointers!

How do you analyze potential market bubbles?

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