Bubble trouble?
The red-hot housing market reminds some of the latter days of the 1990s stock market. How will it end?
Ken Wu and Alan Koder figure they got in just in time. Eager to buy their first homes before skyrocketing real-estate values in San Diego priced them out of the market, two years ago the friends each bought houses in up-and-coming neighborhoods.
"All I could afford was a fixer-upper," Wu, 31, says of the modest 1,500-square-foot house he purchased near downtown for $360,000 in 2002. "It seemed like a ridiculous price. But I figured if I did a little work on it, I could add value."
The sweat equity he put into painting it, installing a skylight, and replacing rotted flooring surely helped. But the real bang for his buck came not from his efforts but from those of a flood of buyers who followed in his footsteps. In a similar rush to get in before prices--and interest rates--increased, they were part of a buying frenzy that has since bid up the price of San Diego real estate by about 50 percent in just two years. "It's pretty amazing," says Wu, a financial analyst, of the $550,000 he believes his home would now fetch. "I thought I was buying at the top of the market, but there are houses just down the street that people are flipping for even more."
Koder hasn't done so badly, either. "I figure my place is worth about $500,000 now," the 27-year-old biologist says of the $330,000 suburban house he bought with a 10 percent down payment and an adjustable-rate mortgage, giving him a total two-year return on his money of more than 500 percent, at least on paper. "I always knew real estate was a good investment. I just didn't know it was this good."
Convinced there is more money to be made, last summer the two formed a real-estate-investment club with another friend and purchased a pair of condominiums in Las Vegas--their favorite gambling spot--for about $125,000 each. The rent they receive doesn't quite cover the mortgage payments. But they figure their real-estate gamble has already paid off "because the market there is just exploding," says Koder, who estimates that the condos have already increased in value by as much as $30,000 each. "We were figuring on about 8 percent appreciation a year, but I bet it'll be more."
Such outsize expectations hardly seem out of line these days. After one of the broadest and longest run-ups in housing prices ever, most homeowners are sitting pretty. But there is a growing angst about how much longer the party can go on. Those who believe housing is now the new "bubble," much like the '90s stock market, point to slowing sales and rising interest rates amid nosebleed prices that have far outpaced growth in personal income. Take Las Vegas, for example, where the median home price has increased an eye-popping 54 percent in the past 12 months alone.
And while much of the middle of the country has enjoyed far more modest gains, red-hot coastal markets in California and the Boston-to-Washington, D.C., corridor, as well as in southeast Florida, have pushed up the national median sales price by more than 7 percent in the past year, three times faster than household income.
Lofty expectations. That said, interest rates remain low by historic standards, and the economy is growing at a steady, if not spectacular, pace. And while prices continue their upward spiral, it's little wonder a growing number of acquisitive home buyers, including speculative investors like Wu and Koder, expect prices in places like Southern California to continue their surge. In a recent Yale University survey of home buyers in Los Angeles, for example, respondents said they expected their homes to increase by an average of 22 percent annually over the next decade, while more than two thirds said they feared being left out of the boom if they didn't buy now. Recent buyers in Boston and San Francisco were similarly exuberant, expecting 13.2 percent and 17.9 percent in annual appreciation, respectively, while also saying they had been anxious to get in before prices rose further.
Yet it is precisely that combination of greed and fear of being left behind that could pop what some experts believe is a dangerously inflated housing bubble in some parts of the country. "It's the same sort of irrational behavior that helped inflate the stock market bubble of the 1990s," Yale economist Robert J. Shiller, author of the prestock market crash book Irrational Exuberance , says of the survey's findings. The last time he observed such extravagant expectations was in 1988, just two years before a housing bust that saw prices in Los Angeles drop by 40 percent in real terms and by about 20 percent in San Francisco and Boston in the early 1990s. Before that swoon, he says, buyers voiced many of the same attitudes they do today: that houses are the best long-run financial investment, with a big upside and relatively little risk.
In cocktail party chatter reminiscent of the days when housewives and taxi drivers confidently traded stock tips, many have oversimplified the real-estate market's underlying fundamentals, Shiller believes. "The typical simplistic view is that it's just supply and demand," he says. "That where they live is such a wonderful place and that since there isn't enough land for everyone, prices have nowhere to go but up."
