Friday, July 30, 2004

Freddie Mac: No Housing Bubble

By Salim Haji

Motley Fool

As sales of existing homes hit an all-time high in June, concern is increasing among investors that the U.S. real estate market may be teetering on the edge of a cliff.

On the front page of last Sunday's New York Times business section was a column entitled "Housing Bust: It Won't Be Pretty," citing a Goldman Sachs (NYSE: GS) study that indicates that U.S. home prices are significantly overvalued. As I first wrote back in April, I believe the evidence is strong that a bubble is building in residential real estate, and that like all bubbles, it will eventually burst.

Not everyone agrees with this view. In a presentation at UCLA a few weeks ago and in a subsequent telephone conversation with me, Amy Crews Cutts, the deputy chief economist at Freddie Mac (NYSE: FRE), argued that there is no housing bubble in the U.S. today.

According to Cutts, the term "bubble" is a situation in which the price of an asset or an asset class is not driven by fundamentals. The Internet Bubble of the late 1990s is a classic example. The prices of stocks were driven by speculators who bought stocks based primarily on the expectation of being able to resell them at a higher price. As Fed Chairman Alan Greenspan famously said, the market was driven by "irrational exuberance."

Bubbles are based on a herd mentality -- as long as the herd believes that prices will continue to rise, bubbles survive. Bursting is difficult to predict, because identifying what makes the herd all of a sudden change its view about future prices is nearly impossible. (Greenspan was about three years early with his comments on the dot-com bubble in 1996.)

According to Freddie Mac, the housing market remains rational. While Cutts cautioned that rational markets can fall based on underlying economic conditions, they don't exhibit the boom and bust characteristics of bubbles. She offered six reasons why Freddie Mac doesn't believe that a housing bubble exists:

1. Supply of housing for sale is low. The current inventory of new and existing homes for sale is lower today than it has been in the last 20 years. For new homes, as the homebuilding industry has consolidated, such homebuilders as KB Homes (NYSE: KBH), D.R. Horton (NYSE: DHI), Lennar (NYSE: LEN), or Centex (NYSE: CTX) have increased their share of the market over small, local players. These larger, more sophisticated homebuilders use options and other tools to minimize the capital they put at risk in particular housing markets. As a result, Cutts argues, the supply side of the housing market can adjust to changes in demand much more quickly than it could in the past. If demand drops off, supply can be quickly cut back, which basic microeconomics tells us will mitigate any steep drop-off in price.

2. Housing doesn't resemble the typical bubble asset. According to Freddie Mac, the purpose of a typical bubble asset is investment, not consumption. In addition, typical bubble assets have low transaction costs and are held for short periods of time -- speculators can buy and resell the asset rapidly to make a quick profit. Housing is different. The transaction costs are high, holding time is typically quite long, and most people buy homes primarily for consumption, not investment.

3. Mortgage rates are low. Freddie Mac argues that even with the recent increase in mortgage rates, we are still very far away from the 30-year mortgage rates above 10% that existed in the early 1990s. Even if rates were to rise 100 basis points, rates would still be below the 1971-2004 average of 8.5%. With sustained lower mortgage rates, people can -- and will continue to be able to -- buy more expensive homes.

4. User costs are negative. Related to the previous point, as long as mortgages are low and home prices continue to rise, net user costs are negative. Freddie Mac argues that interest (after tax), maintenance, and taxes approximate 6.5% of the price of a house. If the home price rises at 6.5% per year, the owner gets to live in the house "for free."

5. Household incomes and house prices in balance in the long term. Freddie Mac's presentation includes data that illustrates that between 1991 and 2001 the growth in home prices and average household income has been about the same. Cutts does concede that if these data were extended to 2004, a gap would exist. (According to The Economist, the ratio of home prices to average household income is now at a record high: 14% above its long-run average.) But she argues that the ratio needs to be compared to similar points in the business cycle -- she now expects wage growth to accelerate as the economy recovers and "catch up" with home prices.

6. Rent vs. price growth is aligned. The equivalent of the P/E ratio in the real estate market is the ratio of home prices to rents. In the U.S., again according to The Economist, that ratio is now at a 20-year high and more than 15% above its average value between 1975 and 2000. Freddie Mac argues that this data is misleading, because it does not take quality of housing into account. Cutts claims that quality in rental housing has not kept up with the increasing quality of homes that are owned. As a result, the widening ratio is explained not a by a bubble in home prices, but rather by a widening spread in the quality of homes for rent vs. those for sale.

My opinion
While I believe that many of the points that Freddie Mac raises do make the real estate markets less susceptible to bubbles than markets where the asset traded is more speculative (such as Internet stocks), I don't agree that one can conclude that bubbles in real estate can never happen.

