Prices are rising- does this mean that the market is in a bubble?
Those familiar with Austin can see that the market is currently rising at a rate that is steep and unprecedented. If you follow closely, you know that this increase did not come from nowhere. For a variety of reasons, Austin property values have been on the rise for years.
But this post isn’t about Austin. Instead, I want to address the question of whether a rise in market value is necessarily a real estate bubble.
So, what exactly is a ‘bubble’ in the world of investing? First, let’s talk about something more basic- value.
The simplest way to discuss value is according to the cost of creation. How much does it cost to produce what is being purchased? There must be a correlation between production costs and sale prices.
If I were to start a pizza business and try to sell each one for $100, I’d probably go out of business fast. Competitors would be able to market their pizzas at cheaper prices and I most likely would not be able to compete. For the same reason, selling pizzas at $0.10 a piece wouldn’t be sustainable either since pizzas cost more than that to produce (This would also seemingly mean that I’d be eating pizzas that cost less than 10 cents, but my shameful eating habits aren’t the issue here!)
While this is a great way to talk about the structure of value itself, it doesn’t completely translate to value within the field of real estate.
For this, we’ll need to discuss value by flow yield.
Suppose that a machine were for sale that prints $1,000 per year and only cost $1,000. Any person with a brain and a wallet would run out to buy it immediately. Demand for the machine would climb up fast. On the other hand, if that machine cost $1,000,000, it probably wouldn’t be quite as popular. As cool as the printer would be, it would take 1,000 years before you made back the purchase cost.
This relationship between cost and how much you get out of it is measured by several different factors and has several names. I tend to think in terms of Return on Investment (ROI). ROI is the direct answer to the question of how much money was spent as compared to how much money the investment puts back in your pocket.
Another thing that greatly impacts value is the speculative value of the investment over time.
Suppose there is a stock that you strongly believe in. You may buy it and once it rises, sell it for a profit. We trust that the value of the product today will change over the years, and that we will realize the profit later.
When talking about value yield, it’s important to consider the questions: why should the value rise? What will be different in the future, compared to the present?
I want to clarify that speculative yield is not fabricated or imaginary- it’s real and very powerful. It’s also important to remember that this is a yield that is earned only when realizing: If I live in a house that has made 500% yield and never move on from it, then my profit is on paper only.
If I move to another property in the neighborhood, my profit will probably be ′′eaten′′ when purchasing the new property. In other words: the profit will only be mine when I leave the region (or the world… how morbid).
Now that we’ve defined value, it’s time to get into bubbles. A bubble is created when the value of the product is completely disconnected from any grip on the ground and leans full force on speculative value yield.
We invest in something because we believe it will rise, which causes an increase in demand, and then people see that the value goes up and say to themselves ′′oh wow the value goes up′′ and from there demand further increases, which raises the value even more, and then more people (…).
This is how situations are created in which the value of a product becomes disconnected from its realistic value. Instead it rises solely due to speculation that it will continue to rise. Eventually, you get to the point where the product value is completely disconnected from the ROI and areas of demand occur in which the effective flow is between 1-2% per year.
It’s hard to recognize *for sure* when the market is in a bubble, and when it’s simply in a fix. Figuring out if people are purchasing purely based on speculation or for rational reasons is difficult. A good indicator, however, is the flowing yield.
The point I’m trying to convey here is:
the fact that something costs more than what it once did, doesn’t mean we’re in a bubble – it’s a necessary condition, but not enough. Specifically in Austin, a beautiful house in the area with good schools 15-20 minutes away from industrial centers costs about 3 times the salary of a fresh out of college engineer.
So it’s true that the prices have gone up but you tell me – is the market in a bubble, or in a repair?