ELITE A Publication of Delray Publishing

First Quarter Report: 2015

How to Gauge Your Real Estate Risks …At Home and Abroad By Harry Dent, Editor of Boom & Bust Elite

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How to Gauge Your Real Estate Risks …At Home and Abroad

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EAL estate markets throughout much of the developed world have continued to rebound in the wake of the devastation that began amid the financial crisis of 2008 and 2009. While this has marked a significant turnaround from those tumultuous times of just a few years ago, it has also led the market into a false sense of security. In spite of the rebound, those who believe the next few years will be a time of growth for real estate are in for an unpleasant surprise. My research reveals a crushing downturn is just around the next corner. This report, therefore, should serve as a warning of what lies ahead. It is also worth bearing in mind that the global financial crisis of 2008 to 2009 began with the bursting of a real estate bubble — characterized by high-risk investing and easy borrowing — that transformed into a world-wide credit squeeze. This unsustainable bubble in the U.S. real estate sector came to be known as the subprime crisis. But if you think that last real estate crash was bad… think again! All bubbles are characterized by a mass delusion, which wrongly assumes that prices move in one direction only, and that’s up. Nowhere is this delusion more starkly illustrated than real estate. In the last property crash, U.S. residential real estate tumbled by 34% and commercial real estate collapsed by 43%. Make no mistake about it: The fragile U.S. real estate market is now setting itself up for an even bigger fall. We are now on the verge of witnessing the bursting of the biggest real estate bubble in modern global history. And its impact will not just be felt by the United States again; its devastation will be global — in London, Paris, Shanghai, Mumbai, Sydney, Vancouver, and this time in New York, Dallas and Houston as well, to name just a few places. I think of this real estate bubble phenomenon like a popcorn popper. It all starts with a few bubble bursts, like Japan, before the popping spreads further afield, as it did in the U.S., Ireland, Spain and elsewhere, until a crescendo builds and bubbles are bursting everywhere. I expect to see that final bubble-popping crescendo building between 2015 and 2021. That’s why, in this special report, I will show you how the inevitable bubble burst ahead is likely to play out in both residential and commercial real estate. I strongly advise you to use this report to gauge your risks and prepare for the inevitable. Because, unlike the stock market, the risks in real estate differ in different cities, states and regions.

The Greatest Delusion The meteoric rise in the overall price of real estate globally through the second half of the 20th century and the beginning of the 21st century is unprecedented in modern history. It is this that has given rise to the illusion that in certain cities, prices just can’t go down. People look at cities, like New York, San Francisco, London and Sydney, and believe that because they are such attractive places, the ultra-rich will always buy there and thus keep the market buoyant. But neither

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history nor common-sense economics supports that idea — and neither does the most basic law of physics, which states that every action has an equal and opposite reaction. The real estate bubbles of recent decades in Tokyo, Los Angeles and Miami tell their own stories, and I will examine these phenomena in greater detail later in this report. But firstly, let’s go back in history a little to consider what occurred in Manhattan during the Roaring ’20s, just as Manhattan is setting new records with condo prices averaging $1.8 million in 2014. Real estate prices in the 1920s boom went up higher and for four years longer than overall real estate in the U.S. Then, in the wake of the 1929 stock market crash, it collapsed by 61%, compared with an average 26% fall on average in the U.S. Manhattan Home Prices 1920-1939 As the chart at right shows, Manhattan real estate prices remained near their lows as far down the road as 1940. At the same time, however, overall U.S. real estate was back at its 1925 highs. Manhattan is an example of exactly what happens to so-called real estate super cities when bubbles burst.

–– Home Price Index, $1.00=1920 $1.40 $1.30 $1.20 $1.10 $1.00 $0.90 $0.80 $0.70 $0.60 $0.50 1920

No market can rise exponentially in the shortterm without killing its own demand. The drivers of bubbles — surges in demand, limited supply, government incentives to buy, or waves of foreign buyers and domestic speculators — are all just drivers of the bubble.