Data indicates that real estate bubbles, while less frequent than in other types of markets, such as equity markets, do indeed occur: A recent study by the International Monetary Fund looked at 14 countries between 1970 and 2002 and found 20 instances of real estate bubbles bursting (as well as 25 examples of equity prices crashes).

I also don't believe that the real estate market is fundamentally rational. Changes in underlying economic conditions simply cannot explain the fact that in the last year home prices soared 18% in Los Angeles or 14% in Miami. In my opinion, like all markets where a subjective view of the future plays a key part in what people are willing to pay for the asset being traded, the residential real estate market is driven in large part by group psychology.

In my mind, Berkshire Hathaway (NYSE: BRK.A)(NYSE: BRK.B) CEO Warren Buffett's famous allegory of the manic-depressive Mr. Market (first articulated by his mentor, Benjamin Graham, and recently explained in a commentary on value investing by Zeke Ashton) also holds true for the real estate market.

Perhaps Mr. Real Estate Market is a bit more emotionally stable than his brother Mr. Equity Market, but fundamentally the family's mental health is not terribly sound.

In the same way that adherents of the efficient market theory believe that stock prices accurately reflect everything that is known about a stock and its prospects, Freddie Mac believes that current prices in the U.S. real estate market are rational and reflect underlying economic conditions. While prices may change as economic conditions change, investors should rest assured that there is no psychological bubble in the housing market that is going to burst anytime soon.

I respectfully disagree.

Fool contributor Salim Haji owns shares of Berkshire Hathaway, but no other stocks mentioned in this article. The Motley Fool is investors writing for investors.

Tuesday, July 27, 2004

Housing Bubble Culture

A theory for why home prices are based on more than interest rates and financial forecasts.
- by Carol Lloyd, special to SF Gate

When the price of something in our culture rises precipitously, we look to economists for explanations. They, in turn, look at a host of what is known as economic indicators -- P/E ratios in stocks, interest rates in housing, shortages in cocoa beans. By analyzing these factors and comparing their relationships over history, our modern-day soothsayers predict the winds of the future. They might conclude that this stock or that pork belly is "overpriced" and "due for correction" or that it's suffering from an out-of-whack economic situation such as a lack of supply. Either way, it all comes down to economics, that enigmatic language of numbers by which we read our global tea leaves.

But can standard economic indicators explain everything when the two-bedroom cottage down the street in Bernal Heights sells for $889,000 with 13 offers? Unless you've been living under a rock instead of a roof, you probably already know that housing prices across the nation -- especially here in the Bay Area -- are at all-time highs.

Yet, as talk of a housing bubble has heated up, I've begun to wonder what came first: housing-bubble economics or bauble-housing culture?

Sure, the economics of housing are central to the surreal estate phenomenon. If the supply of affordable housing in the country were sufficient, there wouldn't be the pressure to drive home prices out of the reach of the average family's income. And if interest rates weren't so low, many home buyers simply couldn't make the mortgage payments on their record-price homes. And if the stock market had not turned so volatile in 2000, fewer home buyers would be eager to sink most of their cash savings into the real estate market.

But what about cultural indicators? Could it be that in this era of war and terrorism, homes mean more -- and therefore cost more? Could it be that in a time when hipsters form "stitch and bitch" knitting circles and read offbeat shelter magazines like Ready Made, when shelter shows like "Queer Eye for the Straight Guy" reach 3.1 million viewers, that home prices reflect not only the value of tax breaks but also that of creature comforts during wartime, not just a lack of alternative investments but a lack of alternative entertainments as well -- not just the desire for shelter, but a shelter for desire?

In other words, might our current culture of homemaking have changed the value of this age-old commodity, the home?

Throughout our recent history, housing booms and nesting obsessions have often gone hand in hand. During the postwar baby boom of the early 1950s, a cult of domesticity coincided with new record levels of home ownership underwritten by government low-interest loans for vets and an abundance of new housing designed for first-time home buyers. Then the domestic scene was a stage for the young housewife -- a place to keep her preoccupied and productive now that she was no longer needed outside the home, working for the war effort. Armed with "The Betty Crocker Cookbook" and perhaps a bachelor's in domestic science or another of the popular higher-education degrees designed for the market in unpaid home labor, the young newlywed raised children, cleaned, cooked and entertained with what we now might characterize as fiendish naïvetè.

It's easy to look back on those days of gingham aprons with matching pot holders and regard the 1950s culture of homemaking as a bit obsessive. In my vintage copy of "Betty Crocker's Easy Guide to Entertaining," the user-friendly title notwithstanding, an entire chapter is devoted to the etiquette of invitations, acceptances and regrets. With maddening exactitude, it specifies when men may be allowed to invite friends over. (Examples: He is a bachelor, his wife has not been able to reach the other man's wife, the wife will immediately follow up on the invitation with the appropriate details.)

