Back to Basics: How to Spot a Bubble
To see a bubble, you first need to know what you're looking for. A bubble in home prices (or in the price of any asset, such as stocks or even tulips) is when prices soar above their fundamental value. Fundamental value is based on supply, demand and realistic expectations about the future. We all learned in Economics 101 that prices move back toward an equilibrium determined by fundamentals of supply and demand. In a bubble, however, rising prices encourage speculation and fuel further demand -- up until when the bubble suddenly bursts and people rush to sell, which causes prices to accelerate downward, sometimes well below their fundamental value. Bubbles are notoriously difficult to predict and hard to confirm until after they've burst. It's impossible to be sure whether price gains are justified by fundamentals until, if and when, a bubble bursts. San Francisco home prices, for instance, are the highest in the country; is that "irrational exuberance" by speculative homebuyers, or are those prices justified by strong job growth, high incomes, great weather and constraints on the local housing supply?
To answer that question, we assess whether home prices are overvalued or undervalued relative to their fundamental value by comparing prices today with historical prices, incomes and rents. Incomes determine how much people can pay for housing, and price increases aren't sustainable if they push prices too high relative to incomes. Rents reflect how much people value housing even if they won't benefit from price appreciation (as renters don't, but owners do); the price-to-rent ratio is like the price-earnings ratio for stocks. Using data from multiple sources, we create several measures of fundamental value and combine them in order to calculate how overvalued or undervalued home prices are relative to fundamentals.
Home Prices are Undervalued 7% Nationally and Regionally in 91 of the 100 Largest Metros
We estimate that national home prices are 7 percent undervalued in the second quarter of 2013. During the last decade's bubble, prices were as high as 39 percent overvalued in the first quarter of 2006, then during the bust, they fell to 15 percent undervalued in the fourth quarter of 2011. Therefore, even with the recent price increases, home prices nationally remain undervalued relative to fundamentals and much lower than in the last bubble. That's why today's price gains are actually still a rebound, not a bubble. This chart shows how far prices are from bubble territory:
At the metro level, prices are below their fundamental value in 91 of the 100 largest metros. Prices are overvalued in the California metros of Orange County (plus 9 percent), Los Angeles (plus 5 percent), San Jose (plus 3 percent), and San Francisco (plus 2 percent), and the Texas metros of Austin (plus 7 percent), San Antonio (plus 5 percent), and Houston (plus 2 percent), as well as in Portland, Ore., (plus Honolulu, which at 0.01 percent is ever so slightly overvalued). The California metros are far less overvalued than at the height of the bubble -- Orange County prices were 71 percent overvalued in the first quarter of 2006! Even the Texas metros, which largely avoided the previous decade's housing bubble, are less overvalued today than at their peaks during the last bubble.
Prices are most undervalued today in Las Vegas and Detroit, even after their price gains in the past year. Several Florida and Ohio metros are also among the most undervalued. All of these metros were overvalued at the height of the bubble, some less so than others.
Other indicators aside from home prices, such as mortgage lending and construction activity, confirm that the housing market isn't forming a new bubble. Mortgage credit remains very tight, especially for people with lower credit scores, and the new "qualified mortgage" rules under Dodd-Frank intend to prevent the recurrence of toxic mortgages that artificially inflated housing demand in the last bubble. Also, construction activity, though rebounding, is still well below normal levels, and the vacancy rate is falling, so there's no evidence of overbuilding today like we had during the last decade.
Is the Next Bubble Coming Soon?
If prices keep rising as fast as they are today, we'd be back in bubble territory in several years. However, prices are unlikely to keep rising as fast as they are today for three reasons:
1. Inventory should expand. Tight inventory is boosting prices today as buyers bid up prices on scarce homes; however, as prices continue to rise, more people will sell as they get back above water or decide to cash out, and more new construction will add to inventory.
2. Mortgage rates should rise. Low mortgage rates today increase buying power because borrowers can afford a more expensive house for the same monthly payment. Rates are likely to rise as a result of the strengthening economy, either through market forces or Fed actions, which – along with more inventory – should slow down price gains.
3. Investor interest should fade. Undervalued prices have attracted investors, who have helped push up home prices as they have bought and rented out homes. But as prices rise, investor interest will fade.
Read the rest of this post at the Trulia Trends blog.
Jed Kolko is the chief economist for online listings site Trulia. This article originally appeared on the Trulia Trends blog.
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