1925

1930

1935

1939

SOURCE: Real Estate Prices During the Roaring Twenties and the Great Depression, Tom Nicholas & Anna Scherbina

As prices continue to climb rapidly, less of the population are able to afford homes. Even the ultra-rich are crowded out. Indeed, the smart money are often the first to exit as bubbles begin to burst. Like all bubbles, this latest one will burst, too, and, as sure as night follows day, tens of trillions of dollars will vaporize. History teaches us that markets that bubble up the most, collapse the hardest. In general, the great mass of the population is blind to real estate bubbles… and all bubbles for that matter. This is largely because prices have risen throughout their entire lifetimes. In fact, the market has been rising since 1933, although most strikingly in the wake of World War II, and the most so starting in early 2000. The assumption that it will keep rising is also based on some flawed perceptions of the market’s mechanics and a real misunderstanding of the uniqueness of the bubble in which we currently live. Since World War II, we have experienced two unique trends that will NOT repeat themselves in our lifetime: • Firstly, the soldiers came home and, armed with government aid, spurred the greatest real estate buying surge in history to the point where it created the world’s first middle-class generation that could broadly afford and mortgage real estate. • Secondly, the massive and unprecedented baby boom that followed World War II put enormous demand pressures on real estate markets, especially those in coastal areas. Both of these trends are over in the developed world. At the same time, people also see real estate as a tangible commodity, perceiving limited supply in a world where the population just keeps growing. Thus they calculate that prices will simply continue to rise.

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But history teaches us that real estate can be highly volatile, nearly as much as stocks. It is also more leveraged by the ability to borrow against it with mortgages, not to mention the fact that markets vary greatly from place to place, with some areas far more prone to bubbles than others. Those who doubt the volatility of the global real estate market should simply ask the good people in Tokyo, many of whom are still paying down underwater mortgages 23 years after that market’s peak. Back in the heady, pre-deflation days of the late 1980s, Tokyo was a global super city of gleaming towers and untold economic promise — and then its real estate bubble burst. Tokyo burst first because Japan went off its demographic cliff more than a decade before the U.S. A study of current property prices reveals that Japanese real estate remains near its lows and still shows no sign of a significant rebound... In spite of its wild bouts of money-printing and the lowest short- and longterm interest rates in the world. But Japan is hardly alone. Many countries in Europe and other nations in Asia are close to tumbling over their own demographic cliffs over the next few years. And that fact means one simple but devastating reality for real estate markets, the U.S. included: There are more die-ers than buyers, a fact that will weigh on both commercial and residential real estate prices for decades to come.

Die-ers Vs. Buyers: Why the Market Has Changed Forever A deep study of the Japanese real estate market over the past few decades reveals something quite surprising — it did not bounce when the next generation came along to buy in 1999 forward. This confused economists and market observers alike. But after reading an article about how adult diapers had begun to outsell baby diapers in Japan around this time, it all became clear. The diapers were a huge demographic insight. Japan had come up against its demographic cliff. In other words, more people were dying than buying. Real estate lasts for a very long time, so when people die they actually become sellers, which increasingly offsets the real estate demand of the next generation. Japan was the first developed nation to come up against a demographic cliff. Dozens of other nations in the wealthy developed world are about to follow and, for the first time in their history of these rich countries, the emerging generation will be smaller than the generation before it (except for a few small countries). The baby boom generation was exceptionally large and exceptionally wealthy, and the rise of a smaller generation has greater implications for real estate than any other sector of our economy. When I forecast inflation or commercial real estate price, both of which follow workforce growth, I add the new entrants at an average age of 20 and subtract retirees who leave the workforce at the average age of 63. I realized I had to do the same with residential real estate. Instead of just forecasting the rise and fall of peak buyers at age 41, I had to subtract the number of die-ers at the average age of 79 from the peak buyers at age 41 in the U.S. (this is as much as age 84 minus age 42 in Japan and 81 minus age 42 in Europe and Australia). As I have already noted, these die-ers are essentially sellers and they decrease the net demand for housing. When I made similar calculations for Japan, I discovered a much more accurate correlation with home prices. It explained clearly why the increasing number of buyers from the younger generation did not cause home prices to rebound significantly. The answer was simply that the number of people who were dying (selling) was greater than the number of younger people buying. Net demand for homes turned negative in Japan in 1999 for the first time in its history, and it will continue its downward spiral into 2033 after a brief bounce into 2015. Hence in terms of price collapse, the worst has yet to come between 2016 and 2033. Japanese home prices are poised to fall even more than 60%

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from their peak, especially as the global economy continues to weaken. The U.S. real estate market faces a similar crisis. But just look at the trend in the chart below, which projects net demand in the U.S. residential real estate market until 2040. Once again, I subtracted the number of Americans dying at the average age of death, 79, from the number of those at their buying peak at age 41 to reveal a very different picture from the one most people would expect. As the chart at right clearly shows, U.S. home prices peaked in early 2006 before the precipitous decline. The anticipated rebound between 2012 and 2014 was a bit better than expected, thanks to unprecedented stimulus and low interest rates. But this new chart also predicts that net demand will see its steepest fall from 2015 into 2021 and, after a brief bounce, plunge even lower into around 2039. And net demand for homes will actually turn negative in 2029.