Despite such a mania for homemaking propriety, in many ways our own cult of domesticity makes that of the 1950s seem tame. Instead of Betty and her pudding-mix cake recipes, we have Martha Stewart tutoring us in preparing, with professional pastry-chef utensils, elaborate wedding cakes for several hundred guests. Then we had newfangled percolating coffee makers, and now we have built-in espresso machines. Whereas we once bought factory-made playhouses for our little ones, now we spend up to $160,000 on deluxe custom-built Victorian "miniature homes."

Even as the size of the average American family has shrunk from 3.1 in the 1950s to 2.6 now, the homes themselves have only grown with our passion for all things domestic. In the 1950s, the average home was less than 1,000 square feet; by 1973, it had grown to 1,650 square feet; and, by 2002, it had swollen to more than 2,300 square feet. Furthermore, thanks to the recent real estate boom, home buyers now willingly sacrifice more to get these bigger homes -- the ratio of mortgage debt to home equity is at record highs, and home owners increasingly spend a greater percentage of their income on housing.

It's not only the size and cost of our homes that reflects our cultural preoccupation but also increasing attention to "quality." According to Adams, Harkness and Hill, a Boston-based investment company that has created a "Better Homes stock index," sales in premium house- and home-related products -- from furnishings to dishware, from appliances to bedding -- are growing much faster than those of their nonpremium counterparts. The company notes that installation of central air conditioning has more than doubled since 1971. The conclusion? The boom in home improvement and decor will outlive the current real estate boom. The company declares in a 2003 report, "We believe consumer and industry factors will drive continued growth for many years to come, long beyond the eventual end of the recent housing boom and after the media tires of discussing the "nesting trend."

Ever since trend watcher Faith Popcorn coined the term cocooning in 1991, Americans have invested not only more money in their homes but also more of their psychic currency. Now that home ownership has reached a record high of 68.6 percent, the White House Web site is touting this fact as a sign of good times and happy days.

But when a society becomes home obsessed, is it really a sign of a healthy culture, or are we trying to compensate for something we're missing?

"War resonates deeply in our hearts idea of home. We talk of 'hardened shelters' and 'sealed rooms' against attack. Americans are buying gas masks. The fear of terrorism keeps us huddling at home." Faith Popcorn wrote these words in 1991, just after the Gulf War, a war that, compared to our current conflict in Iraq, hardly affected our everyday lives. If our current home ownership and homemaking mania reflects an intensification of the trend Popcorn commented on, the country's mad passion for real estate may be driven by more than the sum of economic factors (madly spinning out of control or successfully driving a recovery, depending on how you see it). It may also be about feelings, fear and all sorts of mysterious movements of the heart that make us yearn to own a place that enlarges our private lives and shields us from our public frailty.

So, next Sunday afternoon, when your eyes glaze over as you read about boring economic indicators that tout the existence or nonexistence of a housing bubble, and you begin instead to think about pruning your rare roses or baking an organic marionberry pie or going hypothetical house hunting for a cottage at the beach or shopping for a flat-screen TV, it may be that these impulses to cultivate a safe and beautiful place are just as significant as the numbers in explaining why we've mortgaged ourselves into oblivion. Culture not only cultivates the mind but also drains our bank accounts, and it doesn't take a degree in economics to understand that.

Monday, July 26, 2004

Is U.S. Housing Bubble Fact or Fiction?: John Wasik (Update1)

Is a U.S. residential housing bubble a fact or strange fiction?


There are two schools of thought on the subject. Either speculation is rampant due to low mortgage rates and home prices are poised for a decline, or demand is at an unprecedented level and prices will rise unabated by ``measured'' rate increases by the Federal Reserve and inflationary pressures.

In either case, it's wise to be more careful when buying residential real estate now as prices continue to climb in the largest markets.

Ian Morris, chief U.S. economist for HSBC Securities USA, whose parent company is HSBC Holdings Plc -- Europe's biggest bank by market value and the holder of more than $1 trillion in assets -- is one of those who say a bubble is looming in the U.S. residential market.

``The bubble psychology has manifested itself in very rich valuations,'' Morris says. ``House prices relative to income, rent, replacement-cost and home equity have set new highs. Twenty states that account for half of the population look shaky.''

Bullish on Bubble

Morris supported his argument in a recent HSBC study that examined valuations of home prices relative to rents, income and consumer debt.

His general conclusion was that U.S. housing prices were ``bubbly and 10 percent to 20 percent too high.''

