Chocolate and Gold Coins

Tuesday, May 10, 2005

The Leaky Balloon

A blog that is quickly becoming one of my favorites is Half Sigma. He posts often and he posts about things that interest me: economics and Northern Virginia where I live. One theme he continually hits upon is that the housing market is a bubble that is about to burst:

On a military base this week in the Washington DC area, I overheard two Lieutenant Colonels having a conversation.

“I can’t see how housing prices could go down in this area, all the government jobs means demand will always be high,” said one Lieutenant Colonel to the other.

This is the type of wishful thinking you hear every day in the DC area. I look forward to the day when all these idiots lose everything when the bubble bursts and their houses plummet in value.

Read this post here, and his previous posts here and here.

I believe that the Lieutenant Colonel above is probably senses what other people here sense: the demand for bureaucrats in this administration has increased. It is funny how the Republicans have become the big spenders now they’re in power. Here is someone who fails to see the humor in this. In any case, the increase in quantity and the salary of bureaucrats is one reason why housing demand in Northern Virginia has increased, and I don’t see that going away soon.

However, the market for housing depends both on supply and demand. In the short run, supply is fixed because there is no land available anywhere in Fairfax County, Arlington, or Alexandria. But this tremendous increase in housing prices – housing prices have more than doubled in the last six years since I came here – has made it very profitable to construct new housing. Keep in mind that the cost of building a new home really hasn’t gone up much in the last six years. So if people can now afford homes worth $1.5 million dollars, homebuilders can build a really nice house for that money. All they need is a little land, and they can produce a commodity that is much more desirable than the homes that currently sell for $1.5 million.

I just said that there was no land available, but there is always land available. There are many homes around that were built 50 years ago and are in very sad shape today - and even these cost $500,000. Tear them down for $100,000, build a wonderful new home for $800,000 and your can sell it for maybe $1.5 million. It isn’t quite as easy as that because that home would be next to two other homes in very bad shape. The homebuilders need to negotiate with a dozen homeowners at a time. It a little serendipitous to make such a deal, but does happen over time.

Down the road from our home, a homebuilder did exactly that, and they are building a half-dozen single family homes for $1.5 million right on Gallows Road (a major thoroughfare) just two miles from Tyson’s Corner: Fairfax County’s downtown. Who can afford these homes? People who have homes worth $1.0 million which they bought years ago and now have a lot of equity. They can put $700,000 down and still the mortgage will kill them, but they are willing to do it because housing has always been a good investment. But they don’t realize that this trick of knocking down homes and building new ones is getting more profitable over time and this will eventually saturate the market. A couple of years from now, homes like that will probably sell closer to the cost of producing them, which might be $1.2 to $1.3 million.

The market isn’t bubble, it is a balloon, and the balloon is beginning to leak.


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