With the bursting of the real estate bubble, everyone is asking when home prices will stabilize. Even more, they are asking when the prices will return to those seen in 2007 before the bubble burst. This expectation that the prices of houses should return to where they were during the boom is a common mistake that is seen in stock investors as well.
To understand the mistake, you first need to understand the psychology of bubbles. Most bubbles involve substantial amounts of credit which allow people to bid up the prices of things beyond where they can be supported if everyone were paying cash. One of the reasons the stock market crash was so great in the 1930’s was that a lot of the stock had been bought on margin. Likewise, a lot of the homes bought in the 2000’s were purchased with no money down and very low payments (at least initially). This meant that the normal price controls – in that if you raise the price high enough there is no one who has the money to buy it – did not work because people were able to purchase homes that were far out of their price range by using credit. This lead to an increase in home prices, which caused more people to get these loans and bid the prices higher. Like all bubbles, prices got to a totally unsustainable level.
The home bubble was even a bit more insidious in that people started taking out home equity loans on the inflated price of their homes, which allowed them to spend money they did not have on all kinds of stuff. This produced a market for vacations, products, and services that would not have been there if people had been paying cash. The size of the true economy was distorted. All kinds of jobs existed to meet demand that was a fantasy.
When homes stopped going up in value, all of the borrowing stopped. This meant that all of the people who were providing all of those goods and services to people who did not make enough money to afford those services lost their jobs. While it appeared that there was enough business for 20 coffee houses and 30 movie theaters and 15 car dealers, there was really only enough business for about half the number of each.
This is the nature of bubbles. The demand is not real demand – it is demand borrowed from the future earnings of people. This creates an artificial economy. The apparent value of things, like the homes, the stores, and the companies providing all of these services is not its true value. It is a castle built in the clouds, ready to fall to earth as soon as the cloud vaporizes.
So be it houses or stocks, just because something once sold for some price does not mean that it was ever worth that price, or that it will ever sell for that price again. Particularly if it was during a bubble that the prices were set. The bad news is therefore that even after the economy begins to recover, it does not mean that the level of jobs will return to where it was, or the price of homes will return. The good news is that it may not take as good paying a job to afford those homes.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.