Possibly exacerbating Morris's bubble scenario is the U.S. Federal Reserve Board's stated policy of ``measured'' increases in short-term interest rates. The Fed's move will probably ``cause a reassessment of likely future house-price risks and its associated debt, thereby triggering housing's fall,'' Morris says.

Particularly telling, in Morris's view, is the housing price- to-rent ratio (P/R), which he says is an indicator of home overpricing.

``The P/R ratios for New York, Los Angeles, San Francisco, Boston and Philadelphia have surpassed the peak of the late 1980s bubble, and suggest prices could be roughly 25 percent too high compared to current rents,'' Morris says, adding that Chicago and Detroit also look expensive to him, while Dallas and Houston look ``comfortably priced.''

Situation Normal

While Morris's observations concur with leading economists like Robert Shiller, the Yale University academic and author of ``Irrational Exuberance,'' real estate analysts and the Fed say he's off track. Fed Chairman Alan Greenspan, for one, has repeatedly discounted the existence of a housing bubble.

A report titled ``Are Home Prices the Next `Bubble'?'' by Jonathan McCarthy and Richard Peach of the Federal Reserve Bank of New York, disputes the pro-bubble camp.

The New York Fed's report finds ``little basis for such concerns. The marked upturn in home prices is largely attributable to strong market fundamentals: Home prices have essentially moved in line with increases in family income and declines in nominal mortgage interest rates.''

McCarthy says strong demand is driving prices on both U.S. coasts where there are building restrictions and a shortage of available land for building.

``Here in New York, there's not much land left and there are various regulations, so it's not like they're going to be building a lot of condos,'' McCarthy says.

Being Cautious

Even within the Fed system, though, there's some room for discussion on whether housing prices are peaking. A new study by Morris Davis, a Federal Reserve economist, and Jonathan Heathcote, a Georgetown University economics professor, focuses more on the increase in land prices over the past five years.

Davis and Heathcote concluded that U.S. land prices may post a ``cumulative decline of 6.3 percent'' over the next three years with nominal growth in home prices at 2.6 percent over that period.

``This would be the smallest three-year nominal increase for home prices on record,'' the authors say.

The debate on whether home prices will rise or fall is largely academic because the Fed's interest-rate increase may only spur potential homeowners into a frenzy to take advantage of the lowest mortgage rates in a generation. In a possible nod to that view, Freddie Mac, the second-biggest buyer of home loans, predicted U.S. sales of new and existing homes will total 7.3 million this year, beating last year's record of 7.19 million.

Speculative Frenzy?

Sales and prices of existing homes hit record highs in June, the National Association of Realtors said in Washington today. Sales of previously owned homes unexpectedly increased 2.1 percent from a 6.81 million-unit rate in May, the trade association said. Existing home sales were forecast to fall to a 6.65 million annual rate in June, according to the median estimate in a Bloomberg News survey. The median selling price rose to a record $191,800.

If the U.S. housing boom is coming to an end, buyers certainly aren't acting like the party's over.

``People are buying without money down and using interest-only loans,'' says George Marotta, a research fellow and former financial planner at the Hoover Institution in Palo Alto, California.

``I think we're coming close to the end'' of the housing boom, he says. ``It's not a good time to buy. I hope I'm wrong, but it looks like the stock market bubble.''

Like many in the bubble school, Marotta is concerned about high household debt levels, which he calls ``the biggest bubble of all.''

Marotta says it's troubling that while personal debt has risen, average U.S. home equity has ``dwindled to 57 percent, compared with 85 percent a half-century ago.''

Watch for Overpricing

Randy Johnson, a mortgage broker for Independence Mortgage Company in Newport Beach, California, says it pays to watch for speculation and overpricing in your market if you are buying now.

``I would put an appraisal contingency in every offer and get an appraiser I trust,'' Johnson says, advising the use of the lender's appraiser instead of the agent's to ensure that you're not overpaying for a home.

``What happens in this stage of the cycle is the sub-standard properties come on the market under the `if I can get that much for it, I'll sell it' philosophy,'' Johnson says.

``I have seen people putting these houses into escrow and finding out upon inspection that they need to do a lot more work than they thought.''

``I think that there really are people who are buying property on speculation that they can quickly resell at a huge profit,'' Johnson says. ``You can't build a market on speculators selling to the next wave of speculators.''

Just as all real-estate pricing is local, so should your focus be on your long-term financial goals and debt level. Stop worrying about whether your market is frothy and check if you're saving enough for emergencies, retirement and college. That's the best way to avoid another, more personally damaging kind of financial bomb.

Sunday, July 25, 2004

Housing Bust: It Won't Be Pretty


LET the stock market slide. Let the bond market sink. As long as home prices keep rocking, it's easy for Americans to feel fat and happy.

