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Original link: http://www.fool.com/news/commentary/2005/commentary05102606.htm

The total value of residential property in developed countries rose by more than $30 trillion over the past five years to more than $70 trillion, according to The Economist. That increase is equivalent to 100% of those countries' combined gross domestic products (GDPs). Ponder the magnitude of that statement.

To be fair, it's difficult to grasp exactly how amazing that is without historical context. Those numbers dwarf any previous housing boom, the global stock market bubble of the late 1990s (a GDP increase of 80% over five years), and America's stock market bubble of the late 1920s (55% of GDP). We're looking straight into the eyes of the biggest bubble in history.

Some signs
Consider these bubble indicators:

• Compensation. Robert Toll, CEO of Toll Brothers (NYSE: TOL) is No. 13 on the Forbes list of most highly compensated CEOs. His total compensation for 2005 is estimated to be more than $50 million, including a $30 million bonus.
  
   
• Media. "Flipping" properties has become so popular that there's even a new television show called Flip This House. It's nearly impossible to pick up a newspaper or magazine without reading about the riches to be made in real estate.
  
   
• Cocktail-party barometer. Remember a few years back, when the only thing people wanted to talk about was their latest IPO highflier? Well, listen closely at your next party and see how many of your friends are talking about how much they've made in real estate.
  
   
• New risky mortgages. The Washington Post recently reported that Fed Chairman Alan Greenspan warned that "home prices seem to have risen to unsustainable levels" in certain local markets. An Economist article stated that "42% of all first-time buyers and 25% of all buyers made no down payment on their home purchase last year."
  
   
• Consumer debt levels. Consumer spending accounts for approximately 70% of our GDP. That's well above the 75-year average of 65.5% (covering the period 1929 to 2004) as described in a report (link opens a PDF file) provided by famed value investor Arnold Van Den Berg of Century Management. This spending level is not sustainable, especially now that consumer debt is approximately $10 trillion, or almost 80% of total GDP ($12.3 trillion). The bulk of that consumer debt? Yep, you guessed it: Approximately $8 trillion is mortgage debt.

Don't know much about history
Leverage -- particularly buying stocks on margin (with little or no money down) -- played a big part in the Great Depression. We're doing much the same thing today with interest-only or negative amortization loans.

Remember Black Monday in October 1987? How about the savings and loan failures that followed? From the late 1980s to the late 1990s, real estate was not a particularly great investment. My wife and I bought a home here in Virginia in 1998 for the same price the previous owners had paid way back in 1989. That's nine years and zero appreciation.

But wait, there's more. One of Warren Buffett's early partner letters (with updated numbers) provides a great example of the irrational returns of today's real estate market. Back in 1636, the Dutch purchased Manhattan Island for $24 worth of glass beads. In 2004, the assessed value of all the properties on Manhattan was $186 billion. What a steal, right?

Well, hang on a minute. Do you have any idea what kind of annualized return you'd need if you wanted to turn that measly $24 into $186 billion? Just 6.37%. Real estate, or any other investment for that matter, will not increase at 20% per year for very long. Eventually, reversion to the mean kicks in.

Did you know the housing market in Hong Kong saw a "real decrease" in housing prices of 57% from 1997 to 2002?

It's safe to say that people's expectations are out of whack and that real estate investments won't increase at the same rate they have in the past five years. As a matter of fact, in some markets, I don't think it's out of the question for some properties to lose 20% to 30% of their value in a given year or to see no increases for a decade or more.

Bringing it home: The 150 to 200 rule
If a home is selling for 150 times the monthly rent (or less), it's generally a good deal. If it's selling for more than 200 times the monthly rent of a comparable property, you're better off renting. I ran this little test for a house near Fool HQ in Alexandria, Va. House A has five bedrooms and 4.5 baths, and it sits on one pristine acre. You can rent House A for $3,900 per month. Based on comparable sales, this home would sell for approximately $2 million. Therefore, it's selling for 512 times the monthly rent! Put another way, if you mortgaged the whole $2 million at 5.42% over 30 years, your monthly payment would be more than $11,000.

If it seems like something doesn't add up, you're right.

Who will get hurt?
Bill Gross, famed PIMCO fund manager, believes that holders of real estate, equities, and high-yield debt will get hurt. I agree. Among those likely to be burned are:

• Speculators who own properties that don't generate cash flow exceeding their mortgage payments.
  
