Monday, April 12, 2004

Are Low Interest Rates Causing a Bubble?

By HOWARD R. GOLD

April 12, 2004 -- You've all seen the headlines: Housing prices are going through the roof.

Here in New York City, the prices are particularly insane.

The average sale price of an apartment in Manhattan topped $1 million last month, according to The Corcoran Group, a real estate brokerage firm.

Desperate buyers mob open houses, bidding wars are common, and properties routinely go for above the asking price.

Late last year, an open house for a 500-square-foot studio apartment (that means one room, folks) in the quiet Gramercy Park neighborhood drew nearly 30 people. The apartment got three bids and sold within a day for the $299,000 asking price -- in cold, hard cash, the New York Post reported.

And it's not just in New York. Boston and Washington, D.C. remain hot, too. Housing prices in the District of Columbia posted the nation's biggest five-year gain -- some 90%.

California is also on fire. More than 19,000 homes sold for $1 million or more in the Golden State in 2003, a new record, and the number of homes sold in Southern California hit a 15-year peak last month, according to DataQuick Information Systems.

Even in the San Francisco Bay Area, which is just shaking off the impact of the dot.com bust, home prices are heading skyward again. February's sales were the second strongest on record for the month, after February 2000, according to DataQuick. And you all remember what happened the month after that, don't you?

Which naturally brings us to the question du jour: Are we in a housing bubble?

Well, it sure looks like a bubble and feels like a bubble. We all -- especially those of us in the media -- have a natural tendency to believe that any display of such seemingly irrational exuberance is bound to end badly.

"I promise you, this housing hysteria will end in devastation for many families, and they have only their own 'house lust' to blame," one self-described renter wrote to the Los Angeles Times recently.

We've seen that argument before in newspapers, television programs and magazines.

These days, some observers fear that artificially low interest rates are letting marginal buyers flood the housing market and bid for houses they otherwise couldn't afford.

That's true, to some extent, but there are other forces at work that make this period very different from the late 1980s, when a wave of speculative building and buying sent the market reeling for years.

Here, I need to put in a very big disclaimer: My wife and I recently sold our apartment and bought another one in the mad Manhattan market. So, clearly, we have a vested interest in whether it really is different this time.

The way I see it, though, it all boils down to supply and demand.

On the demand side, affluent buyers in their 30s and 40s, armed with low monthly mortgage payments and plenty of cash, are hitting the market en masse and are determined to "get in the game," says Patricia W. Cliff, senior vice president at Corcoran in New York.

These are typically two-career couples who have good jobs, have saved their shekels, maybe have some family money and emerged relatively unscathed from the bear market.

"People have married later and they're having children later. These first- and second-time buyers have more capital, " says Cliff.

And if they work on Wall Street (as many here in New York do), they have fat bonuses burning a hole in their pockets following a blowout 2003.

If the stronger economy is emboldening people to buy, low mortgage rates are making even pricier properties affordable. Last week, 30-year fixed rate mortgages averaged 5.38% nationwide.

"Big increases in prices are not translating into big increases in monthly payments," says Dr. Raphael Bostic, who heads the Casden Real Estate Economics Forecast at the University of Southern California.

Dr. Bostic has found that homeowners' real monthly mortgage payments today (based on median price, adjusted for inflation) are actually lower than what they were in 1990, when rates on 30-year mortgages hovered around 10%.

He believes mortgage rates would have to go up "quite a bit" -- maybe two to three percentage points -- before we'd see a significant slowdown in the market.

But what sets this housing frenzy apart is a profound lack of inventory in certain markets.

By the end of 2003, there were only 6,000 or so apartments for sale in Manhattan, about half the number there were at the beginning of the year (see Chart).

And it's not only because properties are being snapped up faster.

First of all, some older Baby Boomers, now in their late 50s, have probably settled in to their final family homes and are unlikely to trade up.

"For a number of reasons they are staying put," says Cliff. "There isn't a lot of [upward mobility] in that age group."

Then, environmental laws, growth restrictions, rent control and the sheer lack of affordable land in the most desirable areas all have put a lid on new supply.

"Academic studies show where there is more restriction in building homes, there is more price appreciation," says Lawrence Yun, an economist with the National Association of Realtors.

In cities like Atlanta and Dallas, which don't have such limits, price appreciation tends to be more modest, he says.

"In the coastal areas where the land [has] been developed or restricted and the existing homeowner is not moving out, it's creating a housing crunch," he concludes.

And there you have it: a Perfect Storm of supply and demand.

Markets like this can't last forever, of course -- at least at this level of intensity.

But unless rates move up sharply (which, Dr. Bostic reminds us, would also signal a much stronger economy and could actually encourage more buying for a while) or we have some kind of economic crash, I don't really expect the kind of dramatic drop in real estate values we experienced in the early 1990s.

Demand will probably cool somewhat, but I just don't see where the new supply will come from.

Over the long term, of course, real estate is a great investment. Sure, it took about a decade for the average price of a Manhattan apartment to match its peak in 1988-1989, but it has surged ahead in the years since (see Chart).

And in the 30 years from the beginning of 1974 to the end of 2003, that average price advanced 1,479%, compared with a gain of 1,129% for the Dow Jones Industrial Average.

Of course, few people stay in their homes that long these days. But as we all know, you can't live in a stock, either.

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