Real Estate Center Economist Addresses 'Speculative Fervor'

COLLEGE STATION, Texas (recenter.tamu.edu) – Rapid home appreciation in many parts of the country and easy money with which to buy properties have intoxicated speculators, says Dr. Mark G. Dotzour, chief economist with the Real Estate Center at Texas A&M University.

Federal Reserve Chairman Alan Greenspan recently said that some areas are exhibiting “speculative fervor.”

“The commercial real estate market is looking eerily like the office market from 1982 to 1985.” Dotzour says. The early 1980s was a period when friendly tax laws encouraged overbuilding in office and apartment markets.

“When people base real estate investment decisions solely on tax avoidance, the economics of the investments are thrown out the window,” Dotzour says.

“Today, a lot of people are buying commercial properties because they recently sold property somewhere else and now have to buy another property to defer taxes. Buyers are often willing to pay record prices to avoid tax penalties,” he says. “Their return on investment must come from future price appreciation. Latecomers are going to be disappointed because prices have escalated to the point that future price appreciation could be much slower.”

Dotzour does not expect to see high foreclosure rates in commercial real estate this time around because most investors have a significant equity investment.

Overly zealous investors and lenders in the residential market also are a concern, Dotzour says. They seem to think that residential real estate will go up in value by double-digits every year.

“Similarities to the speculative era of the late 1970s are remarkable. People who bought homes in 1979 thought that houses would appreciate 1 percent a month forever, but robust price appreciation didn’t return until the mid-1990s,” Dotzour says.

Today’s speculators are “high” on exotic mortgage products available today, which are feeding the frenzy, he says.

What are these exotic mortgages? For starters, there is the ALT-A mortgage. These are loans for which the borrower provides little or no income and/or asset documentation.  They have names like “low doc loans” and even “no doc loans” and are attractive to those who don’t want their credit scrutinized.

Then there is the well publicized “interest only” loan, where no principal is repaid for a period of years. For more aggressive borrowers, there is the “Option ARM,” which is an adjustable-rate mortgage that gives borrowers the option to pay less than the total interest expense. When this happens, the amount owed actually becomes bigger. It is called negative amortization — another throwback to the 1980s.

Why would borrowers take such a risk?  Most likely because they (and their lenders) are banking on price appreciation continuing indefinitely.  As long as prices are rising, foreclosures will be few. Buyers who have trouble making their payments will sell at a profit rather than let a lender foreclose.

Dotzour expects foreclosure rates to be higher than historical averages over the next five years because of the massive increase in higher risk mortgages.

According to Dotzour, one of three events is likely to cool the fervor. First, the stock market could begin a sustained rally that would bring investor focus from real estate back to stocks.

Second, the Federal Reserve could raise interest rates high enough to shut off all speculative investment (not just real estate but also commodities, hedge funds, fine art and so forth).  But Dotzour doubts the Fed can raise rates high enough without setting off another recession.

Third, the federal banking regulatory agencies could issue strong regulations to limit higher-risk lending. Ultimately, this is what Dotzour thinks will happen. Until then, the frenzy continues.

The Real Estate Center has been providing solutions through research for nearly 35 years. Funded primarily by Texas real estate licensee fees, the Center was created by the state legislature to meet the needs of many audiences, including the real estate industry, instructors, researchers and the general public.

Source: http://recenter.tamu.edu/news/52-0705.html