   
• Big banks -- in the fourth quarter of 2004, derivatives held by commercial banks totaled $96.2 trillion. If you own shares of a bank (or any other company with a significant amount of derivatives exposure), ask yourself whether you understand the potential risks. Holdings of derivatives are concentrated in the largest banks, with five commercial banks accounting for 96% of the total notional amount of derivatives in the commercial banking system, according to Kathryn Dick, deputy comptroller for Risk Evaluation at the Office of the Comptroller of the Currency.
  
   
• First-time homebuyers who are stretching into their homes using adjustable-rate mortgages, interest-only loans, and "pay as much as you like" loans.
  
   
• Holders of homebuilder stocks like Toll Brothers, Pulte (NYSE: PHM), and D.R. Horton (NYSE: DHI). These stocks seem extremely cheap right now, with price-to-earnings ratios (P/Es) in the single digits. However, this is a cyclical industry, and the best time to buy into cyclicals is when they look expensive.
  
   
• Exuberant buyers of mortgage-backed securities (MBS). As you'll read below, stretching for returns can lead many investors into mortgage-backed securities.

Why will the end be so bad?
Robert Brokamp, editor of the Motley Fool Rule Your Retirement newsletter service and the Fool's resident retirement guru, talks to his members a lot about asset allocation and the importance of negatively correlated assets. If one asset is going up, the other will likely be going down. It worked pretty well during the bursting of the tech bubble, when many people's real estate gains more than made up for their market losses. More than ever, I believe the economy is being driven by real estate. When that asset class turns, it will be like a bunch of dominos, and the stock market will follow. Here's why.

"Loose lending standards are probably the single biggest thing fueling the speculative fever we have today" in housing, says economist Kenneth Rosen, chairman of the Fisher Center for Real Estate at the University of California -- Berkeley. There are loose standards because of strong demand for mortgage-backed securities. In this low-interest-rate environment, an MBS guaranteed by Fannie Mae (NYSE: FNM) or Freddie Mac (NYSE: FRE) is too profitable for investors to pass up. In a time when 10-year Treasuries are yielding 4.2%, you can get an MBS earning 5.5% and a subprime security with no guarantee that can yield as much as 15%. Who is holding these mortgage-backed securities? Asian investors now account for roughly 10% to 20% of mortgage securities, but hedge funds, pensions, and insurance companies are big players in this market.

If we see a sharp drop in housing prices, I expect financial institutions to take a hit, consumer spending to dry up, default rates to rise significantly, and a long-overdue crackdown to come on loose underwriting standards. According to The Economist, over the past four years, consumer spending and residential construction have accounted for 90% of the total GDP growth. Additionally, more than 40% of all private-sector jobs created since 2001 have been real-estate-related sectors. In short, it's going to have a serious impact on our entire economy.

What should you do?
Really, there are a few ways to hedge against the bubble:

• Stay away from long-term bonds.
  
   
• If you're a first-time homebuyer, do not purchase a home that costs more than three times your gross household income, and do not pay more than 200 times what a comparable property is renting for.
  
   
• Focus on top-tier companies that trade at reasonable valuations with pristine balance sheets. There are some large-cap blue chips that qualify right now. Wal-Mart leads that list.
  
   
• If you're not a real estate expert, now is not the time to start speculating.
  
   
• Don't be afraid to hold cash. Some of the best money mangers around are holding 10% to 45% of their portfolios in cash. With rising interest rates, bubbly real estate prices, and government, consumer, and corporate debt at all-time highs, you'll no doubt find more attractive prices in the years ahead.
  
   
• If you have investments that are influenced by the real estate market -- like Home Depot (NYSE: HD) and Lowe's (NYSE: LOW) -- you must understand how a downturn will affect their businesses.
  
   
• It's important to have exposure to economies outside the United States. In his recent book, Wharton Business School professor Jeremy Siegel recommends that investors have 40% of their holdings in international companies.

In short, don't panic. And don't try to time the market. The first step toward becoming a master investor is becoming a compulsive saver. Prudent investors who are not overburdened with debt will be fine. So take stock of your personal situation in the next week or two. And if you'd like some help, consider a 30-day free trial of Motley Fool Rule Your Retirement, where Robert can help you learn more about asset allocation and planning for a financially secure future. Click here for more information.

Buck Hartzell believes that capital preservation is crucial to long-term investing success. He owns a home but none of the companies mentioned in this article. Fannie Mae and Home Depot are Motley Fool Inside Value recommendations. The Fool is investors writing for investors.

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