Tumbling Demand for U.S. Homes –– Real Home Prices, left –– U.S. Net Housing Demand (41 minus 79), right 100=2005 120 100 80 60

Not many people are planning on that — certainly not the nation’s homebuilders. That means there will ultimately be an overbuild of homes before the industry gets its wake-up call the hard way.

40 20 1988

1998

2008

2018

Millions 3.0 2.5 2.0 1.5 1.0 0.5 0 -0.5 -1.0 2039

SOURCE: U.S. Census Bureau, Dallas Federal Reserve, 2014

In an echo of the Japanese residential real estate crisis, the massive U.S. baby boom generation will die faster than the smaller millennial generation can buy into around 2039. And that, simply put, is why real estate will never be the same again! Adding insult to injury, the younger millennial generation is already more reluctant than the baby boomers to buy homes, because they witnessed the first major real estate price collapse of our lifetimes. They don’t assume, as we did, that real estate only goes up. Meanwhile, banks have also become more stringent on mortgages — after one of the most liberal periods in banking history — at the same time as higher young-adult unemployment and unprecedented student loans weigh on the millennial generation as well. Not only do we have unsustainable debt loads around the world and increasingly worsening demographic trends that tell us that this economic winter season is far from over, huge chunks of the developed world still must pay a heavy price for unprecedented monetary stimulus programs in the years ahead as the bubbles they created finally burst. But even without the weight of these added pressures, real estate prices will decline in most developed countries just from natural demographic trends alone. These net demand declines will come at different times in different countries and regions. We have already seen Japan’s decline — and lack of a rebound. The U.S. will be next, as it suffers through a second, larger round of crashes, followed by Canada and most of Europe. Next to suffer these real estate demand declines will be the East Asian countries, like Taiwan and South Korea. Australia will likely be one of the last to cave and most likely to a lesser degree. Consider the following sample projections: • Japan: Net demand again points down between 2016 and 2033. • The U.S.: Net demand will see its steepest fall from 2014 into 2021 before plunging even lower into around 2039.

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• Canada: Net demand points down after 2005 until at least 2036. • Europe: Net demand across the Atlantic is even worse than in the U.S. in most countries, especially Germany, Italy, Greece, Portugal, Austria and Spain. • Australia: Net demand is up into 2015, but then points down modestly into 2020 before pointing down more dramatically between 2025 and 2036. But the greatest single real estate bust in modern history will occur in China — mark my words! I expect the Chinese real estate market to crash near the 85% level when the bubble bursts. And the strongest recoveries, from the early 2020s onward in the next global boom, will come in the emerging countries outside of China, especially India and Southeast Asia. Indeed, China will be the first emerging country to see its workforce and demographic trends slow from 2012 forward and especially after 2025. This comes after the greatest overbuilding of real estate in history. China already has a 27% vacancy rate in its major cities at the top of the greatest boom in world history. It’s not hard to imagine the rate at which this vacancy will increase in a global bust. But as workforce growth declines in most countries around the world — or remains flat, as it will in countries like the U.S., Canada, France, U.K. and Denmark — it’s not just residential real estate prices that will be hammered by these impending demographic cliffs. Commercial real estate will get hit even harder.

The Most Bearish Sector of All Commercial real estate almost always falls faster and harder than its residential counterpart, because when the tough times come businesses are much more likely to default on leases or sell their properties than homeowners. Residential property owners are almost always attached emotionally to their real estate. Japan, whose real estate bubble burst way ahead of other developed nations, is always a great indicator of what lies ahead for the rest of us. Japan saw its residential sector soar 160% and then crash 60%. However, its commercial real estate sector bubbled up 300% between 1986 and 1991, before it crashed 80%. And today it has barely moved from those lows. But there are also overriding demographic reasons why commercial real estate is set to plunge in the U.S. and much of the developed world.

