A Real Estate Bubble Where? It May Surprise You…

A LITTLE GIRL SITS IN A MOVIE THEATER chomping on a piece of bubble gum. She begins to blow a bubble, bigger and bigger, eventually eclipsing her view of the screen. Lost in the fantasy and action on screen, the girl continues to expand the bubble oblivious to the consequence of her ever-expanding sour apple sword of Damocles. Finally, boom. That’s when the crying and whining begins.

As a student of speculative manias and bubbles, I have been lucky enough to witness two giant bubbles during my 10-year stay in the U.S. The dotcom/telecom bubble burst loudly and now the residential real estate bubble has grown too large and extended to support itself as well.

As you read this, we are once again witnessing another speculative bubble. This time, it is in Eastern European real estate.

When I returned back home to Bulgaria in late 2004, people everywhere told me that real estate was definitely the best investment; I also heard that real estate is the safest investment — real estate prices never go down, right? Anytime I tried to object, people interrupted me and said that I was just citing textbook stuff that didn’t apply to Bulgaria; this wasn’t the time to be theoretical, but to make money in real estate.

Average annual gains in previous years ran about 25-35%, and things were only going to get better. Bulgaria was to enter the European Union in 2007, so Western Europeans were on the verge of rushing to buy our real estate at sky-high prices, thereby making us all rich.

Everybody was convinced that real estate prices in Sofia, the capital of Bulgaria, would reach those of Prague and Budapest, which in turn were supposed to reach those of Rome and Berlin in the not-too-distant future. Everyone was investing in real estate — with borrowed money, of course. The smartest and most educated were buying two or more properties, using the first one as collateral for the second, and the second one as collateral for the third; they were the undisputed geniuses that invented the way to pyramid one financial asset on top of another. Many of them, however, had never heard of Charles Ponzi and Ponzi schemes.

The ultimate objects of speculation were resort properties on the Black Sea, where the majority of Western and rich Eastern Europeans will spend their summer vacations. God has blessed our Black Sea with beautiful scenery, sandy beaches, and a perfect climate, and property prices proved it. Prices surpassed their comparables in Dubai and rivaled those in Florida’s Miami Beach. Everywhere, people assured me that this was not a bubble, but sound financial investing based on solid fundamentals. Fundamental analysis, however, indicates that that real estate in Bulgaria is indeed grossly overvalued. Let me explain…

What Makes a Real Estate Bubble?

Real estate has two fundamental indicators that provide the serious analyst with guideposts: (1) the rent-to-price ratio and (2) the price-to-income ratio. The first indicator, rent-to-price, divides annual rent from the property into its purchase price, thus the yield or current return on the investment. A hundred years of U.S. history suggests a normal yield of around 10-12%; property gets cheap when yields approach 15-20%, while yields lower than 6-8% suggest overvaluation and bubble territory. Over the last three-four years, yields in Bulgaria hovered in the 3-4% range, suggesting a strong bubble, with properties overvalued about three-four times the “normal.”

The second indicator, price-to-income ratio, tells how many years of pretax annual earnings are necessary for a household to purchase a house. The historical rule of thumb is that one annual income indicates undervalued properties, two annual incomes normal valuation, and three annual incomes overvaluation and bubble territory. Currently, this ratio for most regional markets in the economy is around 7-9, which is once again indicative that real estate is overvalued roughly three-four times.

Thus, both indicators confirm that there is a real estate bubble across the country, although few analysts in Bulgaria would acknowledge the importance of these ratios. Interestingly, when many analysts consider the fact that real estate earns less than a bank deposit, they immediately respond that rising prices more than compensate for the low yield! What goes up must stay up? This is bubble psychology at work.

Macroeconomic fundamentals look absolutely terrific from one point of view and downright terrible from another. I’m very worried about steady money supply growth rates of 30%; mainstream economists counter that a currency board manages the Bulgarian monetary system, so inflation is impossible, because the government does not print “unbacked” currency.

Even worse, I worry that credit has been expanding steadily for many years at a phenomenal 50% rate, thus driving a wild boom destined to turn into bust sometime in the future. Mainstream analysts would counter that the initial credit base five-eight years ago was abnormally low, so that the credit/banking system has a lot of catching up to do; moreover, they point out that these healthy credit growth rates indicate strengthening confidence in our banking system.

For many years, mortgage growth was 70-80%, which makes me firmly believe that a wild real estate bubble is in the making, which will one day burst. I also worry that current account deficits have reached nightmarish proportions at 20% of GDP, so the collapse of the currency board and the economy is a certainty. Finally, I point to the crisis proportions of the foreign debt, currently standing at 100% of GDP. Mainstream economists bluntly respond that strong mortgage growth underpins growth in the real estate sector and the economy and that trade deficits don’t matter; we are now part of larger Europe. So a sound analysis indicates that the economy is bound to collapse in the near future, while a government-endorsed analysis concludes that everything is great and will get even better.

This gets us to Eastern Europe. One may confidently claim that practically all of Eastern Europe, mostly for similar reasons, has a giant real estate bubble that is beginning to crack.

Here is what the big picture looks like: The real estate bubble slope runs from the U.K. to Bulgaria. And here is the explanation. Early in the decade, the beginning of the bubble was in Great Britain. Weak German and French economies forced the European Central Bank to maintain abnormally low interest rates for many years.

This fueled real estate bubbles across the stronger Mediterranean economies (Spain, Portugal, France, Greece) and, later on, in Western Europe. These bubbles in turn spread across Eastern Europe, first in the Czech Republic, Poland, and Hungary, and later on in the Baltic countries (Latvia, Lithuania, Estonia) and the Balkans (Romania, Serbia, Bulgaria). For all practical investment purposes, the real estate bubble has not spared a single country in Europe.

Anyone looking at the U.S. real estate market before 2005 could have probably seen the same thing coming. Investors should steer clear of Eastern European real estate, unless of course they would like the opportunity to lose their money in a new exotic location.

Best Regards,
Dam Amoss, CFA
November 29, 2007