The Growing Real Estate Bubble

October 7, 2002

Dear Investor:

As the stock market suffers its greatest devastation since the Great Depression, we feel as frustrated as doctors during the Bubonic Plague. The decline of markets has gone further and deeper than we predicted. This is a very difficult time for all investors and we know that many of you are losing faith in equity markets. Please understand that this is a typical reaction at the end of a bear market, one that usually defines a bottom. The only way we have been able to make any client laugh recently is by quoting the recent New Yorker cartoon of two guys sitting at a bar, one saying to the other: “My broker jumped out of a window, but that’s small consolation.”

Money from stocks is logically flowing into bonds and real estate. Unfortunately, this two-pronged safe haven bid is fomenting a growing bubble of menacing proportions. Bond yields have dropped to 40-year lows, artificially supporting real estate prices and in turn making long-term bonds absurdly expensive. People who haplessly climb aboard this new bandwagon will find themselves in the same position as stock investors who were late to the party in 2000: in a dangerous musical chairs game, just as the music stops. When we warned of the risks inherent in the Internet bubble in our newsletters of 1999 and early 2000 (see our website for the original text), we endured tremendous skepticism from many readers. Déjà vu.

We cannot claim to be alone in our early warnings. Both the Wall Street Journal and the Economist—two other publications that warned on the Internet fiasco early and often—are writing of the coming real estate debacle. Few are listening. The Journal just ran a front-page article on October 3 with the following tiered headline: Signs of Strain-After Long Boom, Weaknesses Appear in Housing Market—As Prices Outpace Incomes, Buyers Fall Out of Market And Other Supports Fade. The article begins: “Cracks are spreading in the foundation of the US housing boom, as evidence mounts that the long run-up in home prices can’t be sustained.” Despite its placement on the page, upper-right center, positioned as the most important article of the day, it attracted little attention.

Of course, real estate and bonds are not the same as equities, and there is no doubt that you can live in a house, unlike an Internet stock. We want to make it clear that we think real estate is normally a superb investment–one of the very best. That is why we believe that the best first investment for anyone who is liquid and willing to commit to a location is a home. The tax and leverage advantages of a primary residence are enormous. We also know some very astute real estate investors who are so skilled at direct investment that they can continue to make money in an overvalued environment. We know of one savvy investor in particular who is currently scouring for Brooklyn properties at foreclosure auctions. But this buyer possesses unusual skill at location selection and renovation and therefore has a competitive advantage. His pursuits are analogous to the early-stage venture capitalists who funded Internet companies early on and therefore got in at prices that most buyers only dream of. And the irony is that even he has been recently outbid by outrageous prices above what he considers prudent to pay. But many will get burned, particularly those who are not disciplined in their purchasing.

As the economist Allen Sinai says in the recent Journal article, “I really doubt we will escape [the real estate bubble]…I have never seen an asset market—whether it’s stocks or real estate—that has boomed to excessive prices…without a serious downturn.” Meanwhile, this new speculative mania is starting to take on the classic hallmarks of overleverage and denial. Many people are taking out adjustable rate mortgages at the current artificially low rates because they cannot afford a fixed rate. What now look like low payments will probably balloon to monstrous proportions, causing a bevy of defaults. In effect, these people cannot afford the homes they are buying, but with the sorry prop of a bank desperate to grow its loan book, they are doing so.

It’s interesting in psychological terms that the same people who were clambering for Internet stocks in 1999 are now clambering for 10-year T-bonds and speculative real estate purchases. These people ignore the cardinal rule of buy low-sell high, not because they don’t understand it intellectually, but because they allow themselves to be ruled by emotions. For example, stocks appear so frightening now that no one feels like investing in them. People find it hard to purchase what’s declined in price because it always appears dangerous at the time: they buy into the panicked new ideology of fear on the way down just as they bought into the panicked old ideology of greed on the way up. So stocks are now forsaken. This, though stocks are trading at their best prices since 1932, while real estate commands bubble prices not seen since the late 80’s.

