The curious case of the Houston real estate bubble – An empirical analysis

The Houston real estate market has been on fire over the past 18 months. Since the start Q2 of 2013, we have experienced double digit increases in sales as well as rising prices and rents fueled by low inventories and high demand.

The gallop has felt incessant. Just when you might expect that the market will take a breather for seasonal reasons or otherwise, it keeps sprinting forward. So, in this market climate, it’s no wonder that the hypothesis of a Houston real estate bubble has arisen reinforced by anecdotal “evidence” and largely unrelated 1980s oil crash references.

However, a couple of weeks ago, Trulia released its Bubble Watch report. Mainstream newspapers like the Houston Business Journal and the Houston Chronicle regurgitated the findings without much scrutiny and that seemingly lent some “empirical” credibility to the story.

Here’s where I got involved.

I usually dismiss market studies from companies that are best known for data inaccuracies without a second thought. After all, how much credibility can you assign to a study that finds real estate markets like Las Vegas and Chicago to be undervalued?! But I started receiving calls and forwarded links to articles from concerned clients so I decided to take an in-depth empirical look and share the findings with you here.

It’s hard to argue with anecdotes and I won’t try. I’m sorry to break it bubble proponents but the fact that your cousin’s neighbor’s house sold in 18 hours, 10% over list price to the highest bidder of 15 offers does not constitute evidence for a real estate bubble. Therefore, let’s begin by defining what a bubble is and look at some symptoms that may serve as indication for an overvalued market.

Definitions

In a 2004 Fed letter, Fed economist John Krainer and researcher Chishen Wei wrote:

We borrow from the finance literature to take a different approach. The finance paradigm holds that an asset has a fundamental value that equals the sum of its future payoffs, each discounted back to the present by investors using rates that reflect their preferences. For stocks, the payoffs requiring discounting are the expected dividends. This approach can extend to housing by recognizing that a house yields a dividend in the form of the roof over the head of the occupant. The fundamental value of a house is the present value of the future housing service flows that it provides to the marginal buyer. In a well-functioning market, the value of the housing service flow should be approximated by the rental value of the house.

A bubble occurs—in either the stock market or the housing market—when the current price of an asset deviates from its fundamental value. Right away we see that bubbles are difficult to detect because fundamental value is fundamentally unobservable. No one knows for sure what future dividends are going to be, or what discount rates investors will require on assets. Despite this obstacle, analysts still find it helpful to construct measures of fundamental value for comparison to actual valuations. One popular measure is the price-dividend ratio, which corresponds to a price-rent ratio for houses.

Wikipedia states that “in their late stages, real estate bubbles are typically characterized by rapid increases in the valuations of real property until unsustainable levels are reached relative to incomes, price-to-rent ratios, and other economic indicators of affordability.”

In summary, real estate bubbles occur when property values deviate from their fundamental value as determined by economic indicators that measure values in relation to average rents and incomes. In addition, such deviation usually happens due to rapid increases in property values that are unsustained by economic fundamentals of supply and demand.

Now that we have an idea about what a bubble is and how to identify it, let’s look at each of these factors separately and see how they apply to the real estate market in Houston Texas over the past year and a half.

Economic Indicators of Fundamental Value

There are numerous metrics (economic indicators) one can use to determine the fundamental value of an asset.  Two of the principal indicators are the price to rent ratio and price to income ratio. In the latest report on the Houston real estate market for the month of September, the average single family home price was $196,000 while average rent for the same property type was $20,988/year. Therefore the average price to rent ratio for the Houston market is 9.34. On most investment grade rental properties we analyze daily, the price to rent ratio is usually even lower at 7.5-8.2.

In comparison, the average price to rent ratios in the US is approximately 22! As in, more than double the price/rent ratio for Houston.

Now let’s take a look at the relationship between home prices and income to see if there’s an imbalance. Again the median home price is $196k according to latest HAR data while the median household income is $58,952 (Source: Forbes) so the price to income ratio is 3.32. Put a different way, the median house costs 3.32 times the median income. In comparison, the US price to income ratio was 3.76 in March 2014 (Source: Department of Numbers)

Put differently, neither price to rent nor price to income ratios point to a bubble in the Houston market. Our price to rent ratio is about half the national average and our price to income ratio is in line with the national average.

