Monday, January 15, 2018

Housing: Part 277 - Was there an internet bubble?

While I generally find the notion of "bubbles" to be overstated, there are a couple of markets that seem reasonably to fit that description.  (1) The Contagion cities in 2004 and 2005, when mass migration from the Closed Access cities contributed to valuations that were unlikely to be sustainable, and (2) the internet stock bubble.

On number (2), I think there is a credible explanation that somewhat salvages an efficient markets perspective: We invented the internet.  There has been a undeniable technological revolution such that even residents of the developing world now frequently have smart phones.  If there was a miscalculation, it was that firms couldn't figure out how to monetize it, and most of the value accrued to consumer surplus instead of to producer surplus.  The value of the products and services the firms were producing in 2000 was worth as much as the stock market estimated that it was.  It's just that the value was captured by consumers through real (if sometimes unmeasured) growth instead of by firms through profits.

This is an optimistic story, and I think there is something to it.  But, it is at best a partial story.  Any story will be a partial story.  I was poking around the stock market back then, and there were hardware firms - basically electronics manufacturing firms that had revenues from infrastructure buildup - that had traded at multiples that were far above levels that I could imagine ever being justified by any realistic level of production.  I hate to call something a bubble because of conclusions from my own imagination because most of the time I see things being called bubbles, it looks to me like it is the observer's imagination that is off, not the valuation they are second-guessing.  But, it does seem like there was froth.

But, I have another story, which may also provide a partial answer.  This is not an optimistic story.  And, this story is much more easily verified and quantified.  Frankly, I can't believe it hadn't fully occurred to me until now.  The reason the internet bubble popped wasn't because the added value went to consumers.  The reason it popped was because the added value went to real estate owners.  Those technology valuations in the late nineties, at some point, had to be justified by profits, and those profits didn't fully materialize.  Where did they go?  They went to bloated wages, because in the cities where almost all of those firms are located, they must pay their workers a 50% wage premium, and that wage premium flows on to the owners of real estate.

Of course, the common parlance is to blame this all on money, on the Fed, on unsustainable borrowing, and to just conclude that there was an unsustainable tech bubble which we tried to replace with an unsustainable housing bubble.  Readers know that there are many problems with that story.  First and foremost, a problem with that story is that the most expensive homes have high prices that are fully justified by high and rising rents.  It was incorrect to conceive of those rising property values as sources of home equity borrowing for consumption we couldn't afford.  It is at least as accurate to conceive of those rising property values as sources of collected economic rents for owning property that has been politically protected from competition, so that it earns monopoly rents.

Those Closed Access real estate owners got their spoils the old fashioned way, not from hapless lenders, but from limited access political orders - local planning commissions that weren't sure the new condo building next to the train station was really necessary.

This is admittedly slapdash.  But, here is a graph that compares the real value of US nonfinancial equities to the value of the sum of equities and real estate.  If we just look at equities, the value peaks in 2000, and never comes close to reaching the same relative level above trend.  If we look at both, the value of residential real estate owned by households plus the value of equities hits the trendline in 2000, then hits it again in 2005.

Then, we took a sledgehammer to credit markets and the economy to make sure that wouldn't happen again.  Keep in mind, because of capital repression in mortgage markets, real estate is probably collectively undervalued by more than $5 trillion.  (In other words, if households who could afford homes were able to get mortgages to buy them, they would likely be able to bid home values up from the current cumulative value of about $27 trillion.)  In addition, we have underinvested in new housing stock over the last 10 years by at least another $5 trillion.  In this way, we have brought this total value down from the trend.  Surely, some significant amount of innovation and production has also been lost due to the geographic obstacles we have in place that prevent workers from moving to prime locations.

We didn't replace an internet bubble with a housing bubble.  Housing owners just claimed their fat portion of the gains in production.

Currently, households own about $27 trillion of residential real estate, and nonfinancial equities are worth about $25 trillion.  If we had started building hundreds of thousands of homes around New York, Boston, LA, and San Francisco in the late 1990s, would we currently have equities worth something like $40 or $50 trillion, instead?  In that case, even though we would have spent trillions on residential investment, the value of real estate would still probably have been about $30 trillion, because the value would have been based on the value of shelter, not the value of political exclusion.


  1. Man Kevin, this is really smart analysis. Thank you for sharing it.

    1. Thanks, Ken!

      There have been two phases to this whole project. For a while, every night I would chat with my wife, and I'd say, "can you believe everybody claims x happened, but today I looked at the data, and x totally didn't happen. In fact it looks like -x happened. This is weird."

      Then, at some point, there were enough "-x"s to make a whole story, and now when I sit down and chat with my wife, it's like, "I can't believe I didn't think of this months ago, but if we have all these '-x's around, then 'y' has to be true. Duh! Why did it take this long for me to realize this?"

  2. This is an amazing insight. I'm waiting for Amazon, maybe in conjunction with a couple other companies, to buy 50,000 acres somewhere just west of the Rockies so they can build a whole city for themselves from scratch.

    1. Thanks Bill.

      I'm not sure Seattle is a lost cause for that role.

    2. Maybe Detroit has a chance to get HQ2? ;-)

    3. Singapore might be more likely? Though somewhere in the Rockies will have an easier time capturing the US labour market.

      Google has a nice office in Boulder, Colorado.

