Averting Disaster-When a Financial Bubble Bursts

Wall StreetThis week [April 2015] the NASDAQ finally exceeded its previous high reached in March 2001. Here is a graph that shows what happens when a financial bubble bursts.

NASDAQ Composite Index Financial Bubble

Since 2009, however, it has been essentially a straight shot upward as if nothing were going to get in its way from reclaiming a new high.

[UPDATE – September 2016]

NASDAQ Composite Index 2016

I have been a student of financial bubbles for a long time and being in real estate I have lived through a few of them myself. I thought I would briefly lay out some of the main catalysts for creating bubbles and their subsequent crashes from my experiences in real estate.

What Happens When a Financial Bubble Bursts?

  • Government incentives can dramatically boost demand but if those incentives change, then demand can also be eviscerated. In 1981 the tax laws were changed allowing for people who invested in real estate to apply the accounting losses from those investments to offset all other forms of taxable income. This led to an enormous demand for real estate, especially among individual investors, since they could reduce their taxable income generated by their wages and other investment income. Tax-oriented syndicators mushroomed throughout the United States to aggregate capital from individual investors to purchase and build real estate. This helped stimulate an economic boom but also a lot of fraudulent lending, especially among savings and loans, particularly those in Texas. The demand for buying and building real estate was tax-driven and not based on traditional supply and demand fundamentals. The bottom fell out when oil collapsed, the tax laws changed in 1986 which no longer allowed investors to offset passive losses from real estate against active income, and the terrible and illegal business practices of the most aggressive lenders, S&Ls, were exposed. These all conspired to lead to a dramatic drop in demand for real estate investments, virtually all types of real estate was overbuilt, investor losses piled up, and the S&L industry essentially collapsed and had to be taken over by then newly created Resolution Trust Corporation.
  • When there is a significant loosening of credit standards and availability, this is a big red flag. Like tax law changes, this can create a huge increase in demand that can then be reversed when easy lending practices go too far and credit tightens again. It’s important to always ask “who will buy this property when I want to sell it?” If it’s the type of property that requires a buyer who needs very loose lending standards, then you need to know you’re taking a big risk that if credit standards tighten up, then the buyer pool may shrink significantly and the price will be negatively impacted.
  • Buying lesser quality real estate during good times and believing that this prosperity, which could be temporary, is the same as safety. When the tide goes out, the properties with the most vulnerable occupants and lower quality locations get hurt the most because there is not the same economic demand to backfill the weaker occupants who have left or stopped paying rent.
  • Not having a margin of safety to withstand an inevitable downturn. Real estate can be a forgiving asset class if you have the financial wherewithal to manage through challenging market conditions. Problems arise when too much leverage is deployed and cash flow drops so the debt cannot be serviced and/or property values have dropped, loans come due, and there is not enough equity to refinance the loans. It’s important to make sure one has access to cost-effective capital to manage through the tough times. Think of investors who bought prime New York City office buildings in 2007 at the peak and lost the buildings during the downturn only to see that their values skyrocketed far above what they paid for them seven years later and beyond. They didn’t have the staying power to manage through their debt problems.
  • Speculation is also a hallmark of every real estate bubble I’ve experienced. It’s predicated on making easy money by flipping properties and often times the speculator uses a great deal of leverage via short term loans. They are buying for quick profits and throwing out traditional valuation metrics. When the tide goes out and they cannot sell their properties for the prices they thought and as quickly as they were expecting, this source of demand becomes a large source of panicked supply. This happened with many condo and home flippers in 2007 and 2008.

Generally speaking, I don’t see the same excesses in real estate that were present during previous bubbles.

  • Lending is not out of hand, the government’s involvement seems to be muting speculation.
  • “Get Rich Quick” psychology is not present.
  • No dot com environment where companies were priced on newly invented financial metrics to justify insane valuations.
  • Real estate is trading hands based on valuing the cash flow in place versus emphasizing where it will be in future years.
  • There are of course exceptions like the Bay Area, but overall I don’t see many excesses that would lead me to be overly cautious.

Over to you

What are the changes you are seeing as a result of the current state of the stock market? What happens when a financial bubble bursts?

If you are new to my blog, welcome. I’d like to hear from you in the comments below. What brings you to visit my blog?

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