The “million dollar home,” which once conjured images of stately mansions and sprawling estates, now represents the average asking price for a 2500 square foot fixer-upper in the middle class neighborhoods of Midwood, Gravesend, and Homecrest in South Brooklyn. Is the recent run-up in prices an accurate representation of the value that these properties now represent – or are hysterical buyers simply inflating prices irrationally?

A Regional Phenomenon

While nationally, home prices have been on a tear over the past six years, increasing at about 7%-plus annually, certain markets, like South Brooklyn, have seen even higher increases. The overall year-over-year increase in second-quarter median price in New York was 22.3% in 2002 and 15.5% in 2003 – two to three times the national average. Some economists are worried that the upsurge could be a sign of a real estate “bubble,” when frenzied buyers bid up prices artificially high. Eventually, the bubble bursts and prices plummet.

Slower growth
Year-over-year increase in second-quarter median price in selected cities:
Metro area	2002	2003
Atlanta	5.2%	3.1%
Austin	3.8%	0.2%
Boston	11.7%	2.9%
Chicago	13.0%	8.1%
Milwaukee	11.9%	6.6%
New Haven, Conn.	16.2%	11.8%
New York	22.3%	15.5%
Orlando	11.8%	3.8%
Phoenix	7.9%	6.4%
San Diego	21.3%	12.5%
San Francisco Bay Area	11.8%	3.8%
Seattle	6.7%	5.1%
Tucson	14.9%	6.8%
Washington	20.8%	14.4%
USA	7.4%	7.1%
Source: National Association of Realtors

The debate over the existence of a housing bubble has been going on for some time. Believers in a real estate bubble worry that years of low interest rates, which increase purchaser’s potential buying power, have inflated home prices beyond reason. They warn that the inevitable rise in mortgage rates could cause a coast-to-coast plunge in values that would have disastrous effects on the economy.

 

The Interest Rate Connection

There are signs that the housing market has reached its pinnacle. The average interest rate on a 30-year fixed-rate mortgage rose by more than three-quarters of a point from March to April, one of the sharpest one-month spikes in years. As a result, applications for purchase mortgages have softened. Industry forecasters generally agree that by the end of the year, the rate of sales will decline from its record, and home price growth, which has risen over 50% nationwide over the past six years, will slow or maybe even reverse.

 

Stephen Roach, chief economist for Morgan Stanley, believes that low mortgage rates are driving up house prices artificially. Roach has urged the Federal Reserve to raise short-term interest rates now, to deflate the bubble before it gets bigger. He compares what’s happening in residential real estate today, with the “dot-com” bubble of the 1990s. The Internet boom led investors to drive up stock prices irrationally, ultimately causing a financial meltdown that, in a matter of months, wiped out billions from the American Tech sector.

 

Leveraged to Max

The surging home equity value has been tapped by consumers through wave after wave of cash-out mortgage refinancings – transforming homes into ATMs. Refinancings have totaled $2.5 trillion over the past two years. In addition, Americans’ home-equity loans stand at around $800 billion. At the same time, Americans’ equity in their homes, net of debt, has dwindled to 57%, compared with 85% a half-century ago, even with the recent powerful surge in home prices.

Economist Gary Shilling, of A. Gary Shilling and Co. in New Jersey, calculates that 39% of U.S. homes are owned free and clear – and that the remaining homeowners have debt burdens exceeding 80% of the value of their homes. Many Americans, then, have little margin of safety should home prices level off or should they fall as much as 20%, as they did in many overheated areas in the late Eighties.

Consulting firm Economy.com in Pennsylvania calculates that in 34 metropolitan areas, the typical household lacks sufficient income to buy a typical house. That’s up from 14 metro areas in 1999.

Many buyers nowadays borrow 90 percent or more of a home’s price just so they can buy a place before even the least-expensive houses in their areas are out of reach. They figure they can move up to a better house in a few years. Some of these buyers get adjustable-rate or interest-only mortgages. They stretch their finances to protect themselves from further increases in home prices, but that makes them vulnerable to dramatic drops in values.

