"Is there a real estate bubble?" That's the question I'm asked repeatedly. When I reply honestly -- "I hope so" -- my questioners' fear occasionally turns into anger.
"You want the market to crash?" asked one young man incredulously, an attendee at the Learning Annex's Real Estate Wealth Expo in Dallas, where I was a featured speaker.
"Yes," I replied. "I love market crashes."
Apparently not wanting to hear the rest of my explanation, the young man stomped off muttering a word that sounded like "moron."
I've covered this subject of booms, busts, and bubbles before in my columns and books, but since the world seems to be on the brink of so many different booms and busts, I think it's a good time to revisit it.
Over the years, I have read several books on the subject of booms and busts. Almost all of them cover the Tulip Mania in Holland, the South Seas Bubble, and, of course, the Great Depression. One of the better books -- "Can It Happen Again?" -- was written in 1982 by Nobel Laureate Hyman Minsky. In this book, he described the seven stages of a financial bubble. They are:
Stage 1: A financial shock wave
A crisis begins when a financial disturbance alters the current economic status quo. It could be a war, low interest rates, or new technology, as was the case in the dot-com boom.
Stage 2: Acceleration
Not all financial shocks turn into booms. What's required is fuel to get the fire going. After 9/11, I believe the fuel in the real estate market was a panic as the stock market crashed and interest rates fell. Billions of dollars flooded into the system from banks and the stock market, and the biggest real estate boom in history took place.
Stage 3: Euphoria
We have all missed booms. A wise investor knows to wait for the next boom, rather than jump in if they've missed the current one. But when acceleration turns to euphoria, the greater fools rush in.
By 2003, every fool was getting into real estate. The checkout girl at my local supermarket handed me her newly printed real estate agent business card. The housing market became the hot topic for discussion at parties. "Flipping" became the buzzword at PTA meetings. Homes became ATM machines as credit-card debtors took long-term loans to pay off short-term debt.
Mortgage companies advertised repeatedly, wooing people to borrow more money. Financial planners, tired of explaining to their clients why their retirement plans had lost money, jumped ship to become mortgage brokers. During this euphoric period, amateurs believed they were real estate geniuses. They would tell anyone who would listen about how much money they had made and how smart they were.
Stage 4: Financial distress
Insiders sell to outsiders. The greater fools are now streaming into the trap. The last fools are the ones who stood on the sidelines for years, watching the prices go up, terrified of jumping in. Finally, the euphoria and stories of friends and neighbors making a killing in the market gets to them. The latecomers, skeptics, amateurs, and the timid are finally overcome by greed and rush into the trap, cash in hand.
It's not long before reality and distress sets in. The greater fools realize that they're in trouble. Terror sets in, and they begin to sell. They begin to hate the asset they once loved, regardless of whether it's a stock, bond, mutual fund, real estate, or precious metals.
Stage 5: The market reverses, and the boom turns into a bust
The amateurs begin to realize that prices don't always go up. They may notice that the professionals have sold and are no longer buying. Buyers turn into sellers, and prices begin to drop, causing banks to tighten up.
Minsky refers to this period as "discredit." My rich dad said, "This is when God reminds you that you're not as smart as you thought you were." The easy money is gone, and losses start to accelerate. In real estate, the greater fool realizes he owes more on his property than it's worth. He's upside down financially.
Stage 6: The panic begins
Amateurs now hate their asset. They start to dump it as prices fall and banks stop lending. The panic accelerates. The boom is now officially a bust. At this time, controls might be installed to slow the fall, as is often the case with the stock market. If the tumble continues, people begin looking for a lender of last resort to save us all. Often, this is the central bank.
The good news is that at this stage, the professional investors wake up from their slumber and get excited again. They're like a hibernating bear waking after a long sleep and finding a row of garbage cans, filled with expensive food and champagne from the party the night before, positioned right outside their den.
Stage 7: The White Knight rides in
Occasionally, the bust really explodes, and the government must step in -- as it did in the 1990s after the last real estate bust when it set up an agency known as the Resolution Trust Corporation, often referred to as the RTC. As it often seems, when the government does anything, incompetence is at its peak. The RTC began selling billions of dollars of unbelievable real estate for pennies on the dollar. These government bureaucrats had no idea what real estate is worth.
In 1991, my wife Kim and I moved to Phoenix, Ariz., and began buying all the properties we could. Not only did the government not want anything to do with real estate, amateur investors and the greater fools hated real estate and wanted out. People were actually calling us and offering to pay us money to take their property off their hands. Kim and I made so much money during this period of time we were able to retire by 1994.
Today, Phoenix is the fastest-growing major U.S. city in the U.S. with the highest per-unit appreciation. Las Vegas is the fastest-growing small city.
This is why I say, "I love market crashes."
Although my wife and I continue to invest, we're more like hibernating bears, waiting for the party to end. As Warren Buffett says, "We simply attempt to be fearful when others are greedy, and to be greedy only when others are fearful."
So instead of asking, "Is it a bubble?" it's more financially intelligent to ask, "What stage of the bubble are we in?" Then, decide if you should be fearful, greedy, or hibernating.