House flippers: here’s what a bubble looks like

At a restaurant in Palo Alto in 1999, I overheard a woman say she hoped her stock options would keep converting profitably, because “I need them to pay my rent.” She was the Silicon Valley equivalent of today’s house-flipper.

She depended upon constantly rising asset prices to cover her negative cash flow.

Today the buzz in Orange County cafes is strikingly similar, along the lines of, “sure hope I can sell my house in Lake Perris — I need the money to pay my variable-rate mortgage in Irvine.”

Plus ca change, plus c’est la meme chose. If you have never personally lived through an investment bubble — that is, have never watched your friends and relatives wipe out — it’s naturally difficult to recognize the signals. House flippers, you may want to review these personal observations from Silicon Valley in 1999.

  1. People with no investment experience get rich quick, with little effort.
  2. You feel a bit foolish for not doing the same.
  3. Negative cash flow becomes normal.
  4. Investments rely mainly or entirely on other people’s money.
  5. “Profits” come mainly from selling assets, not products or services.
  6. All agree prices are crazy, but stay in, hoping to exit ahead of a crash.
  7. Asset prices dominate conversation.

Ask yourself honestly: doesn’t this sound pretty familiar?

When, you may ask, does it end? With websites like “condoflip.com” inviting you to buy and resell property that isn’t even finished yet, you have to wonder if the end is near.

But if this were knowable, bubbles would not occur. The reign of unreason is by definition unpredictable. Flipping might work for 3 more months, or 3 more years. All that can be said with certainty is that negative cash flow is unsustainable, and corrects itself one way or another.

When the end does arrive, it plays out quickly. There is no single precipitating reason — buyers suddenly dry up and the musical chairs game stops. Whoever still holds inflated assets is ruined in a “race for the exits,” to use a phrase popular in Palo Alto in autumn 2000. Most of the instant wealth in Silicon Valley was lost within 18 months after the peak.

Yes, property prices move more slowly, and inflation may even disguise a real decline beneath a nominal increase. But the debt load is huge, so the impact may be more severe. Who keeps paying that mortgage when there is negative cash flow and no prospect of an exit?

One last salient feature of investment bubbles: the smart money gets out first. Warren Buffett, the most successful living investor and noted for rarely selling any investment, recently unloaded a Laguna Beach home he had owned for 30 years. He actually joked at the Berkshire Hathaway shareholders’ meeting in May 2005 about how overpriced the property was. Charlie Munger, chairman of Wesco Financial in Pasadena and an L.A. real estate investor for over 40 years, chimed in that the smartest people he knew were selling all but their best properties in the L.A. area. A friend of mine at Pimco, the bond fund in Newport Beach, tells me some investment analysts there are actually selling their primary residences.

Ask yourself, house flippers: are you a smarter investor than Warren Buffett? Do you know more about interest rates and mortgages than an analyst at the world’s largest bond fund?

If not, you might consider this a good time to begin that race for the exits.