The Philosophical Investor: Real Estate Bubbles

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By Gary Carmel | Special to the NB Indy

I have been a student of financial bubbles for a long time, and being in real estate I have lived through a few of them myself. Here are some of the main catalysts for creating bubbles and their subsequent crashes:

 

  • Government incentives can dramatically boost demand but if those incentives change, then demand can also be eviscerated. In 1981 the tax laws were altered, allowing people who invested in real estate to apply the accounting losses from those investments to offset all other forms of taxable income. This led to an enormous demand for real estate, especially among individual investors, since they could reduce their taxable income generated by their wages and other investment income. The demand for buying and building real estate was tax-driven and not based on traditional supply and demand fundamentals. The bottom fell out when oil collapsed, the tax laws changed in 1986 which no longer allowed investors to offset passive losses from real estate against active income, and the terrible and illegal business practices of the most aggressive lenders, S&Ls, were exposed.

 

  • When there is a significant loosening of credit standards and availability, this is a big red flag. Like tax law changes, this can create a huge increase in demand that can then be reversed when easy lending practices go too far and credit tightens again. It’s important to always ask “who will buy this property when I want to sell it?” If it’s the type of property that requires a buyer who needs very loose lending standards, then you need to know you’re taking a big risk that if credit standards tighten up, then the buyer pool may shrink significantly and the price will be negatively impacted.

 

  • Buying lesser quality real estate during good times and believing that this prosperity, which could be temporary, is the same as safety. When the tide goes out, the properties with the most vulnerable occupants and lower quality locations get hurt the most because there is not the same economic demand to backfill the weaker occupants who have left or stopped paying rent.

 

  • Not having a margin of safety to withstand an inevitable downturn. Real estate can be a forgiving asset class if you have the financial wherewithal to manage through challenging market conditions. Problems arise when too much leverage is deployed and cash flow drops so the debt cannot be serviced and/or property values have dropped, loans come due, and there is not enough equity to refinance the loans. It’s important to make sure one has access to cost effective capital to manage through the tough times.

 

  • Speculation is also a hallmark of every real estate bubble I’ve experienced. It’s predicated on making easy money by flipping properties and often times the speculator uses a great deal of leverage via short term loans. They are buying for quick profits and throwing out traditional valuation metrics. When the tide goes out and they cannot sell their properties for the prices they thought and as quickly as they were expecting, this source of demand becomes a large source of panicked supply. This happened with many condo and home flippers in 2007 and 2008.

 

I don’t see the same excesses in real estate now that were present during previous bubbles. Lending is not out of hand, the government’s involvement seems to be muting speculation, and the “get rich quick” psychology is not present. This is no dotcom environment where companies were priced on newly invented financial metrics to justify insane valuations. Real estate is trading hands based on valuing the cash flow in place versus emphasizing where it will be in future years. There are of course exceptions like the Bay Area, but overall I don’t see many excesses that would lead me to be overly cautious.

Gary Carmell is President of CWS Capital Partners, a real estate investment management firm based in Newport Beach, California and Austin, Texas. He is the author of the book “The Philosophical Investor: Transforming Wisdom Into Wealth.” For more information, visit garycarmell.com and cwscapital.com.

 

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