Annual Labor Force Growth

We looked at buyers vs. die-ers for residential real estate, and it is that same demographic trend that impacts U.S. commercial real estate via its effect on workforce growth. I simply calculated the difference Why Commercial Real Estate Will Fall between new entrants to the U.S. workforce at an average age of 20 and retirees at an average age of Millions 2.5 63. The result is the disturbing downtrend that’s evident in this chart. 2 The chart also reveals why the 1970s marked the best decade in history for commercial real estate. This was when baby boomers entered the workforce at the highest rates, while the older and much smaller Bob Hope generation had not peaked in their retirement yet.

1.5 1 .5 0 -.5 -1.0 1972

Workforce growth would have been higher in 1982, but the severe recessions of 1980 and 1981

1982

1992

2002

2012

2022 2027

SOURCE: U.S. Census Bureau, Dent Research

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to 1982 cut into employment and commercial real estate prices. So, the commercial real estate boom peaked in 1980. And it’s worth noting that strong growth and a peak occurred, in spite of the recessionary 1970s, as well as the highest inflation and mortgage rates in modern history — proof that demographics are more powerful than interest rates to the health of real estate! The next peak in workforce growth and fundamental demand for commercial real estate occurred in much better economic times — between 2000 and 2002. And, as you can see from the chart on Page 5, the trends have pointed down more sharply since 2008, and they do so again from 2015 until around 2022 before they start to grow again. After 2028, the peak year at which the millennial generation will have fully entered the workforce, growth rates will slow and eventually decline again. In other words, the farther you go out, the worse things look for commercial real estate. Even without an economic downturn, the U.S. workforce total will fall into negative territory by 2016 and will remain negative until around 2031. The massive downturn I forecast between 2015 and early 2020 will exacerbate the decline and workforce growth will contract even further, taking commercial real estate with it on its downward spiral. During the last crash, U.S. commercial real estate prices collapsed by 43% and residential real estate tumbled 34%. For years now, I’ve advised U.S. businesses not to own commercial real estate, but to rent until around 2023, when the nation’s workforce begins to grow again (albeit from lower levels) and the next global boom begins again. In fact, my advice is to avoid this sector at all costs between 2015 and 2021.

The Fall of the Super Cities Signs of trouble in the commercial real estate sector are already evident globally. For example, the richest family in China has been feverishly dumping its commercial real estate holdings over the last year. But this family is not alone. One of the clearest recent trends in developed countries is the veritable cornucopia of foreign money being invested by the super-wealthy in the world’s most attractive large cities, especially cities where foreigners can get their kids a good English-speaking education. These cities include London, New York, Toronto, Miami, Los Angeles, San Diego, San Francisco, Vancouver, Singapore, Sydney, Melbourne, Brisbane, Auckland and Dubai. These cities are the most bubbly. Most people think that the super-rich will always buy in these desirable areas, but history proves otherwise. Because these cities are prone to the biggest bubbles, they also have the greatest downside. The ultra-rich have always represented the smart money. When the bubble starts to burst, a chunk of this group will be the first to get out — but for many, it will be too late. This is exactly why I predict that these super cities around the world will crash the hardest. And many of the ultra-affluent, who have been driving these real estate bubbles, will see their wealth evaporate — just as the Japanese did when their bubble peaked in 1991. Wealthy Japanese used their instant riches from the country’s real estate bubble to buy overseas. But when Japan’s bubble burst (ultimately 60% in residential and 80% in commercial) their wealth evaporated and they became sellers overseas and at home. This is how bubbles work. The same speculators and trends that inflate bubbles, end up collapsing them. In the following section, I will reveal the real estate risks in 20 major U.S cities and how to best gauge their downside. I also reveal how some of the most attractive and desirable cities in the world are likely to fare when the biggest real estate bubble in modern history bursts.

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Where the Risks Are Greatest The real estate bubble in the U.S. between 2000 and 2006 was not quite as extreme as Japan’s 1986 to 1991 bubble. During those six years, Japan’s housing prices increased a whopping 160%, compared with 127% in the U.S., as the following chart shows. If the U.S. retracement echoes the Japanese experience, that would suggest a 46% fall from price levels in late 2014. You can see how prices begin to diverge upward increasingly from the natural trend line in early 2000. This is where the bubble began. The first decline in major cities was 34% — greater than the 26% decline during the ravages of the Great Depression, because home prices did not bubble up across the U.S. during the 10-City Real Estate Index Roaring ’20s. There has been a rebound since 2012, but not even near the old highs. With net housing –– January 2000=100 100=2000 demand pointing down sharply between 2015 and 250 225 2021, another deep collapse is all but inevitable. 200 175 150 125 100 75 50 1990

Given that real estate prices vary greatly on a regional basis, I have always advised people that the best simple measure to gauge your downside risk is to look up the value of your property in January 2000. When the bubble bursts, this is the point to which your property is likely to fall — or perhaps even 10% to 20% lower.

