Freddie Mac: No Housing Bubble

The author below disagreed with Freddie MAC almost a year ago and was dreadfully wrong.

Perhaps the author could be persuaded to revisit this commentary and comment on the current situation?

Fool.com: Freddie Mac: No Housing Bubble [Commentary] July 30, 2004

According to Freddie Mac, the housing market remains rational. While Cutts cautioned that rational markets can fall based on underlying economic conditions, they don’t exhibit the boom and bust characteristics of bubbles. She offered six reasons why Freddie Mac doesn’t believe that a housing bubble exists:

1. Supply of housing for sale is low. The current inventory of new and existing homes for sale is lower today than it has been in the last 20 years. For new homes, as the homebuilding industry has consolidated, such homebuilders as KB Homes (NYSE: KBH), D.R. Horton (NYSE: DHI), Lennar (NYSE: LEN), or Centex (NYSE: CTX) have increased their share of the market over small, local players. These larger, more sophisticated homebuilders use options and other tools to minimize the capital they put at risk in particular housing markets. As a result, Cutts argues, the supply side of the housing market can adjust to changes in demand much more quickly than it could in the past. If demand drops off, supply can be quickly cut back, which basic microeconomics tells us will mitigate any steep drop-off in price.

2. Housing doesn’t resemble the typical bubble asset. According to Freddie Mac, the purpose of a typical bubble asset is investment, not consumption. In addition, typical bubble assets have low transaction costs and are held for short periods of time — speculators can buy and resell the asset rapidly to make a quick profit. Housing is different. The transaction costs are high, holding time is typically quite long, and most people buy homes primarily for consumption, not investment.

3. Mortgage rates are low. Freddie Mac argues that even with the recent increase in mortgage rates, we are still very far away from the 30-year mortgage rates above 10% that existed in the early 1990s. Even if rates were to rise 100 basis points, rates would still be below the 1971-2004 average of 8.5%. With sustained lower mortgage rates, people can — and will continue to be able to — buy more expensive homes.

4. User costs are negative. Related to the previous point, as long as mortgages are low and home prices continue to rise, net user costs are negative. Freddie Mac argues that interest (after tax), maintenance, and taxes approximate 6.5% of the price of a house. If the home price rises at 6.5% per year, the owner gets to live in the house “for free.”

5. Household incomes and house prices in balance in the long term. Freddie Mac’s presentation includes data that illustrates that between 1991 and 2001 the growth in home prices and average household income has been about the same. Cutts does concede that if these data were extended to 2004, a gap would exist. (According to The Economist, the ratio of home prices to average household income is now at a record high: 14% above its long-run average.) But she argues that the ratio needs to be compared to similar points in the business cycle — she now expects wage growth to accelerate as the economy recovers and “catch up” with home prices.

6. Rent vs. price growth is aligned. The equivalent of the P/E ratio in the real estate market is the ratio of home prices to rents. In the U.S., again according to The Economist, that ratio is now at a 20-year high and more than 15% above its average value between 1975 and 2000. Freddie Mac argues that this data is misleading, because it does not take quality of housing into account. Cutts claims that quality in rental housing has not kept up with the increasing quality of homes that are owned. As a result, the widening ratio is explained not a by a bubble in home prices, but rather by a widening spread in the quality of homes for rent vs. those for sale.