Real estate and bonds appear “safe” now because they keep going up. New ideologies emerge to explain this “safety,” namely that bonds are “guaranteed” and that real estate is always attractive because you can “touch and feel it.” These people apparently did not live through the early 90’s when real estate collapsed nationwide, bankrupting many landlords and savings and loans, and causing the average home price to plummet. During this period, speculative “flippers” who got caught with property when the music stopped found themselves in Chapter 11 rather quickly, regardless of the amount of touching and feeling. Apparently these people were also on vacation in 1994 when bond yields skyrocketed due to several Fed rate hikes, causing devastating loss of principal in long-term bonds and rendering the guaranteed yield useless.

It should be noted that we are also great fans of bonds at the right price. We always rely on large bond positions for conservative portfolios. Unfortunately, we have had to shorten average duration to under two years in our client portfolios to protect against the massive interest rate risk that is building in bond prices. This decision sacrifices yield but will pay off when long-term bond prices sink. There are still some going out ten years to eke out that little bit of extra yield and it begs the question once again: where were they in 1994 when bond investors lost their button-down shirts?

Are memories really this short? Now people feel stocks will never go up again, just as they thought they would never go down again in 1999. People who climb aboard trends are sensitive to swings in public opinion, and they make money in the short-term, as the trend temporarily follows its own momentum. But this oversensitivity is their ultimate undoing as they react too fervently and rashly. They make the cognitive and very human mistake of thinking this time is “different” and that these price distortions have never happened before, supported by the feeling that we live in “unique” times, “worse than ever” before. However, this feeling is always false and shows a marked and disturbing ignorance of history. History is always changing the world, but few times are as unique as people feel they are at the time. What’s more, this feeling leads investors to buy high and sell low.

I doubt Americans were feeling very sanguine about the world in the 1860’s when the Civil War threatened to end the Union, or in 1932 as 44% of all banks collapsed, or in 1941 after the Japanese bombed Pearl Harbor and brought us the deadliest war the world has ever seen. I doubt most people were delighted when Fascism ruled half the globe or when Communism threatened nuclear annihilation on a daily basis. According to most chronicles, Americans did not see times as routine during the Cuban Missile Crisis or in the early seventies when the US lost the Vietnam War, its very first major defeat. Not many Americans thought it business as usual in 1974 when we saw a President resign for the first time in history, or during the Iran hostage crisis, or leading up to the last Gulf War. Who, on the cusp of each of these events, did not feel they lived in unique times? Who did not worry the world was coming to an end?

In fact, at each of these points in history, emotions ran to despair, newspapers universally proclaimed that the world would never be the same, and the stock market sank to alarming lows. At each of these moments, it was a small club of Americans indeed who wanted to put a nickel in stocks. But after every single one of these events, the stock market returned to new heights, and the world did not end. In a remarkable example, the Dow went from a low of 41 in 1932 up to 194 in 1937—a startling quintupling during the depths of the Great Depression, when people were lining up for soup lines instead of stock tickers. Those who sold at the 1932 low hammered the final nail in their own coffins.

During the seventies, many people literally thought America was coming to an end. And very few people wish to ante up a chip at a casino that won’t be around tomorrow. But these people were underestimating America. To their credit there were a few brave souls buying stocks at that time: Warren Buffett, Peter Lynch, Marty Whitman, Charlie Munger, and Lawrence Tisch.

Real estate prices are unlikely to “collapse” like stocks. They are more likely to trend sideways or slip gradually as interest rates perk up. But going forward, both bonds and real estate are likely to underperform equities over the next ten years, just as they have over the past 100.

Even those who are not convinced by the weight of history that what goes up comes down (and what goes down comes back up) should maintain a wisely diversified portfolio, allocated among real estate, stocks, bonds and cash.

We very much appreciate your support and patience during this very difficult time in markets. Please call with any questions or concerns.