But what happens when the run-up in housing prices loses steam, or worse? The implications are sobering, not only for homeowners but also for the economy as a whole.

With the growth rate for home prices starting to slow, now may be the time to ponder what a bear market in real estate may bring. A recent study by two economists at Goldman Sachs provides some answers.

For now, prices are still climbing over all. The average home price in the nation rose 7.71 percent in the 12 months ended in March.

But the first three months of this year showed far slower growth than previous periods. Prices rose only 0.96 percent, according to the Office of Federal Housing Enterprise Oversight, which keeps an eye on Fannie Mae and Freddie Mac. The last time housing prices grew by less than 1 percent in a quarter was in the spring of 1998.

More ominous, six states showed declines in housing prices in the first quarter: Vermont, Alaska, North Dakota, South Dakota, Iowa and Nebraska. No state had price declines in the previous quarter.

To be sure, home values are still hot in many spots. In the most recent 12 months, prices have jumped by more than 15 percent in Hawaii and Nevada, by 14 percent in California, 11 percent in New Jersey and 10 percent in New York.

In nominal terms, United States home prices are up 60 percent since 1995; in real terms, adjusted for inflation, they are up 37 percent. Viewed historically, home prices are up twice as much now as they were in the bullish real estate markets of both the mid-1970's and the 1980's.

As a percentage of disposable income, home prices are more than 18 percent above the long-term average. Prices exceeded that average by only 4 percent in the 1970's and 8.5 percent in the 1980's boom.

Michael Buchanan, a senior global economist at Goldman Sachs, and Themistoklis Fiotakis, a research assistant there, reckon that at current interest rates, home prices are now overvalued by 10 percent, on average. Because this figure spans the entire nation, the hottest markets - California and New York - are obviously more overpriced.

The economists compute fair value in home prices by using a variety of measures, including interest rates, population and demographic data, and the overall health of the economy. If interest rates increased by one percentage point, the economists said, home prices in the United States would be overvalued by 15 percent.

None of this would be worrisome if homeowners had not turned the paper profits in their properties into cold, spendable cash. But withdrawals from home equities have recently totaled 6.3 percent of household disposable income, according to the Goldman study. In the late 1980's, equity withdrawals reached only 2.5 percent of disposable income.

Federal Reserve studies indicate that as much as half of the equity withdrawals went into personal consumption and home improvements. As a result, the Goldman economists estimate that equity cash-outs added 1.75 percent to the growth in the gross domestic product in 2003. That is a significant increase from the 1.25 percent kick that equity withdrawals added in 2002.

Consumption would slip 1 percent, Goldman estimated, if housing prices fell by 10 percent, to the fair value level. But if prices decline to well below that, as often happens when overheated markets go cold, consumption may fall by 2.4 percent, Goldman reckoned.

Such a housing crash took place in Britain in the early 1990's. At the market's low, home prices had fallen by 27 percent, 5 percent below Goldman's estimate of fair value at the time.

Such a decline is not expected here, said Dominic Wilson, a senior global economist at Goldman. That's because home prices in Britain had escalated much more than they have in this country, even now. And interest rates had soared into the high teens, which is unlikely here.

But even small declines in home prices could hurt the economy. "The precise degree of the vulnerability isn't going to be clear until we see house prices slow," Mr. Wilson said. "You've never seen consumers this stretched, operating at levels of leverage we've never experienced before. House prices are starting at a level that is pretty high relative to what we think fair value is going to be, and the economy as a whole has gotten a lot more sensitive" to housing-related spending.

Indeed, Goldman estimates that home equity lines of credit and the like have magnified the effect of housing wealth on consumption over the past decade, taking it to 10 percent from 4 percent.

Although rising home prices have been stopped dead in the past by sharply higher interest rates, the Goldman economists note that bear markets don't necessarily need major triggers to get started.

Small events can change the market's psychology, and asset bubbles sometimes just cave in on themselves.

One risk that looms large, however, is that United States policy makers would have few tools to cushion the fall if a housing decline gained real momentum. Interest rates are already so low and fiscal policy so loose that little could be done to ease the pain.

"This is one of a series of risks and imbalances that suggest there has been a price to the low-interest-rate policy that led the recession to be much shallower than it might otherwise have been," Mr. Wilson said. "Fiscal and monetary policy are both already fully utilized. If things go wrong from here, the U.S. finds itself in a more fragile position."

Monday, July 19, 2004

More Would-Be Sellers Finally List Their Homes

Dow Jones Newswires

July 19, 2004 -- Higher mortgage rates may not have tempered prices in the red-hot real-estate market yet, but the reversal of a two-decade trend toward lower borrowing costs has nudged some would-be sellers to finally list their homes.