Unsustainable Rapid Increases in Property Values?

In its summary of the last confirmed real estate bubble in the US. Wikipedia states that “despite greatly relaxed lending standards and low interest rates, many regions of the country saw very little growth during the “bubble period”. Out of 20 largest metropolitan areas tracked by the S&P/Case-Shiller house price index, six (Dallas, Cleveland, Detroit, Denver, Atlanta, and Charlotte) saw less than 10% price growth in inflation-adjusted terms in 2001–2006.[65] During the same period, seven metropolitan areas (Tampa, Miami, San Diego, Los Angeles, Las Vegas, Phoenix, and Washington, D.C.) appreciated by more than 80%.” (emphasis mine).

Is something similar happening in the Houston market? Let’s look at the facts about property values and sales in Houston from 2006 to 2013.

So what do the facts tell us? During 6 out of the last 8 years, the property values in Houston have been moving sideways: Either flat or barely keeping up with inflation. Moreover, during the last two years of recovery, the market performed same as historical appreciation in 2012 and almost reached 10% appreciation in 2013.

If that’s a bubble, I’m an olympic gold medalist.

Again, you don’t have to take my word for it. Just look at the empirical evidence. In the five year period between 2001-2006, markets that were proven to be in a real estate bubble appreciated by more than 80%. That’s an average of 16% per year for 5 years! But that’s not all. Most importantly, the economic fundamentals didn’t change a bit during that period to warrant such an increase. Prices rose just because. Just because there were loose lending practices and people turned their homes into ATMs, just because people speculated that they would all become millionaires but just holding on to their homes for half a decade, just because they thought it was normal for the price on a new home to be 100k higher three months after they bought it. I’m looking at you, Las Vegas.

Unlike that situation, the economic fundamentals in Texas (generally) and Houston (specifically) are present to support a robust recovery.

Let’s start with demand. Houston didn’t just become hip overnight and now all of a sudden everyone wants to move here because we’re the new Orange County. Houston has the highest population growth in the country for two simple reasons: Jobs and low cost of living. During the 8 year period from 2005-2013 employment has grown by 18.6% in Houston compared to 1.8% nationally. Also, Houston has the lowest cost of living among 10 most populated metro areas in the country at 5.6% less than the national average.

When more people move into an area than leave, demand for housing grows. When Exxon Mobil builds a 20 building complex in North Houston that will house 10k employees (many of which have families), demand for housing in that area grows. From basic economics, what happens to prices when supply remains the same and demand rises? They must go up. It’s not speculation – It’s just how the world works.

Now add to that the fact that supply has not remained the same. During the month of June 2008 (arguably the hottest month of year for real estate sales) there were 6.6 months of inventory in the Houston real estate market. Fast forward six years later and inventory during the month of June 2014 is 2.8 months. That’s a 67% drop in available properties while demand rose at the same time! Why is supply down? There are several reasons:

1. Higher sales (demand) are depleting inventories faster
2. Foreclosures accounted for 25% of sales in 2008. They account for about 5% of sales this year.
3. Builders are struggling to fill the supply void with new home inventory

Now what happens to price when demand is up at the same time that supply is low? They rise even faster.

Basic supply and demand is at the basis of home price increases in the Houston market, not some speculative, unsustained inflation of a bubble.

Here’s a final riddle for you: If prices are supposed to decline or remain flat during a recession, what are they supposed to do during a recovery?

The answer may sound obvious, but if it is so obvious why are people screaming “bubble” after one or two years of higher than normal appreciation?

Last but not least, Trulia’s Bubble Watch report (which is basis for most bubble predictions in Houston) posts “Home Prices relative to fundamentals” as their reason for determining if a market is over or undervalued. I would love to know what “fundamentals” they are using because whatever they are, they’re certainly not price to rent and price to income ratios or median home price appreciation over the last 9 years.

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