      The productivity gains from putting your office in the tech hubs seem to be real, though. I don't know exactly what's driving this, especially for major established companies like Google. (I can imagine more factors for startups with their need for people and capital, and limited means to just throw money at problems like Google can.)

    4. I think there are tipping points on geographical capture, and when an area gets leaded up with rent extraction, like Detroit did, the far side of that tipping point ain't pretty.
      I think you might be right that the tipping point may move the innovative centers to Asia. When that happens, our grandkids might react to the idea that people used to think San Francisco was once the most expensive place to live because it was just so awesome the way kids today would react to the idea that Detroit was a cultural and economic centerpiece.

    5. Maybe not on SF, LA etc.

      But I lived In Washington DC. Texas and had to work Phoenix for two weeks every summer for about 10 years.

      The weather on LA OC is just wonderful.

      I live in a hot and muggy climate now.

      Believe me, LA-OC-SF will always be desirable

    6. California has indeed a nice climate. But so do other places like Italy that are not hotbeds of innovation.

      Btw, Singapore is beyond hot and muggy. But they have good governance, and actually managed to build residential (again after a lull). Cranes and new condos everywhere. New subway lines, too.

    7. I would not bet against SF and California though. New York has had lots of problems for ages, and is still going strong.

    8. That is true. They have been resilient.

      But, it is likely that between now and that future recovery, there will be a massive capital loss as property values fall to their sustainable levels when they lose their monopoly on Google-worthy or Goldman Sachs-worthy labor markets.

  3. Great stuff.

    Love the analysis, will think about it more.

    Meanwhile, in my little corner of the world, I keep seeing stpries like this.

    In my profession I see a lot more such deals that not seeking media.

    Foreign capital is pouring into zoned and restricted supply US real estate.

    If one believes in supply and demand in capital markets, this means higher prices.

    If one says the value of RE is set by some ratio to rents, then maybe not.

    1. It's a big, big world. Be careful not to overestimate the importance of the piece of the elephant you happen to be touching. $500 million to renovate apartments in CO, NC, and TX is just a drop in the bucket for what is needed just to maintain depreciation.

    2. True...but remember that $500 million will be leveraged to buy $4 billion...and it ain't the only deal

      If foreign buyers accept lower cap rates and the marginal buyer sets the price....

    3. I'm going to push back against this. I think this is a rhetorical problem with the way people think of leverage. Leverage doesn't just magically make money appear from nowhere. The only way that $500 million gets leveraged to buy $4 billion is that $3.5 billion in capital has to be raised from creditors. Everyone talks about leverage during the boom as if leverage could lead to investment without investors.

    4. I am not sure what your reply means.

      I am positing that if offshore property investors accept a lower cap rate than US investors, then they are the marginal buyers and set the price of real estate that US investors must match.

      I noted leverage only because $5 bil in equity from offshore can command some multiple of that in deals, so leverage obviously multiplies the impact of foreign investment.

      BTW, in commercial real estate circles, the impact of China money on rising land values is not considered controversial.

      Okay, this is from PwC 2018 report on Asia. Yes, Asia is not the US. Still....

      "While the biggest supplier of Chinese outbound capital is institutional (its sovereign wealth funds deployed around half of the total US$25.6 billion in outflows in the first half of 2017, according
      to CBRE), outflows from Mainland developers have had the bigger impact on regional markets. This is mainly because China’s institutional investors are currently focused on markets in the West, while Chinese developers tend to invest in projects
      in Asia. Bidding by Chinese developers—who are often willing to pay more for development plots than local rivals—has caused land prices to soar in many Asia Pacific cities, and particularly in Hong Kong, Singapore, and Australia. Development site sales in the region climbed 38 percent year-on-year to
      US$239.7 billion in the first half of 2017, according to RCA."

      Emerging Trends
      in Real Estate®
      Asia Pacific 2018

      PwC takes it for granted that China capital is influencing property values in Asia.

      Again, the topic of capital controls---the same Sino capital controls that knocked the stuffing out of the Vancouver housing market--are mentioned.

      I am not sure what my point is, except that if property is zoned tightly, then foreign demand can result in prices that rise even more than otherwise.

      And this appears to be an international problem now.

  4. Kevin, I like your idea for the combined chart. I just wonder about the higher of the two trendlines being off? Also, log scale might be useful?

    As for what it shows: to make your efficient market argument, we would need to argue that shareholders could not predict that land owners would take the surplus, wouldn't we?

    Similar in the customer surplus case: shareholders must have had reasonable expectations one way or another that they were going to get the surplus. Otherwise we need to look for another reason to explain equity prices.

    Scott Sumner argues that if you bought an index of stocks (or even a tech index of stocks) even around the 'bubble', you'd have an OK return, if held until today?

    I just checked the numbers, and can confirm, that holding Nasdaq basket was bad but not bubble-y bad, just normal bad investment bad.

    1. I looked at the chart in log scale, and decided on this one. Maybe I'll add the log scale chart in a PS when I get the chance.

    2. If you looked at the log plot, and it didn't reveal more information, it's probably fine to leave it out.

      Looking at the log-plot is just my natural instinct when looking at exponentially growing data.

    3. Ah. I just realized, I deleted the file that this came from because it was just basic Fred data, so I don't have it easily handy.

      I think both trendlines were set at the beginning levels in the data series, with 1.2% per quarter growth.

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