 

The Local Outlook

New York real estate developer David Gindi, of Metco Investments, says that there’s a presumption around the South Brooklyn community in general that the entire area is prime real estate. “Inasmuch as people think that, therefore their demands, when they’re selling properties speaks to that perception,” he says.

But the property values in most communities can and do fluctuate. According to Gindi, the misperception across the board in the community is that property prices won’t go down ever. “People are forgetting that in the early 90s, there was a sign. Properly values dropped. There has been a prolonged rise in prices, fed by [low] interest rates. It has emboldened people to think that prices will never ever go down. When the prices do go down, there will definitely be reverberation across the community.”

There are exceptions to the rule, however, such as “trophy buildings” in Manhattan, where even in a bubble or an otherwise general drop in property values, those properties retain their value because they retain their status and marquis location. To obviate potential busts, Gindi says that Metco retains property that appears to have intrinsic value that will withstand such price fluctuations.

“The difference between what’s prime and what’s not prime is what people don’t understand,” Gindi says. “People who need money have already maxed out their mortgages. So now moving has become more difficult for them, because they are demanding a higher price [for their real estate]. Then, when they look for properties and find the prices are higher, it becomes a domino effect, and that causes prices to spiral upwards.”

 

Local real estate broker Sharon Franco agrees that the asking prices of some homes is unjustified but contends that the high demand for certain areas is warranted owing to significant community investments in certain neighborhoods. “The community has spent significant amounts to develop schools, houses of worship and other facilities that in themselves increase the value of the surrounding property.” Other considerations include the insistence of many potential buyers to be within “walking distance” of family in order to accommodate holiday and Sabbath observance, Franco points out.

Still, Franco is not particularly bullish on the likelihood that the market will continue to push prices upward. “My advice to potential buyers is to look for something well within budget. Often that means being open to consider homes on the outskirts of the neighborhood a buyer is most interested in.” Since the surge in home prices has been so widespread, even those properties often stretch the limits of what first time buyers can afford.

“Real estate has been considered a very hot investment for some time now,” Franco continues, “many buyers who thought they would just wait out a temporary up-tick in prices years ago are still waiting – but the difference is now many of them couldn’t afford buy if they wanted to because prices all over have gone up so high.”

 

Nationwide Vulnerability

Experts are concerned that throughout the country, housing is now highly vulnerable, owing to the likelihood of higher interest rates, softer economic forecasts and tighter credit standards. This, experts say, could have a devastatingly dangerous domino effect on real estate prices nationally.

“In the near future, price increases will stall, even decline, in some cities,” economists Robert Shiller of Yale University and Karl Case of Wellesley College concluded in a report to the Brookings Institution, a Washington, D.C. think tank. Most at risk, they say, are cities where home prices have seen the sharpest rise, “notably cities on both coasts, and especially those cities that have weakening economies.”

Dean Baker, an economist and co-director of the Center for Economic Policy and Research, agrees that low mortgage rates have inflated a bubble. He says the fad for cash-out refinances, lines of credit and high loan-to-value mortgages are signs of a bubble. What is driving the rapid increase in house prices is the belief that the price will rise more. What that means is that people buy houses on the belief that they will soon be worth more, looking at their houses as a source of return.

“I think it’s probably in general a bad idea for anyone to buy a home with the expectation that it will go up.,” Baker says.

Baker believes that a bubble will pop eventually, and the overall value of the nation’s housing stock will decline 15 to 20 percent over a period of years. He thinks the financial fallout will be worse in places where prices have been rising fastest – like New England, the District of Columbia, New York City, California, Seattle and Portland, Oregon. Baker’s advice? “I would really discourage someone from buying in a bubble market today.” He believes that many of today’s buyers will “get nailed.”

 

 

No Bubble Trouble

Anthony Hsieh, president of HomeLoanCenter.com, believes that Baker advocates, market timing – a tactic that is bound to fail in the long run. Hsieh disagrees that people buy their primary residences with the aim of making a profit on the resale in just a few years. “If you want to make money, go short a stock,” he says. “People have got to understand that the first objective for buying a house is for someone to have a decent habitat for themselves and their family.” Of course, Americans don’t buy a home in or near a particular city because of the short-term prospects – they buy one because their jobs and families are there.

