The Morning Report
Get the news and information you need to take on the day.
With the median San Diego home price recently having exceeded its prior bubble peak, there is some concern that the housing market may be entering bubble territory again. But while San Diego’s housing market is certainly hot, and its home prices a good deal more expensive than usual, it’s hard to make the case that this is a genuine bubble.
A bubble is more than just a market that’s become pricey. Investment bubbles are characterized by extremes in two areas:
• Valuation: Prices become exceptionally high compared with the economic factors that have typically driven pricing in the past. Often, prices and valuations will experience very rapid increases.
• Psychology: Investors are optimistic to the point of euphoria. They are dismissive of risks (and skeptics who raise them), and seem to fear only missing out on further gains.
San Diego housing in the mid-2000s was an absolutely classic bubble. From 2001 through 2005, local home prices increased 63 percent faster than incomes and rents. At their peak, home valuations reached 73 percent above the historic norm; the highest it had gone previously was 12 percent above normal, and that had led to a six-year downturn. By mid-bubble, prices — already totally unhinged from their fundamentals — were growing at a blistering pace, as much as 33 percent in a single year.
As for the sentiment … I was a housing skeptic on these pages, so I could go on at length. Suffice it to say that one reader informed me that by not buying a house, I was dooming myself and all my descendants to be part of a new permanent underclass of non-homeowners. That was one of the nicer comments.
Things look quite a bit different in 2017.
The best way to measure housing valuations is to compare home prices with rents and incomes. By this metric, home prices — while far less expensive than they were at the bubble peak — are indeed higher than average.
But it’s important to distinguish valuations that are simply on the expensive side from those that have reached bubble-like extremes. A good approach was developed by a well-known investment manager and bubble scholar, Jeremy Grantham, who proposed that a market had become a bubble if its valuation reached two standard deviations above its historical fair value. (In somewhat plainer English, this roughly means that the valuation rose to a level that would statistically be expected to occur less than 2.3 percent of the time). This has actually turned out to be a good metric; nearly every market in history that reached this level of valuation has eventually ended up “bursting” in a return to historical average value.
Here’s a graph of San Diego housing valuations with the Grantham bubble threshold highlighted in green:
By this definition, home prices would have to rise a further 18 percent in excess of rents and incomes to qualify as a bubble. And that’s without factoring in today’s unusually low interest rates, which, by keeping monthly payments reasonable, could support higher-than-normal home prices for as long as the low rates persist.
The breakneck price increases often seen during bubbles is also lacking. Home prices have risen at a solid clip in recent years, but nothing like they did in the last decade’s bubble. This is seen in the graph below, which charts home price changes during the last three years alongside the three years leading to the bubble peak.
The sentiment of market participants is a lot more subjective, but there doesn’t seem to be any comparison to the exultant days of the mid-2000s.
There is the optimism that’s typical of a market that’s been doing well, but it seems tempered with at least some analysis and sense of caution. The chest-thumping, the implausible narratives, the cavalier risk-taking, the fear of missing out — all the behavioral red flags that were flying high during the bubble — are largely absent, at least in my observation. The prevailing mood is good, but it’s not euphoric.
The question of whether housing is in a bubble is more than just semantic. Bubbles usually end very badly, whereas merely expensive markets stand a much better chance of coming in for a soft landing. (San Diego home valuations would be back to normal, for example, if prices simply flattened out for four or five years while rents and incomes continued to grow at their recent pace.)
San Diego homes are expensive, for sure — the priciest, compared with rents and incomes, that they’ve ever been outside of the bubble era. This poses challenges to our city and risks to the market itself. But the housing market exhibits neither the valuation nor the behavioral characteristics of a true bubble.