That's good news for buyers who are anxious to either join the growing ranks of homeowners or trade-up to a bigger and better home.

A recovery in the U.S. economy and the lead up to the well advertised Federal Reserve interest rate increase on June 30 -- the first in more than four years -- has dragged 30-year mortgage rates up more than 1.5 percentage points from their low point in March to 6.01%, (the 30-year rate hit a historic bottom last June of 5.21%)

This may not seem like a huge increase at first glance, given the historically low financing homeowners have enjoyed over the last few years, but it can make a big difference in monthly mortgage payments, which most borrowers use to gauge affordability.

On a loan totaling $333,700, the maximum size that mortgage financing giants Fannie Mae and Freddie Mac will guarantee, the rate increases mean a homeowner would pay roughly $127 more now than a few months ago. On a $800,000 loan, the average price of a Manhattan apartment minus a 20% down payment, the borrower would have to pay over $300 more per month.

Though mortgage rates have actually fallen a bit since the Fed raised rates, economists expect the central bank to keep tightening monetary policy into next year, as it lifts interest rates from historic lows, meaning the cost of financing a home can only get more expensive.

Some sellers already have seen the writing on the wall. Barbara Corcoran, chairman of the Corcoran Group, one of the leading residential real-estate firms in New York, said "the rising rates have more of an effect on the sellers than the buyers. Sellers start thinking that the party might be over so to speak, and if they toyed with selling their house in the past, they are now bringing their houses onto the market."

Tight inventories in New York and other regional housing hot spots has helped accelerate the run-up in home prices this year, although anecdotal evidence suggests higher rates have indeed encouraged some to list their homes for sale.

According to a report from realtor Prudential Douglas Elliman, a scarcity of apartments in the beginning of the second quarter helped push the average price of a Manhattan apartment above the $1 million mark for the first time ever to $1.05 million from $998,905 seen in the previous three-month period. Compared with the April-June period a year ago, the price of an average apartment is up 20.9%.

While a paltry number of listings in April set the tone for prices, the realtor noted that the number of apartments for sale at the end of the three-month period jumped by 21.2% to 5,211, in line with the three-year quarterly average.

Bubble Trouble

And as anyone familiar with the New York City real estate is acutely aware, Manhattan isn't the only New York City borough where interest rates and home values are shaping homeowners decision to sell.

Terry Decaro of Staten Island, New York, recently sold her two-family house -- that her parents bought back in 1968 for just $33,500 -- for a handsome profit. When asked why she decided to leave New York for the warmer pastures of Florida, she said "because rates are low and we could get a good price for the house."

As interest rates started to climb, Ms. Decaro said she felt it was time to move. She closed the sale in June, getting $610,000 for her family home, a substantial sum, especially considering the $287,000 price tag of the 2,600 square foot house she bought in University Park, FL.

While Federal Reserve officials and most economists are adamant cheap financing hasn't inadvertently created a national housing bubble, they're quick to point out that regional markets do look frothy.

After all, a 20.9% increase in apartment prices in New York contrasts sharply with the average 7.7% rise in the rest of the country in the 12 months ending in March. The problem though is "you don't know you have a bubble until it bursts," noted John Lonski, chief economist at rating agency Moody's Investors Services.

If Federal Reserve officials are right and recent inflationary pressures prove temporary, the rise in interest rates and by association, mortgage rates should be gradual and not provoke major disruptions in housing, either regionally or nationally.

An external shock to the financial system, such as a sharp drop-off of foreign investment in U.S. government debt, is one of the few events that could cause some trouble, especially for homeowners who have adjustable-rate mortgages or weighty home equity loans.

But, "the market is so buoyant right now ... that I feel like rates could have a bit of run-up without it really impacting the market terribly," said Ms. Corcoran.

Is A Housing Bubble About To Burst?

Business Week
As rising rates send mortgage payments higher, demand may cool

How crazy is real estate getting in parts of the country? Ask Sierra and Corbin Stewart, who just bought a modest, 2,000-square-foot house in Pleasanton, Calif., for $730,000. Mortgage and tax payments will consume 55% of their income, forcing them to do without extras such as cable TV. Says Sierra, a 29-year-old marketer: "The other night we were doing our budget, and we almost called the real estate agent and said we want to get out."

It may not be long before the Stewarts -- and other recent home buyers paying exorbitant sums around the country -- wish they had paid attention to their cold feet. After an amazing four-year boom in residential real estate, the housing market could finally be topping out and heading for a downturn. The culprit: rising interest rates. House prices could flatten on a national level in the next year or so while taking a spill in overheated coastal markets. A downturn in housing would squeeze recent buyers who overleveraged themselves to pay top prices -- and risk slowing the entire economy by cooling consumer spending as well as housing construction, lending, and the real estate business.

