Robert Shiller is worried about a new housing bubble.

Dr. Robert Shiller, one of the creators of the famed Case-Shiller Housing Index expresses his concerns about the formation of a new housing bubble in this interview with Fox Business Channel.  At the beginning of the interview, Dr. Shiller points out just how much government policy is supporting the housing market through Fed policy, Fannie, Freddie, FHA and the tax code.   In fact, he is surprised that despite so much support, the housing recovery is not stronger.

More importantly, he points out that when you take into account the record low mortgage rates that have driven the housing market, home price appreciation, in real terms, is more moderate than people think.  Although he is not predicting that home prices will go down in the next year or so, he is concerned that as interest rates return to historical norms, it will have a dampening effect on both the housing market as a whole and home prices in particular.

Is this the beginning of the end of home price increases?

The substantial run up in home prices caused by strong investor demand and a shortage of inventory may be nearing an end.  With the double digit increases in home prices over the past year, fewer people are underwater with their existing homes and are starting to put them on the market.  As this article in the LA Times points out, the recent price appreciation has also spurred homebuilders to increase their production.  With this new inventory coming from both existing homeowners and new construction, combined with rising home mortgage rates off their historic lows, forecasters are predicting home prices will begin to stabilize and home price appreciation will moderate.

Is private equity starting to head to the exits?

It is no longer a secret that much of the recent run up in housing prices is the result of institutional investors and private equity buying houses on a bulk basis.  This has made it very difficult for traditional buyers to compete in the current market as the investors are buying with all cash forcing traditional buyers to scramble to compete when they are dependent on obtaining financing in a more conservative lending environment.  In some cases this has led traditional buyers to feel so desperate at the prospect of being frozen out of the market that they offer significantly over list price just to win a bidding war.

It is important to remember that it was just this fear of being left behind that led to much of the irrational exuberance near the height of the last bubble.  It is also worth remembering that investors want to foster this perception in the market because buyer sentiment is critical to home price appreciation, which is key to their investment strategy.  As this recent New York Times article points out, while investor capital continues to say that it is in housing for the long-term, investors’ actions are showing the first signs of heading to the exits as they scale back their acquisitions and take money off the table in the form of IPO’s.  It is worth remembering, a smart investor is not likely to tell you what they are doing until they have locked in their position so they can profit off your response.

How strong is the housing recovery?

We have seen meaningful price appreciation in most housing markets over the past 24 months. With double digit annual gains and bidding wars for homes being reported in some markets, it is tempting to think we are at the beginning of another bull market in housing. But the big questions that remain are how strong is the current recovery and how sustainable is it?

While there are certainly signs for optimism, there are also strong indicators for caution as well. As Rick Newman points out in his article in US News and World Report, there are 5 Reasons the Housing Recovery Remains Wobbly. They are:

1. Lack of good land for development;

2. Record low interest rates are due to rise;

3. Recovery is dependent on government aid;

4. Foreign buyers are driving up prices; and

5. The recovery is focused on certain markets (see 4 above).

While Mr. Newman focuses on 5 signs that homes may be overpriced, the key take away is that a homebuyer’s biggest risk is primarily in the next few years. If you are buying a home today as a short-term investment, you may want to think twice. However, if you are buying a home as a long-term residence, now is probably as good a time as ever. With 30-year mortgages at the artificially low rate of 3.5% you can lock in your housing costs for the next 30 years and enjoy the savings when interest rates return to their historic norms.

Unfortunately, even if your plan is to live in your new home for 10 years or more, life has a funny way of interrupting those plans. That is why it is always prudent to have some downside protection in case your circumstances unexpectedly change.

Can young buyers pick up the slack when investors pull back from the market?

In US News & World Report, Robert Dietz, an economist with the National Association of Homebuilders, asks the question, “What Happens to the Housing Market When the Investors Leave?”  Mr. Dietz points to the fact that the Great Recession forced many younger individuals to delay the formation of new households by moving back in with their parents and/or delaying marriage.  Implicit in his opinion piece is the assumption that there is pent-up demand for new housing once these individuals return to forming new households.