-34%

Pre-Bubble Trend

2000

2010

-46% -59% 2017

SOURCE: Standard & Poor's Case-Shiller U.S. 10-City Home Price Index, 2014

You can see in the chart that the key support levels for the residential real estate market took hold in January 2000, when the bubble really took off, thanks to the transfer of speculation into real estate after the collapse of the tech bubble. As a rule, bubbles always retreat from their peaks to where they began, or even a bit lower. This is what forms the likely range of downside exposure over the following seven years, when net demand stops sliding — at least temporarily — and the next global boom begins. To just erase the bubble that started in January 2000, home prices would have to fall 56% from their top in early 2006. That’s 46% from the recent highs in October 2014. If home prices fall back to their previous lows of 1996, that would mean a 67% decline from the top and 59% from recent highs. All of this means that you have to prepare yourself for what’s coming, because your residential and commercial real estate, along with your investment portfolio, is likely destined for deeper declines than we saw during the great recession and its aftermath. And not only will the next downturn be much deeper, it will stretch further around the globe. I expect all major real estate markets around the world to crash as the popcorn popper accelerates. In the U.S., the greatest bubbles occurred primarily on both coasts. Between the Rockies and the Appalachian Mountains, the real estate bubbles were less extreme and, in some cases, minimal. Cities like Dallas, Houston, St. Louis and Kansas City bubbled mildly into 2006. Smaller central cities, like Omaha, Nebraska, bubbled less. The exceptions are now North Dakota, Dallas and Houston, thanks to the U.S. fracking industry, and Austin, the new hipster city in Texas. The table below shows the downside risk in the broad bubble from January 2000 to the peak in each city. Note the third column shows the worst-case scenario — if prices fall back to the 1996 levels just before the bubble.

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With this, you can gauge your likely downside risk of a price tumble to the levels of early 2000 and to mid-1996 valuations to ensure the bubble has largely been erased. Only at this point can you be sure about investing in real estate again — but don’t expect a robust rebound. I would advise that you own for utility or renting for the sake of cash flow in the future, rather than for appreciation.

How Bad Can This Get?

City

Downside Risk Downside Risk to 2000 Levels to 1996 Levels

Los Angeles

-55%

-67%

Washington, D.C.

-51%

-57%

San Diego

-50%

-64%

Between early 2000 and the peak in 2006, prices in Miami surged 180% and prices L.A. were close to that. The first crash into 2011/2012 was as high as 62% in Las Vegas and 58% in Miami and as low as 9% in Dallas and 12% in Charlotte. That is how much real estate varies within just one country.

San Francisco

-48%

-65%

Miami

-47%

-53%

New York City

-43%

-55%

Boston

-42%

-59%

Portland

-40%

-50%

Seattle

-40%

-56%

When looking at this table, be sure to note that Miami could still fall 45% after its stronger rebound, and prices in San Francisco stand to tumble 49% if they fall to the point where the bubble began in January 2000.

Tampa

-37%

-45%

Denver

-35%

-53%

Dallas

-34%

-45%

Phoenix

-32%

-46%

Minneapolis

-27%

-44%

Las Vegas

-26%

-34%

Charlotte

-21%

-33%

Chicago

-21%

-33%

Atlanta

-14%

-30%

Cleveland

-5%

-20%

Detroit

-5%

-23%

Also note that prices have hit new highs in Dallas (also Houston) and Denver — cities that were not hit hard in the last crash — could see much higher declines ahead. Dallas and Houston are now very vulnerable due to the collapse in oil prices and the threats to the fracking industry with 42% of crude production in the U.S. now in Texas. Such potential declines will likely still be a good bit lower than the strongest bubble cities.

