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Is California the beginning of a new U.S. housing bubble?

Look at affordability and expectations

(Photo: Dennis Novak/Getty)

(Photo: Dennis Novak/Getty)

Whenever sensible people talk about the state of the U.S. housing market, they don’t just talk about prices. Sure, those have risen by over 12% since this time last year, which is fast. But you need other metrics to assess whether that’s a quick recovery from the housing collapse or the beginning of a new bubble. You should compare prices to incomes and to rents, which tell us how much people value housing regardless of which direction they think house prices are headed. And you should compare those ratios to historical trends, which are calculated excluding booms and busts. According to those gauges the U.S. housing market is recovering, not inflating. Home prices nationally are still 4% below their long-term value.

Except for a couple of places. California is one. The Golden State is a red warning sign flashing on the U.S. real estate map. Of the 18 cities where home prices have risen above their historical value, eight are located in California, according to real estate website Trulia. And it’s not just San Francisco and San Jose, where the housing supply can’t seem to keep up with the demand created by the latest Silicon Valley boom. It’s Orange County and Los Angeles too, where Trulia figures home prices are currently 13% and 12% above fundamentals respectively. That’s still tame compared to the 39% overvaluation seen nationally in early 2006. But does look like a bubble.

Texas is another potential danger zone. Austin, Houston and Dallas all made it onto Trulia’s “overvalued” list.

The crucial question here is: Are California and Texas bellwethers for the rest of the country? The Lone Star State famously by-passed the housing crash altogether, and California was one of the quickest jurisdictions to recover, thanks to its speedy processing of home foreclosures. Other states, like Florida, are still struggling with a sizable shadow inventory of bank-owned homes that are slowly working their way through the courts. So, are Houston and L.A. simply leading the way into bubble territory, soon to be joined by, say, Las Vegas, Phoenix and Orlando?

I can think of a good many reasons why prices should slow before any new bubbles have a chance to reach critical size:

1. Mortgage rates will go up. They already climbed one percentage point (and then come down a little) in response to the Federal Reserve merely talking about rolling up its asset purchases next year. This has already had an appreciable effect on home sales, though not so much on prices. As the Fed actually starts tapering its bond buys, which, barring unforeseeable cataclysms, will happen sometime next year, rising long-term interest rates should cool price-growth as well.

2. As prices keep going up, more people will want to sell their house or build new ones. A big reason why prices have shot up so quickly is that there isn’t that much residential real estate to be bought. Many homeowners have put off selling, hoping for prices to go up just a little bit more. And there’s some anecdotal evidence that builders have done the same, playing the waiting game in hopes of reaping better profits. Both supply constrains should ease as prices approach their long-run value.

3. The memory of the latest housemageddon is still fresh in people’s minds. Robert Shiller, who sure isn’t afraid to call a bubble when he sees one, doesn’t seem too concerned about Americans’ current expectations of future home prices. His latest survey found that people believe prices will rise by over 8% annually in the near term but see more reasonable increases of 4% per year a little further into the future.

4. When prices stop being undervalued, investors will leave the market. Over the past two or three years, it made a lot of sense for well-heeled investors to snap up underpriced property and rent it. That money-making opportunity, though, is going to disappear as prices keep rising.

Still, I can also think of a couple of reasons why the current price momentum might take on a life of its own:

1. Rapid price increases invite speculative behaviour. In many markets with breakneck price growth, house-flipping is back. The reason for this is quite simple: If prices rise fast and you believe they’re going to do so for the foreseeable future, then you can make money from buying a house for the sole purpose of re-selling it and pocketing the difference. This is the kind of belief-driven housing demand that can fuel bubbles.

2. People have become accustomed to making bets on real estate. As the same Robert Shiller has been saying, “we now think of [real estate] as a speculative asset.” In the past, he recently noted, “nobody thought much about it.” Housing might just become more prone to boom and bust cycles.

For now, Trulia likes to say that the current U.S. housing market is “simmering,” not bubbling up. That might be a fair depiction for the time beeing. But the Fed and other U.S. housing authorities had better keep a close eye on it — for we all know what can happen when a simmering pot left is unattended.

Erica Alini is a reporter based in Cambridge, Mass., and a regular contributor to, where she covers the U.S. economy.

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