If you buy a house and the value declines, Hsieh says, “So what? It’s not going to be any less warm. If there is a bubble and house prices go down 5, 10, 15, 20 percent, you live in the same house with the same monthly payment.”

Some argue that the steep rise in prices in recent years is nothing new, that demand for housing is high and supply is low and that houses are bigger and better than they used to be. All of these factors push up prices. Home prices have risen much faster than rents because the benefits of homeownership together with easier access to credit have made rental accommodation less attractive. Sure, home prices will go through an “adjustment period” as mortgage rates rise, but that doesn’t necessarily mean a price drop, and certainly not nationwide, Hsieh says.

Doug Duncan, chief economist for the Mortgage Bankers Association, says he expects some local housing markets to slow their pace of price appreciation. Prices might even fall in a few areas on the coasts, but not nationally, he says, because housing simply isn’t a national market.

Housing bubble believers acknowledge that real estate markets are local, and that all real estate bubbles in the past were local. But they say the past few years’ rapid run-up in home prices has been national and unprecedented, so a nationwide drop in values is possible.

 

Does A Bubble Really Burst?

Home prices are “sticky,” says Case. When demand first slows, sellers don’t automatically lower their prices – indeed, they’ll even continue to increase them a little bit. Properties then begin to sit on the market for a longer period of time, and the gap between what sellers ask and what buyers bid starts to widen. Prospective purchasers put in lowball offers that get rejected. Sales volumes begin to fall. The only deals closing are the ones where sellers are getting what they want, which is why the “recently sold” column in your local newspaper may not reflect the softening market.

In a slowing market, home shoppers are at higher risk of buying at the top, taking on excessive monthly payments, and setting up for financial disaster when they go to sell for less than they paid.

But if we really are on the verge of a bust, Shiller and Case point out that history shows that a housing bust is qualitatively different than a stock bust. “I think you can say with some degree of comfort that the housing market doesn’t seem to collapse the way the stock market can,” he adds. “It just kind of gradually deflates. It doesn’t burst, even if it’s a bubble,” says Case.

The serious declines in home prices have mostly occurred in places where there’s been a big run-up – places, for example, like the Boston metro area, where the average home price almost tripled between 1984 and 1991.”That’s a big boom – in fact, I think we proved – that that was irrational, that there was a bubble. But even when the Boston market busted, it didn’t go down 80 percent; it went down 20 percent, despite the fact that there was a very serious recession.” Around the same time period, houses in L.A. went down 30 percent, even though the price escalations over the previous years had not been so dramatic. “It might go down 30 percent,” says Shiller, “but it’s not [highly volatile] like the Nasdaq. It’s like the S&P.”

Even if a real estate market suffers a slowdown, says Case, particular neighborhoods may respond differently. In Southern California during the 1991 bust, the low-priced homes held up the best and the high-priced homes fell the most. But the opposite was true in the Northeast: The low-priced homes fell the most, and the high-priced homes fell the least.

The big problem with thinking about real estate the same way that we think of stocks is that we don’t have earnings to look at. “You don’t have any real benchmark, and the value of the piece of property is what someone is willing to pay for it,” Case says. “There’s no sort of objective present value of any [revenue] stream that’s observable, and it reflects the value that people place on the location. It’s land. And that makes it fundamentally different from a stock. It makes you much less able to say it’s overpriced relative to fundamentals.”

 

Bubble Protection

For all the contention about the existence of a bubble, experts tend to agree that embracing certain bubble-protection strategies is a good idea. First, buyers should not count on any sort of future appreciation in the value of a home they plan to purchase for their own use. Second, don’t overextend, saving up for a hefty down payment (of 20 percent or more) provides a buffer against short term price fluctuations. Other advice includes avoiding bidding wars for houses in hot markets, staying away from interest-only loans and buying houses for the long term.

 

Article Written By: Dave Gordon

This article courtesy of Community Magazine, the most widely circulated Sephardic monthly in the world. www.communitym.com