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  1. Santa Barbara Housing Prices: Another Dot-Com Bubble? Stephen F. LeRoy, UCSB Department of Economics Economics Forum -- October 26, 2004

  2. SANTA BARBARA COUNTY MEDIAN HOME PRICE $690,883 Existing Single Family $634,154 $476,100 $417,700 $302,029 $243,249 $210,768 Economics Forum -- October 26, 2004 92 94 96 98 00 02 04 06 08

  3. 50% 45% CALIFORNIA 40% 35% 30% 25% 20% 15% SANTA BARBARA COUNTY 10% 96 97 98 99 00 01 02 03 Housing Affordability Index Economics Forum -- October 26, 2004

  4. S o u t h C o a s t S i n g l e F a m i l y H o m e M e d i a n P r i c e $1,000,000 $975,000 Aug 2003 headlines = $950,000 950,000 2003 = $825,000 900,000 2002 = $749,000 850,000 800,000 750,000 700,000 650,000 600,000 Economics Forum -- October 26, 2004 2002 2003 2004

  5. The March 2004 Montecito Median Home Price was $2.3 million. Economics Forum -- October 26, 2004

  6. 2003 Median Home Prices for Cities in Santa Barbara County All Inclusive $650,722 $557,646 $481,246 454,792$ $291,729 $282,563 $210,453 Buellton Carpinteria Guadalupe Lompoc Santa Barbara Santa Solvang Economics Forum -- October 26, 2004 City Maria

  7. Recently, some signs of leveling off: • Home sales in August dropped 47% relative to a year ago. • Same with condos • Median price Jan-Aug: $1,049,000 • Median price August: $989,000 • - SBNP, September 25 Economics Forum -- October 26, 2004

  8. What Is A Bubble? • Prices rise, then drop? • Markets are irrational? • What does irrational mean? • With 20-20 hindsight, of course I shouldn’t have bought all those dot-com stocks • Was it obvious at the time? • Anyone could have shorted the NASDAQ … Economics Forum -- October 26, 2004

  9. Rationality • Economists like to think of people as being rational. • People are doing the best they can, given limited information. • They aren’t making mistakes that are big and obvious Economics Forum -- October 26, 2004

  10. Of course, a few people are irrational by any definition • But if they dominated markets, there would exist obvious trading strategies by means of which rational people could exploit them • Who are these rational people? What are the trading strategies? Economics Forum -- October 26, 2004

  11. Rational Bubbles • Here’s a definition of bubbles that doesn’t appeal to irrationality • Suppose rental income (or the service yield of a home) is I dollars per year • The price of an apartment complex in year t is Pt • The return that the market demands (in view of risk, illiquidity) is r • If the expected value next year is Pt+1, what is Pt? Economics Forum -- October 26, 2004

  12. Return consists of rental income (per dollar of value) plus rate of capital gain: • Solve: Replace t by t+1: Economics Forum -- October 26, 2004

  13. Now substitute the last equation in the one before: • Keep doing this. Eventually you get: Economics Forum -- October 26, 2004

  14. Present-Value • Let n go to infinity. • You get that the price of the apartment complex equals the discounted value of its rents Economics Forum -- October 26, 2004

  15. But only • IF the present value of its price n periods in the future (the right-most term) goes to zero! • But suppose it doesn’t! If this term approaches a positive number, that’s the bubble • So price = fundamental value + bubble • Existence of a bubble is consistent with equilibrium because the rate of return equals r by construction. Economics Forum -- October 26, 2004

  16. The Bottom Line • Under a rational bubble, rental income per dollar is low, but price is expected to rise so as to generate the appropriate return • This justifies the current price • Therefore I/P is decreasing, as well as low • Investors don’t lose by holding an asset with a bubble • That’s why it’s a rational bubble • What about uncertainty? Doesn’t change the story much: even if the bubble may burst, the bubble may still be consistent with equilibrium, if it grows really fast when it doesn’t burst. Economics Forum -- October 26, 2004

  17. The task • We have to figure out whether housing prices can be explained by the present value model without bubbles • Or can we explain the price runup only by assuming that there’s a bubble? Economics Forum -- October 26, 2004