It's always tricky to call the top of an overheated market, and the pessimists have been wrong before. Optimists argue that even if there is a correction, most homes will remain far more valuable than they were a few years ago. And they say immigration, second-home purchases, and boomers' inheritances will support housing. Says Angelo R. Mozilo, chairman and CEO of mortgage lender Countrywide Financial Corp. (CFC ): "I think [the market] will continue to rise."

But this time something important is different: Interest rates are inching up. It was the Federal Reserve-engineered decline in rates that inflated the housing bubble. But starting with a quarter-point increase in the funds rate on June 30, the Fed has begun what promises to be a prolonged tightening cycle. Even if the Fed's hikes are measured, higher mortgage rates will inevitably make houses less affordable. If 30-year fixed-rate mortgages rise just one percentage point, to 7.2% from their current 6.2% -- well within the range of forecasts -- house prices would have to fall 11% to keep new buyers' monthly mortgage payments from rising. If fixed rates went to 8%, prices would need to fall 20% to keep payments level.

Rising rates will hurt more than in the past because the market is more dependent on heavily leveraged buyers. Mortgage debt has shot up even faster than home values since 2000, leaving homeowners' equity at just 55% of housing value, down from 72% in 1986, according to Federal Reserve data. Leverage intensifies the pain of falling prices. If, say, a buyer owes $450,000 on a house that's valued at $500,000 and the house's price falls 10%, the equity shrinks to zero.

Heavy mortgage borrowing since 2000 has enabled the housing market to dodge an iron law: House prices can't perpetually rise faster than incomes. For the past four years, they have. The ratio of house prices to median family income is a record 3.4, a figure that's 19% above the 1975-2000 average, according to data from the Office of Federal Housing Enterprise Oversight and the Census Bureau. As rates rise, a return to the long-term-average ratio would require housing prices to fall 19% -- or incomes to shoot up an implausible 24%.

A downturn in housing, if it comes, is likely to chill the economy. People will feel less wealthy, hence more reluctant to spend. Goldman, Sachs & Co. (GS ) economist Jan Hatzius, among others, argues that a decline in housing wealth dampens consumer spending at least twice as much as a same-sized loss in the stock market. Even homeowners who still feel like spending would have a harder time qualifying for home-equity loans or cash-out refinancings -- a major source of consumer liquidity for the past few years.

Rather than a sudden wallop, the economic impact would be gradual and grinding. Ian Morris, U.S. economist at HSBC Securities Inc. (HBC ), estimates that housing prices nationally will slide 5% to 10% over the next five years. That could cause economic growth to slow to 2% by the second half of 2005 from 4% now, he predicts in a report called The U.S. Housing Bubble.

Optimists on housing point to the National Association of Realtors' Housing Affordability Index, which shows that a median-priced existing house at $184,000 is easily affordable by a family with the median income of $55,000. But that's only because interest rates are so low, holding down monthly payments. The juice of cheap mortgages has made housing pricey by every other measure. They're high not only in comparison with family incomes but in relation to rental rates for similar properties and relative to the cost of new construction.

Federal Reserve Chairman Alan Greenspan has downplayed the danger of a national housing bubble, arguing in part that housing is a local market. Sure enough, prices are still reasonable in most of the Heartland, from Ohio to Texas to Arizona, because construction has kept pace with demand. But bubbles are appearing in enough markets that their impact, if they were to pop, would be felt nationally. Greenspan also asserts that the high cost of buying and selling houses dampens speculation. Nevertheless, some markets are seeing speculative behavior such as "flipping," in which people buy houses or condos before they're even built and then sell them for a profit a few months later.

The overheating is greatest in markets such as Los Angeles, San Francisco, San Diego, Washington, New York, and Boston. The takeoff in coastal real estate started around 2000 -- suggesting that the speculative fever of the late 1990s did not die but instead jumped from stocks to real estate. From 2000 through the first quarter of 2004, single-family home prices are up at an annual rate of 8.2% in the Pacific region, 8% in New England, and 7% in the Middle Atlantic region, according to the Office of Federal Housing Enterprise Oversight. Prices rose 18% in Los Angeles, 14% in Miami, and 13% in Washington in the year through the first quarter, says the agency.

The most troublesome aspect of the price runup is that many recent buyers are squeezing into houses that they can barely afford by taking advantage of the lower rates available from adjustable-rate mortgages. That leaves them fully exposed to rising rates. In fact, the rise in one-year adjustable rates since late March has already raised annual borrowing costs for new buyers by 25%. And data from the Federal Housing Finance Board show that the most expensive markets tend to have the highest share of buyers with adjustable-rate mortgages.