In truth, sprawling housing developments across the country attest to the housing industry's ability to readily supply the demand, and then some. Last year alone, America's builders started construction on about 2 million homes, nearly twice the number of households the country added. Meanwhile, growth of so-called exurbs in outlying areas demonstrates Americans' willingness to commute more than 50 miles one way to buy where prices are more affordable. Even in crowded places like Miami, a building boom that has transformed once moribund inner-city neighborhoods into massive construction zones is expected to add 25,000 condos in the next year and a half--about five times the number sold last year.
Space crunch. To be sure, physical limits to growth in some areas like Miami's beachfront and along New York City's Central Park are real. As the old adage goes, "The key to real estate is location, location, location," says Patricia Whitehead, an associate broker with New York's Corcoran Group, which estimates that the average price for a condominium in Lower Manhattan has surged by nearly 80 percent since 2000, to more than $880,000. "This island is only so big."
That may be true. But a lack of available housing didn't stop real-estate prices from plummeting there amid the economic downturn that followed the 1987 stock market crash. That's when Sheryl Lieberman bought her first apartment in Manhattan for $230,000. Six years later, a friend in the same building sold a similar apartment. "It was two flights higher, so it should have been worth more than my place. But she only got $160,000," recalls the 45-year-old financial adviser. "People forget that what goes up can also come down. Like right now, they think real estate can't fail. I heard the same thing in the early 1980s, and then came the late 1980s."
Convinced the New York City market is overpriced, she recently decided to sell the apartment where she now lives on Midtown's Sutton Place and rent for a while. "I may not be selling at the top of the market," she says of the sum she received, which is nonetheless about triple what she paid for the apartment in 1996. "But as inflation picks up, you'll see interest rates go up, too. And as a direct result, real-estate prices are going to go down."
Lieberman doesn't expect an outright crash in the market. "But having been an investment professional for the past 23 years, I've seen the cycles come and go," she says. "And we're near the end of one now."
Predicting exactly when a financial bubble will burst is next to impossible. That's partly because it's so hard to account for the vagaries of human psychology: how greedy will people get (usually, more than anyone expects) and what will it take to make them panic (often, far less than is rational). Yet there is mounting evidence that things are getting out of whack. In addition to buyers' increasingly unrealistic expectations of appreciation, one worrisome sign is the surging gap between housing price increases and growth in personal income.
Trusty real estate. Until recently, the run-up in housing prices roughly tracked increases in personal income. But that relationship, long considered a bellwether for judging housing affordability, began to change a few years ago as the recession put a lid on workers' salary increases yet failed to dampen their demand for homes. Burned by the stock market debacle, many Americans turned to real estate as a safe investment. Even if a home wasn't the "next big thing," at least it wouldn't turn into a worthless scrap of paper. Buyers were enabled, in part, by record low interest rates and a growing menu of adjustable-rate and interest-only mortgages that allowed people like Wu and Koder to purchase their first homes, while giving existing homeowners the buying power to trade up. Low home equity loan rates, too, sent others on a remodeling binge that may have increased their homes' values but put them further in debt.
For much of the past 30 years, median home prices in the United States remained between 2.7 and 2.9 times Americans' median household income. In other words, if you spent every dime you earned to pay off your house (not including interest), you'd do it in about three years. But starting in 2000, that ratio began climbing to about 3.4 times personal income. In relatively subdued markets like Pittsburgh and Milwaukee, it remains closer to the historic norm. In the hot markets like San Diego, however, where prices have doubled since 2000 while income has increased by only 10 percent, the cost of houses approaches 10 times what buyers earn each year.
At a 5 percent annual interest rate, that represents a mortgage payment of about half of your household income. "I suppose you could pay that much if you stopped going out to dinner and cut back on travel," says Shiller. "But what if you have an adjustable-rate mortgage, and we get an oil shock that pushes interest rates way up? Then you've got a major family crisis."
That's exactly the predicament a growing number of home buyers could face. As of last month, more than a third of those buying homes financed them with adjustable-rate mortgages--up from just 12 percent three years ago--mostly because they feature lower payments than fixed-rate mortgages do (at least initially), allowing buyers to qualify for homes they might not otherwise be able to afford. In hot markets like San Diego and New York City, as many as half of all buyers are now using such strategies to get into their dream houses.
