For the past several years, we've posted nuts and bolts educational articles about investing in and developing real estate here in the Learn section of realdata.com. So this article stands apart from that practice, a somewhat out-of-character op-ed piece.

In my recent appearances on Consuelo Mack's WealthTrack on PBS, I would have loved to talk about income-property investing, but the topic of the day was always the housing market, and particularly the "real estate bubble." So what about that bubble? Where did it come from and where is it going?

Since early last year you have undoubtedly heard (and more likely read) the rising drumbeat of stories about how the real estate bubble was poised to pop and make a big mess everywhere. Over the summer, there were stories in virtually every newspaper and news magazine, special reports on the evening news broadcasts and pundits popping up everywhere to say something like, "What goes up must come down, and come down hard." One economist even warned that home values could drop by as much as 50%.

I think it's instructive, helpful and even hopeful to consider the etiology of these bubble stories and how homebuyers, investors and developers have responded.

R.E. 101

Let's start with a little real estate econ 101. There are plenty of reasons why real estate values may go up or down and many, perhaps most of them, are entirely local. If it's commercial real estate we're talking about, then value is a function of the property's income stream. If developers have overbuilt office space in a market, the law of supply and demand pushes rents – and the value of office properties – down. If inducements such as tax abatements or infrastructure improvements lure business to move their headquarters to a particular town or city, the opposite is likely to occur.

With residential real estate, if the local job market is strong then the housing market should follow suit. If speculating "flippers" have invaded a market then values may drop if and when they decide to bail out.

Perhaps the most obvious non-local factor that can affect real estate is the interest rate on financing. With the Federal Reserve gradually but continually tightening credit it's easy to predict that it will become more costly to finance a home. Higher interest equals higher monthly payments and that diminishes the pool of qualified and willing homebuyers.

Usually, the most immediate sign of this diminished pool is an increase in the amount of time it takes to sell a home, which results in a corresponding increase in the inventory of unsold homes. If the market was superheated before, this can help put it back into equilibrium. If it goes on too long, this inventory growth can tilt the market the other way, with supply exceeding demand and holding prices down.

Interest rates have no less of an impact on commercial real estate. Income-producing properties live and die by their cash flows. Higher interest payments cut into those cash flows. Values must go down to reflect those lower cash flows or rents must go up to compensate.

Curiously, higher rates can have a silver lining for one type of commercial property: the apartment complex. Apartment operators suffered during the recent historic lows in mortgage rates because they lost potential renters to home ownership. With rising rates, the demand for apartments has grown.

The Pundits, the Press, and the Bad News

So where do all those "end of the world" stories fit in with this discourse on basic real estate economics?

It is undoubtedly true that higher interest rates will have a braking effect on the warp speed growth in housing that we've seen for the past few years. Beyond that, local economic realities will probably fill in the rest of the picture for both residential and commercial, determining whether a particular community sees slower growth, no growth or a pullback over time.

But is the sky really falling, as so many newspaper and magazines would have us believe? With apologies to all those who told us to run and tell the king, I might humbly suggest that our overwrought, media-intensive culture has more to do with this bubble phenomenon than does the actual economic data. First we have the pundits (whoops – I guess I just fell into that category myself). If one wants to garner a lot of attention in short amount of time, proclaiming an imminent disaster is a good way to do it. Forgive the cynicism, but it's a low-risk play. If you're right, you achieve instant fame, or at least notoriety. And if you're wrong, everyone is happy to forget about the messenger, so relieved that the message was a false alarm.

The pundits would be nowhere without the help of both the media and our own ever-rising threshold for shock and awe. I am not suggesting that anyone harbors a willful intent to mislead. Rather I believe we've become so desensitized by the rising level of calamity, mayhem, terror and malevolence that we see on television and read in the newspapers, that no one who tries to get our attention expects anything less dramatic would even show up on our radar.

We may have reached the point where really bad news is the only news we notice and, to reverse an old chestnut, good news is no news. Did you ever see a headline that said, "Local Residents Applaud Timely Trash Pickup," or "No Meteors Strike Metro Area This Month?" Stories of disaster sieze our attention, especially those stories that hit close to home. What could be closer than, "Your Biggest Personal Asset, the Equity in Your Home, Likely to Disappear Soon." Film at eleven.

Good News, at Last

There is, I think, some actual good news in this, my bad-news story. Given the intensity of the hype about an impending bubble burst, one could have expected a stampede to the exits with people selling for whatever they could get while they could still sell at all.

So, after nearly a year of doomsday press about real estate, what has actually transpired so far?

In most markets, sales of existing homes slowed somewhat in October and November, according to a report by the National Association of Realtors®, although prices continued to rise. Inventories rose to a 5-month supply, up from 3.8 in January, 2005.

Developers continued to prosper, with new home sales up 13% in October, the largest increase in 12 years. This followed a 3.4% increase in September. Meanwhile, apartment REITs were up almost 10% for the first 3 quarters of 2005.

The hype: Real estate values will collapse, homeowners will lose all their equity, developers will be saddled with unsold properties. The reality: A gradual retreat from double-digit price increases and frenetic buying and a return to a more balanced marketplace; property "flippers" will have to re-enter the job market.

The good news that I mentioned above is really twofold. First, the real estate world as we know it has shown no signs that it is about to implode and bring the economy down with it. Second, and almost as important, is that American investors and developers have shown themselves to be a lot more savvy than they might have been a generation ago and certainly more composed in the face of changing economic conditions. They looked at the hype and they looked at the hard facts, the economic data. It appears that they dismissed the hype for what it was and trusted the facts. A good 9 months into the bubble talk and after 13 consecutive interest rate increases by the Fed, there is, appropriately, no sign of panic.

January, 2006