Real Estate Bubble

By Ramesh Akkineni

Warren Buffett and Charlie Munger at Berkshire Hathaway's annual meeting 2005

Q: What would happen to Berkshire if the housing market declines?

WB: A decline in the housing market would hurt certain of our businesses, such as carpets, but those reversals would be made up for elsewhere. If there is a bubble, and it’s pricked, we’d feel it in some of our operating businesses. But we’d also likely see an increase in investment opportunities. I’m generally not big on making macro calls (our foreign exchange bet notwithstanding); it’s better to invest company by company, as we have with Petro-China. The current state of the housing market brings to mind what happened 25 years ago in farmland in Nebraska. Land was selling at $2,000 an acre, that could be bought a few years later at $600 per acre from the FDIC. The thinking during the farmland boom was that cash was trash. Inflation was high. A lot of banks, some of which had survived the depression, failed. People go crazy in economics periodically.

Residential housing is a bit different from farmland, of course. People live in houses, so that the investment isn’t purely economic. But I’m not sure why prices should be expected to rise faster than construction costs over a long period.

CM: There’s a real estate asset price bubble going in places like Laguna, Calif. and Washington, DC. A very ordinary oceanfront house in Laguna sold for $3.5 million. Figure $500,000 for construction costs; that means that the land sold for $3 million. Granted, it was an oceanfront property, and so relatively scarce. Still, the plot size was just under an eighth of an acre, which means that the land underneath a modest oceanfront house sells for around $27 million an acre.

WB: At $27 million an acre I’d rather stare at the bathtub.

Q: How will the shift in mortgage lending to more 0%-down mortgages affect the overall savings rate?

WB: Any house represents savings. Home construction comes about through savings. Lending terms have gotten easier as prices have risen. That’s the opposite of normal. Mortgages are now intermediated; the buyer of the mortgage doesn’t need to look at the particulars of the individual borrower. It just cares about the guarantee. . During the farm bubble in small towns, things got crazy. People began to say that farmland was an appreciation investment, not an income investment. It was just a form of the greater fool theory, and is nothing that banks should engage in. Right now, the rest of the world is our savior in providing credit.

CM: It’s obvious that easy lending on houses causes prices to rise, and new houses to be built. Eventually, this will cause prices to decline.

WB: Suppose for a minute that Omaha were static, with no births or deaths, and no net migration, and that every year everyone sold his house to someone else in the community. In the first year the price might be $100,000, then the next year it’s $150,000. There’s no net change in wealth. This kind of thing happens in the economy as a whole; people stop thinking and just depend on the guarantee. There are these kinds of “buried Ponzi effects” in any economy that are little studied.

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