That is why some experts believe an interest rate spike could be the pin that pops the housing bubble. In the best-case scenario (one already underway since the Federal Reserve began raising interest rates in June), a steady but modest rise in mortgage rates begins to cool demand as buyers find they can't afford to pay top dollar. Sellers unwilling to accept lower offers hold out, increasing the inventory of unsold homes over time and eventually forcing sellers to begin lowering prices. In such a case, "it's not going to be a free fall," housing economist Celia Chen of Economy.com says of forecasts that call for slowing price increases over the next year or two, followed by a small decrease in prices for a few quarters. "We see up to about an 8 percent decline in the overpriced areas."
Far scarier, however, would be an oil price shock, a rapid decline in the U.S. dollar, or ever mounting budget deficits (or all three), which could force the Fed to aggressively raise interest rates to stave off inflation. That could quickly bring the real-estate market to a standstill. As higher rates begin to affect homeowners' ability to pay their adjustable-rate mortgages, some will be forced into foreclosure while others who have put little money down will simply walk away. (Even those with fixed-rate mortgages could find themselves in trouble if circumstances force them to sell into a declining market.) Banks will be left holding the bag, as will Fannie Mae and Freddie Mac, the nation's largest purchasers of mortgage debt. If they stumble, "we will be looking at trillions of dollars of losses and a major recession or a possible banking crisis," says economic consultant John R. Talbott, who predicts such a meltdown in his book The Coming Crash in the Housing Market.
Most experts think that scenario is unlikely. Yet even some longtime real-estate boosters are proceeding with caution. Take real-estate analyst Sanford Goodkin, who three years ago decided to sell his large house in Del Mar, just north of San Diego, and downsize to a condo, in part out of concern that the market had become overheated as hordes of speculators bid up prices. "My rule of thumb is when 15 percent of sales are to speculators, you're in trouble," says Goodkin. "And I would say San Diego is up to 20 percent by now."
David Shulman wouldn't just downsize. "If it was only an economic decision, I'd sell and rent for a while," says Shulman, who oversees real-estate equity research for Lehman Brothers in New York. The only thing stopping him: "my wife. She'd divorce me if I sold our place."
To be sure, a house is as much an emotional investment as it is a financial one. And even Shulman and Goodkin say those who buy and hold for the long term aren't likely to lose their shirts. That said, "anyone who can wait should," says Shulman. And those who can't "absolutely should lock in a fixed-rate loan," Goodkin says of 30-year mortgages that are still below 6 percent. "It's wonderful insurance that can protect you over the long run."
It's advice even gamblers like Wu have taken to heart. Although he purchased his San Diego home with an adjustable-rate loan, he recently refinanced at a fixed rate. "My parents think I'm going to go broke," he says of his real-estate investments. "But I ran the numbers, and I feel like even if the worst-case scenario happens, I'd only be losing maybe $500 a month, which is the equivalent of buying a new Bimmer [BMW]. And at least my real estate will appreciate."
Or so he hopes.
UP, UP, AND AWAY
Most of the country is seeing a housing boom, but some places have seen a small decline.
Top number: Percentage change in median house prices in the third quarter of 2004 vs. the third quarter in 2003.
Bottom number: Median house price in 2003, in thousands.
San Diego, Calif.
32.5 pct.
$424.9
Las Vegas, Nev.
53.7 pct.
$179.2
Honolulu, Hawaii
19.5 pct.
$380.0
Tacoma, Wash.
12.1 pct.
$178.1
Boise City, Idaho
3.3 pct.
$130.6
Albuquerque, N.M.
1.6 pct.
$138.4
Fargo, N.D.
8.5 pct.
$115.1
Oklahoma City, Okla.
17.5 pct.
$103.0
Dallas, Texas
-1.6 pct.
$138.4
Madison, Wis.
10.2 pct.
$188.7
Des Moines, Iowa
4.3 pct.
$133.9
Champaign, Ill.
8.6 pct.
$118.3
Shreveport, La.
8.5 pct.
$100.7
Toledo, Ohio
-3.0 pct.
$111.1
Providence, R.I.
17.6 pct.
$223.4
Monmouth, N.Y.-Ocean, N.J.
14.7 pct.
$288.3
Washington, D.C.
22.3 pct.
$286.2
Bradenton, Fla.
40.7 pct.
$172.7
Source: National Association of Realtors
This story appears in the December 6, 2004 print edition of U.S. News & World Report.