I like to break these top 20 cities into three distinct categories of downside risk: • Greater Bubble Cities: Miami, L.A., D.C., San Diego, Tampa, Las Vegas, Phoenix, San Francisco and New York. • Medium-sized Bubble Cities: Seattle, Portland, Boston, Minneapolis, Chicago, and now Houston and Dallas. • Lesser Bubble Cities: Cleveland, Detroit, Charlotte, Atlanta and Denver. There are enough differences to warrant looking at individual cities separately to target where the bubble began and where the last correction occurred. You can duplicate the approach I used by looking at longerterm prices in any city in which you are living or doing business. Now let’s look at the bubble risks in five major American cities. I’ll start with Miami, because it experienced the biggest bubble since 2000… • Miami: This beautiful South Florida multicultural metropolis had the steepest rise of 146% with its bubble beginning around mid-2000. I witnessed this myself between 2002 and 2005, and I sold there near the top of the market. To correct the bubble, Miami home prices would have to fall 47% from late 2014 prices. However, prices

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have surged higher than the 2006 peak in Miami’s two hottest areas, South Beach and downtown. Those two super-bubble areas could see devastating price declines, because the rises have been driven largely by those ultra-rich foreign buyers and they are the one who disappear fastest! • New York City: The bubble in the U.S.’s largest city appears to have begun around early 1999 and rose 141% into its peak. It would take a 48% decline to erase that bubble and a 58% fall to return to the previous lows in early 1991. Real estate prices in parts of Manhattan are similar to those in Miami, ranging from $5,000-plus per sq. ft. for prime condos to as high as $13,000 per sq. ft. for the poshest penthouses, some of which make South Beach look like a bargain. The average condo jumped from $1.5 million in 2013 to $1.8 million in 2014 — up 20%. The greatest gains came in the $10 million-plus segment. But make no mistake about it, when the global bubble finally bursts between 2015 and 2022, these places could decline by 80% or more. This is why the richest people in the world will become the biggest losers? • Los Angeles: The bubble in this Southern California City of Angels began later than most, around early 2002. To erase its bubble, L.A. would have to fall 42%. The major Californian cities — just like Boston and New York, have always been expensive. They became even more expensive. And after the bubble bursts, despite the inevitable price decline, they will still be substantially more expensive than Miami or Phoenix — as will New York. San Francisco has had a bubble rise of 127% and a potential fall ranging from 49% to 69%. San Diego had a more typical bubble of 102% and has downside risk of 38% to 64%. • Chicago: If we move to the largest city in the center of the country, Chicago had a bubble that was slightly smaller than the average bubble. Chicago is an example of a major city where the downside risk is not extreme, especially in the outer suburbs and exurbs. As you can see from chart on Page 7, it started around mid-1998 and saw an 89% rise to the top. Chicago would have to fall a mere 28% to erase the bubble and 45% if it went all the way back to its previous low in early 1990. • Atlanta: Like most of the southeast U.S., Atlanta has benefited from migration trends for decades. Its bubble began in early 1997. While its rise was 63%, that’s 40% lower than the average 20-city gain. Hence, its downside risks are lower. The Atlanta real estate market would have to fall 28% to return to pre-bubble levels. The city’s last fall was steeper than would have been suggested by the size of its bubble — but this was the result of stronger overbuilding in this city. Now the table on Page 10 reveals how real estate bubbles began at different points in time in different cities. Therefore, the downside risks to the origins of the bubble vary from city to city. This table leans toward slightly greater declines on average, although cities like L.A., San Diego, San Francisco, Portland and Seattle would have slightly less decline projections. Hence, you can compare Table I (on Page 8) and Table II (on the next page) to get a broader range of downside risks. The two cities that don’t fit the normal bubble patterns are Dallas (and Houston not listed in the CaseShiller top 20 city index) and Denver. Both experienced minimal bubbles and consequently minimal declines after the first bubble burst. But unlike most major cities, these areas have continued to have high migration and strong job growth with 67% of the increase in U.S. crude production. At the same time, Denver has become the pot capital of America. Because of these trends, Dallas and Denver have bubbled in the rebound and have hit substantial new highs. Therefore, the risks are now much greater than they were when the last real estate bubble peaked in

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early 2006.

Bubble Gain and Burst Scenarios

Dallas, as Table II shows, would have to fall 41% to erase the bubble and 47% to return to previous lows in early 1991. Meanwhile, Denver would have to fall 47% return to the level at which the last bubble began and 69% to get back to its early 1991 lows.



One scenario that is likely to take place in a number of cities is that this second crash will have a similar price drop to the first crash. In another group of cities, which includes Cleveland, Charlotte, L.A., New York City and Washington D.C, prices will likely fall back to the bubble origin or perhaps even halfway between the bubble origin and the worst-case scenario. Meanwhile, there is a second group, in which these declines would take them all the way to the worst-case scenario, or at least close to it. That group includes Atlanta, Chicago, Miami, Portland, San Francisco, San Diego and Seattle. Boston is another anomaly. This city held up well in the last crash, despite being one of the most expensive cities in the country as well as having a bigger-than-average bubble. Boston will come down to earth only if it erases the bubble price rise and takes a 52% fall. A 62% fall will take prices back to their late-1991 lows.

