Home prices have risen over 50% in America in the last 8 years. These days even old Grandmas in line at Safeway can be heard chatting about a real estate bubble. So why won’t those stubborn prices stop jumping?

According to Robert J. Shiller, economist and author of Irrational Exuberance, a bubble happens when investors are drawn to an investment through envy of others’ successes -- despite their doubts about the real value of the investment. As people keep buying knowing that a crash is hovering, this definition seems particularly relevant to our housing market situation.

To explain what propels this bubble, it might be helpful to take a look at adaptations of some of Shiller's explanations for stock market bubbles.

1. First, people are less loyal to their employers nowadays then our parent’s generation was, and less likely to depend on their employer for wealth. This makes assets look more enduring than paychecks, so demand for things like houses goes up.
2. There has been a significant rise in materialistic values, and three car garages and superfluous square footage satisfies these values.
3. Everybody has forgotten about the Great Depression and therefore is willing to spread themselves thin on loans and live with limited or no savings.
4. The coincidental coinciding of Internet technology development and business profit increases during the earlier part of this time period gave the illusion that the two were inextricably connected and encouraged thinking that this was a new (easier, richer) age.
5. The media has become drenched with advertising about mortgage financing, no down-payments, refinancing plans and the like.
6. There has been a decline in inflation and a resulting decrease in people calculating returns net of “money illusion”. Although inflation is not that high, it’s still there and affects returns on investment. But many of us don’t translate nominal prices into real prices as often as we should when hearing the hype about real estate investment success.
7. A general rise in gambling opportunities in our culture has heightened the awareness of “winners” versus “losers” in our society.

Again, the above are twists on some of Shiller’s explanations for a stock market bubble, not necessarily a housing one (although he does analyze real estate in his book).

My favorite explanation, however, is that people's thinking caps are getting dusty. (Mind you, this is a highly sophisticated theory.) We, as consumers, are not educating ourselves enough to resist bubble pressure. People buy homes because they think they're supposed to buy homes at a certain point in their lives. It's a decision made based on one's placement in society, not one's required return. This is happening despite the countless warnings in the Wall Street Journal and other publications calling the market blatantly overpriced and preparing us for an inevitable, “it’s just a matter of when” crash.

These warnings are falling on deaf ears. Hearing about our neighbor's house going up by 10% last year, or our former classmate's pity for those who are "still" renting, only exacerbates this problem. The risk that we might “miss out on a great opportunity” is too much to bear, and blinds us from breaking out a spreadsheet – heck, or even a calculator – and figuring out what is really the right investment for us.

When looking at a home as an investment, one must consider how much real return the asset will actually gain. Once inflation is accounted for, home prices have increased only 0.4 percent per year over the long-term. Even your fee-ridden savings account probably earns more than that. Plus, it is rare nowadays that people sell a home and don't reinvest that cash right into a new, larger property. So how useful (liquid) does that return actually become?

When making a purchase as big as real estate, it would serve us well to think as investors, not emotional consumers. People should do the math - serious, objective math. And not math just to find out what mortgage payment we can afford, but what investment will really be smart for the long term.

So, this author's advice? Shake that cap from its dust. Think of real estate as an investor, and crunch some numbers (or ask someone objective to crunch them for you). Because when that happens, Big Bubble beware. Thinkers aren't so easily swayed, and the more we Americans have among us the faster our markets will head back toward reality.

Posted by Michelle Smith on September 18, 2005 06:37 AM