I have yet to find the definition of a bubble in any financial literature I have read. In practical terms, I would define a bubble as a temporary price level that is thought to be unsustainable. Therefore, prices will be lower when the bubble bursts.

Are we in a real estate bubble?
Real estate prices in Sonoma County, as measured by the median home price, have almost doubled in the last 5 years. This is an average annual rate of growth of 14% per year. In my view, this rate of growth is higher than can be sustained over the long haul. As a result, it is reasonable to expect prices will not to continue to rise they as have in recent years. So, by my definition, we may be in a bubble.

It's much harder to know if prices will simply rise slower, level off or decline in the immediate future. The dramatic drop in common stock prices makes some people leery of the possibility of a similar drop in real estate values. There is no question that real estate values, like any market driven asset, are subject to cyclical swings. Still, absent some major shift in the attractiveness of Sonoma County as a place to live, or a more severe economic recession than we have seen so far, I do not see a sharp drop in property values, like we have seen with stock market values. Historically, cyclical swings in home values have been much less dramatic than swings in other assets. This may be explained by the fact that most people do not sell their homes when prices do soften, whereas, they may sell other assets held strictly for investment.

How should I react to this bubble?
This largely depends on your time horizon. If you are contemplating buying property that you expect to sell in less than 2-3 years, the risk that prices when you sell will be lower is certainly greater than that risk would have been a few years ago.

On the other hand, if you expect to hold the property longer, I believe trying to time the market is not a productive investment strategy. Numerous studies have shown that a consistent, long-term investment strategy outperforms a market timing strategy, for two main reasons. First, it's not very likely you can pick the tops and bottoms very accurately and consistently, until they have passed. For example, who predicted a 15% rise in values in 2002 after a basically flat market in 2001 following 3 years of rampant price increases? Second, a timing strategy requires being out of the market, conserving capital, when prices are deemed to be high. To be out of the market requires selling property and incurring capital gains taxes (except for some sales of primary residences). A long-term strategy of staying fully invested in all markets can be more productive simply because it avoids the capital erosion from taxes that buying and selling cause.

What's the bottom line?
Property owners, investors especially, might exercise more caution in their acquisitions now, if they expect to sell soon. Still, those with a long-term outlook should be comfortable purchasing real estate based on its long-term track record of appreciation, knowing they will experience some up markets, some down markets and some sideways markets.