City

Downside Risk Downside Risk to Bubble to Lower Origin Bubble Levels

Boston

-52%

-62%

San Francisco

-49%

-65%

New York City

-48%

-58%

Minneapolis

-47%

-39%

Denver

-47%

-69%

Washington, D.C.

-43%

-57%

Los Angeles

-42%

-67%

Dallas

-41%

-47%

Miami

-39%

-58%

San Diego

-38%

-64%

Portland

-33%

-46%

Seattle

-32%

-56%

Charlotte

-31%

-42%

Chicago

-28%

-45%

Atlanta

-28%

-40%

Tampa

-25%

-45%

Phoenix

-22%

-56%

Detroit

-21%

-39%

Las Vegas

-14%

-40%

Cleveland

-13%

-36%

Finally, four cities erased (or more than erased) their bubbles in the last crash — Phoenix, Las Vegas, Detroit and Atlanta. Detroit is a special case, because it remains a victim of the shrinkage of U.S. auto industry and the transfer of jobs to Asia and the southeast U.S. Meanwhile, Phoenix and Las Vegas were two of the most speculative cities in America, whose steep and late-stage bubbles burst dramatically. At the same time, Atlanta experienced some of the greatest overbuilding in country. These four cities are more likely than others to see the worst-case scenarios play out. However, they also have much less downside risk than the most bubbly of U.S. cities, like Miami, L.A., San Francisco and New York.

Global Bubbles in the Developed World Real estate bubbles have not been restricted to the U.S. In fact, as I have said in the past, the bubbles are generally even more extreme in the major cities around the world than they are in the U.S. Indeed, there are many global cities that have yet to peak. I will start with my favorite city in the world…

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• Sydney: The trends here are very similar to trends in other major bubble cities, like Melbourne, Brisbane, Vancouver and Toronto. After the U.S. subprime crisis and the real estate collapse between 2006 and 2012, prices in Sydney have continued to climb. Australia has the most favorable demographic trends in the developed world, largely thanks to the volume and quality of its immigration over many decades. It is one of the very few developed countries to have a millennial generation substantially larger than its baby boom (along with Israel, Sweden, Norway, Switzerland and New Zealand). At the same time, demographics and strong exports have kept Australia’s economy more buoyant. It also continues to benefit from strong immigration from Asia, especially the affluent from China. It is China’s second foreign real estate market after the U.S. The Chinese are the strongest factor that continues to drive Sydney’s high real estate prices ever skyward. The same phenomenon has been occurring in Melbourne, Brisbane, Vancouver, L.A., San Francisco and Toronto. Real estate prices in Sydney began to accelerate around mid-1998, and then saw a mild correction after early 2003 into 2005. After that correction, Sydney’s prices surged 64%. To correct back from current levels, prices would have to fall 37%. Given Australia’s favorable demographics, that 37% fall looks like a likely scenario in coming years. When Sydney sees a demographic decline from 2025 forward, it could then fall back 59% to its early 2000 levels — but that may not occur because the world’s economy should be back in a general boom by then and the commodity cycle will come back around to favoring Australia again. The downside risks over the next several years are similar for Melbourne where the downside risk is 46%; Brisbane has a 38% downside risk.

Real Estate Prices, Sydney 1986-2014 Index=2000 250

• Vancouver: Real estate prices in this Canadian metropolis would have to fall 30% just to erase the bubble from mid-2009, and 63% for prices to decline to early 2000 price levels. In Canada, the real estate downside is now worse than the U.S. because prices have continued to rise.

200

+59% Rise

150

-37%

100

-59%

50 0

1986 1990 1994 1998 2002 2006 2010 2014 • Toronto: Given Canada’s weakening SOURCE: Australian Bureau of Statistics demographic trends and high export levels, it will feel the global downturn more than the U.S. By that token, real estate prices here would have to see a 36% decline to erase the bubble from mid-2009, and a 60% fall for prices to reach the levels of early 2000.