  18. Special cases • Suppose there’s no bubble and that I is constant. Then price is: • So if r is 10%, P=10*I • This is the constant perpetuity formula Economics Forum -- October 26, 2004

  19. If I grows at rate g, this becomes • This is the growing perpetuity formula • If r=10%, g=5%, P/I = 22. So a growing revenue stream gets a higher price multiple Economics Forum -- October 26, 2004

  20. Bad News • Price-income multiplier is very sensitive to both r and g: • r=10%, g=5%, P/I = 22 • r=8%, g=5%, P/I =37 • Conclusion: given the margin of error in estimating r and g, it’s hard to get an exact estimate of what P/I should be in the absence of bubbles… Economics Forum -- October 26, 2004

  21. This checks out. • In Philadelphia, P/I is around 8. In Santa Barbara, it’s maybe 20. Why? Nobody expects rents to grow much in Philadelphia (because they haven’t in the past). • People do expect rents to grow in Santa Barbara (because …). • Equivalently, rental income in Philadelphia is higher than in SB per $ invested, but capital gains are expected to be lower. Economics Forum -- October 26, 2004

  22. Good News • The constant perpetuity formula can give some guidance in interpreting changes in P/I. • Changes are traceable to variations in r or g Economics Forum -- October 26, 2004

  23. Suppose there’s a bubble • (Take g=0 for simplicity) • Set Pt equal to some number greater than that implied by the constant perpetuity formula • You can use the relation between Pt, Pt+1, Pt+2,… to calculate future prices. • If there’s no bubble, P = constant. Economics Forum -- October 26, 2004

  24. Economics Forum -- October 26, 2004

  25. If there’s a bubble, price rises at an accelerating rate. • It must. Income per dollar invested is dropping, so capital gain rate must be increasing. Economics Forum -- October 26, 2004

  26. Therefore in a Rational Bubble • P/I rises over time. • That has happened in SB, nationally. Prices now average 20 x rents in parts of CA, Florida. • Was around 10 x rents in 1995. • WSJ, 8/31/04, p. A2 Economics Forum -- October 26, 2004

  27. The big question • Are people bidding up the price of real estate because • Their estimates of growth rate of rental income have been revised up, • or because the discount factor has dropped (no bubble) • Or • Just because they expect prices to rise (there is a bubble)? Economics Forum -- October 26, 2004

  28. Rents • SB is a nice place to live • But: it was a nice place (even nicer?) in 1975, when housing prices were much lower • So you really need to argue that people have been finding SB more attractive in the last few years Economics Forum -- October 26, 2004

  29. That’s possible: with telecommuting, you can trade options without living in Chicago. • Supply of new housing is limited • Boomers are starting to retire ($) • Lots of $ in LA, and many want second homes in SB • But: SB economy looks a lot like the rest of California (remember those affordability indexes). Economics Forum -- October 26, 2004

  30. Rents have been flat in SB since 2000 or so • It’s possible that investors revised upward their expectations of the growth rate of rental income over the distant future, even though rents are flat now. • But is it plausible? Economics Forum -- October 26, 2004

  31. Interest rates have dropped. • Were expected to rise in the past 6 months, but they haven’t Economics Forum -- October 26, 2004

  32. Mortgage rate, 1971-2004 Economics Forum -- October 26, 2004

  33. Mortgage rate minus CPI growth, 1971-2004 Economics Forum -- October 26, 2004

  34. Conclusion • I don’t see fundamentals – as reflected in the growing perpetuity formula -- as justifying anything like the price runup that we have seen. • Modest mortgage rate decreases, flat rents don’t justify price doubling in the last several years. • Fundamentals justify high prices in SB • But not this high Economics Forum -- October 26, 2004

  35. Past Bubbles • Have almost always occurred when there were genuine reasons to be optimistic • 1720 – South Sea bubble (East India Company had a monopoly on English trade with South America) • 1929 – electricity, automobiles • Japanese stock prices, 1980s • 2000 – internet • Same with SB housing Economics Forum -- October 26, 2004

  36. A good sign: housing prices weathered a recession • However, interest rates will increase sooner or later. • Signs of speculation: purchases of second homes. If there’s a price break, will owners of such properties hang on? Economics Forum -- October 26, 2004

  37. Thanks for coming! Economics Forum -- October 26, 2004