This is not an unreasonable assumption.  However, it may be based more on wishful thinking than actual data.  Recent college grads should hold the best prospects for forming new households and re-entering the housing market.  Unfortunately, Mr. Dietz does not take into account that the tepid pace at which jobs are being created has left a significant portion of this demographic either unemployed or underemployed.  Combine that with the fact that this same group has over $1 trillion in outstanding college debt to be repaid, more of which is going into default every day, and it begs the question, even if they want to form new households or buy a new home, do they have the means to do so?

If economic and job growth does not materially improve, it is hard to see where the resources will come from for them to do so.

Are foreigners buying up the American Dream?

We have seen the stories about large pension investors and  private equity getting into the business of buying up SFRs  to fix them up, rent them out and then sell them off for a large profit once the market recovers.  With the strong rental market and the recent uptick in housing prices, this would appear to be a winning strategy, at least so far.  However, once the herd gets a whiff of short-term success, money starts crowding into the market chasing these higher yields.  This results in more competition driving up prices on an ever shrinking pool of “distressed” housing and making the returns that the early entrants enjoyed, harder to find.

Now we can add the foreign buyer, who is not only chasing higher yields, but as the WSJ points out, is also trying to take advantage of favorable foreign exchange rates.  With this new development, investors who are looking to buy SFRs not only need to beware of the institutional yield chasers but the ForEx speculators.

This does not bode well for a sustained housing recovery because both the institutional investors and foreign buyers are treating SFRs as commodities that can be traded for yield or ForEx gains, much like they did when they were packaging and selling off subprime mortgages.  However, owning and operating SFRs for rent is an inherently inefficient business model for institutions because it requires too many levels of administration from the money manager, to the asset manager all the way down to the local mom & pop property manager whose job it is to collect the rent, mow the lawns and unclog the toilets when the tenants call.  As with subprime lenders, once you are done paying the fees to all of these service providers, there is not a whole lot of yield left for the investors.  When the initial wave of fast home appreciation fades and the yields no longer justify all of the fees being incurred to operate the homes, it is reasonable to expect that the money will leave this new cottage industry as fast as it entered. . . and then where will home prices go?

Risk Still Present in the Market

In an interview with the WSJ, housing guru and creator of the S&P/Case-Shiller Housing Index Robert Shiller states that despite recent improvements in housing prices, risk still remains in the market.  While Shiller sees upward momentum, he is not ready to say the market has bottomed out.  He does not see much enthusiasm in the market and has concerns regarding the impact of the high level of government support for housing (i.e. low interest rates and the government backing almost 90% of all mortgage originations through Fannie & Freddie).  While one could say he is cautiously optimistic, he attributes much of the recent price spikes in some indexes to a slowdown in foreclosures and some markets overshooting on the downside.  In conclusion, he sees today as an “OK” time to buy a house as most homes appear to be fairly priced and mortgage rates are near historic lows.  He is predicting modest price appreciation more in line with historic norms of 1% – 2% per year.  If you are buying a home to live in, now is still a good time to buy but if you are buying a home strictly as an investment, you will want to be careful.

Is another bubble starting to form?

As housing inventory continues to drop and sales continue to increase, we are beginning to see annual home price appreciation approach double digits in select markets. While it is exciting for those thinking of selling their homes to hear stories of new listings getting bid up over list price and being put into escrow within days of going on the market, we are reminded that this is not necessarily evidence of a sustained and healthy market recovery. As reported in Investors Business Daily on February 14, 2013, this may instead be a sign of another bubble forming within the larger housing market.

Buyers should beware that data showing signifcant year over year price increases may be indicative of substantial activity from investors and flippers.

Over the past 18 to 24 months, investors have been snapping up foreclosures at liquidation prices, fixing them up and then reselling them.  However, most home price indexes don’t take into account the renovation costs.  For example, if an investor purchases a home out of foreclosure 12 months ago for $150,000, invests $50,000 to fix it up and then sells it for $230,000. This will show up in the local market statistics as a 53% increase even though almost 2/3 of the appreciation was due to the improvements. It only takes a few foreclosure flips in a local market to skew the averages and make price appreciation in that market appear much higher than it truly is. As such, both buyers and sellers need to be aware of what data is behind the statistics before buying into significant price increases in a local market.