• London: The U.K. capital is the most overvalued English-speaking city in the world, and its bubble — 65% since mid-2009 — would suggest a decline of at least 39% and potentially as much as 64% to return to early 2000 levels. London is a major global financial center. Given that this coming financial crisis will hit cities with major financial centers the hardest, I expect London to trend toward the worst-case scenario. Paris and Rome are even more expensive.

Global Bubbles in the Emerging World Real estate bubbles in the emerging world have been the most extreme since 2000. I have focused a lot in the past on Shanghai and the unprecedented China bubble, which I think will be the greatest bubble to burst. Home sales are already down 9.7% in 2014. I also think it will have the greatest domino effect on

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global real estate markets, because the rich Chinese, like the affluent Japanese in the late 1980s, have been the greatest bidders in the top cities of the world. Here, I am going to use Mumbai as an example, because as it is similar in its extreme appreciation to Shanghai and the major Chinese cities. • Mumbai: Real estate in this Indian metropolis has been on a tear since early 2000 — with 463% appreciation. This is similar to Shanghai’s 563% price surge since 2000. A large part of this acceleration took place at the beginning of 2010, with 83% increase in the last five years alone. Mumbai has two key support points. If it falls back to the bubble from early 2010, that would mean a 46% decline. If it falls back to early 2006 levels, prices would fall 59%. A decline to early 2000 levels would see a massive 79% drop, similar to Shanghai. The difference with China is that the Middle Kingdom has been overbuilding at a massive scale, while India has been underbuilding. Demographically, China’s workforce will slow modestly in the decade ahead; India’s workforce will continue to grow rapidly. The overseas boom in emerging cities is harder to gauge, because there is little historical perspective to measure against. However, I think India’s crash will be closer to the 46% level and Chinese real estate could plunge by as much as 85%.

Mumbai Real Estate Prices 2000-2014 Index=2007 250

The table at the bottom of the page lists a few key foreign cities in the developed and emerging world, as well as where I have calculated the downside risks to be.

+85% Rise

200 150

-46% -59%

100

One key city in Asia is Singapore. It has become the new financial and trade center in the region. Its real estate bubbled first with the Southeast Asia bubble into 1997 and then collapsed. It has only recently experienced a small bubble between early 2009 and late 2013 — about four years with a price rise of 69%.

50 0 2000

2002

2004

2006

2008

2010

2012

2014

SOURCE: National Housing Bank, Bank of India

Key Global Bubbles and Bursts

Singapore will be hit hard by the China bubble burst, but it will also be a safe haven for such affluent Chinese. I estimate that the range of declines there will be between 37% to merely erase the recent bubble and 52% to go back to the strongest support around its previous lows in 2002.



Final Word The real estate bubble in which we all now live has been fueled by unprecedented speculation, liberal lending and government guarantees — more so than at any time in modern history. The bubble is not just confined to the U.S. It is global and even includes emerging-country cities like Mumbai,

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City

Downside Risk Downside Risk to Lower to Bubble Origin Bubble Levels

Shanghai

-81%

-86%

London

-62%

-72%

Rio de Janeiro

-60%

-72%

Dubai

-52%

-70%

Toronto

-52%

-59%

Vancouver

-50%

-64%

Mumbai

-46%

-59%

Sydney

-37%

-59%

Brisbane

-36%

-67%

Singapore

-36%

-51%

Bangkok and Shanghai. Although we have seen a number of bubbles burst in stocks and commodities in the past several decades, the real estate collapse ahead will be more severe than anything experienced in our lifetime. Bubbles don’t correct; they burst and prices retreat to at least where they began — if not lower. That means a downside of more than 40% in most major U.S. cities, and much more in the most extreme cases, such as in Miami and Shanghai. Our advice has not wavered: Sell all non-strategic real estate for your business and personal use now. Your business is better to lease than own for the next several years. Keep your primary home, but only if you plan to stay in it long term. If you plan to downsize or move in the next few years, sell! Certainly, sell vacation homes that are not dear to your heart. Most importantly, look at the risks from city to city. For example, when I moved from Miami to Tampa in 2005 and decided to rent, I would have considered buying if I had moved to Dallas, where the downside risk of buying was much smaller back then. But even Dallas looks riskier today after being one of a few major cities to move to new highs after the first bust (including Houston and Denver). As always, outside of your real estate holdings, there are ways to play the coming bubble burst in our Boom & Bust model portfolio. Falling price growth suggests we could see the downside start to hit as early as mid2015. The time to act is now… because in most areas this bubble is getting stretched further than ever before.

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