Today's housing prices are predicated on an impossible combination: the strong growth in income and asset values of a strong economy, plus the ultra-low rates of a weak economy. Either the economy's long-term prospects will get worse or rates will rise. In either scenario, housing will weaken. Caveat emptor.

By Peter Coy in New York and Rich Miller in Washington, with Lauren Young in New York and Christopher Palmeri in Los Angeles

Wednesday, July 14, 2004

Prime real estate plagued by vacancy

By Carol Lloyd
Inman News
Consumer Real Estate News

The building has been empty for years. Now the windows are boarded up, the facade is peeling and the neighbors are talking.

Crime, drugs, death, madness? How can something this valuable, tangible and costly fall through the economic cracks? Shouldn't there be a law against leaving a perfectly livable or usable space uninhabited year after year?

Whether it's a forgotten warehouse, a burned-out home or a vacant storefront, unused properties languish in every big city and podunk town in America. In some areas where property is relatively cheap and the economic activity extremely slow, it's a shame, but it's also quite understandable. After all, in these places, it may be very difficult to find tenants or buyers, while the cost of keeping the property empty may be negligible.

But in the San Francisco Bay Area, where urban lots are among the most expensive in the nation, it's weird to see houses and commercial buildings just sit around like so many architectural cadavers. Unused properties still cost money: Most are mortgaged, and all have property taxes. Why would property owners keep a piece of property year in and year out that was losing them money?

"There are all kinds of reasons," said Arthur Goldman, a commercial real estate broker with Ritchie Commercial in Oakland, Calif. "Sometimes the building needs more work than the owner can afford." He offers an example of the Bermuda Building, a recently demolished commercial property in Oakland that suffered severe earthquake damage in 1989 and was known to have asbestos. After it stood empty for a decade, the city and the owner finally brokered a deal in which Oakland wound up owning the building and doing the demolition, then selling the lot to developer Ted Dang for $1.

"It would have cost the owner more to demolish the building and do the necessary asbestos abatement than the whole value of the property," Goldman said. "So there are all these questions about who is responsible: What's the responsibility of the city? What's the responsibility of the owner?"

Sometimes, Goldman said, the price of using the building is so costly that owners simply chose to walk away: "They may be heavily in debt. They bought at the market peak, and now that the market has dropped, they can't see how they can renovate the building and find tenants, so they go into foreclosure." With the dot-com crash and the subsequent rise in office vacancy, Goldman said, such foreclosures are almost surely going to become more common.

Other times, the building simply falls into an existential bureaucratic maw. Goldman recalls one building in San Francisco owned by a very elderly people who had no money to renovate it to bring it up to code. "The couple died, and then there were problems with their estate, then there was a foreclosure," he said. "All this stuff can take years to work out."

Although, when viewed from an outsider's perspective, this strategy seems insane, property owners often calculate that they can make more money in the long run by losing money in the short run. According to Goldman, many storefronts sit empty because the owners have some vague plans to sell the building and don't want to endanger their chances of selling by passing out long-term leases. "They'll usually rent the place month to month," Goldman said, "but most commercial tenants don't want to take the chance of a month-to-month lease."

Mark Tarses, a landlord and a member of the Berkeley Property Owners Association, said owners of residential property engage in a similar risk-assessment process when they leave their buildings empty. "In Berkeley (Calif.), a lot of property owners choose not to rent their places because of rent control and the sheer number of regulations that effect landlords," Tarses said. "A lot of small-property owners are older, and security and comfort is more important than maximizing profit. Basically, they're afraid."

As evidence of this trend toward leaving units off the market, Tarses points to the 20 percent decline in the number of apartments registered with the Berkeley Rent Board since 1980. As an example, Tarses tells the story of a Berkeley professor who owned and lived in a small apartment building and chose to leave his apartment vacant rather than rent it out when he went away on sabbatical. "He knew when he got home, he might not be able to get it back," Tarses said. "Even in the case of single-family homes, it's sometimes taken years for people to move back into their houses."

The argument that tenant-friendly rent ordinances have a deleterious effect on the rental stock is part and parcel of the bitter battle between tenant advocates and property owners in the San Francisco Bay Area. Tenants often argue that property owners like Tarses exaggerate such claims. In any case, such owner nightmares are one reason units sometimes remain uninhabited.

Another cause, Tarses said, is that preservation laws and landmark boards have become ever more active in designating property as "historical." "They designated the Top Dog on Durant a historic building," he said with a laugh. "There are corrugated steel buildings that are rusting through that the owners are not allowed to demolish."

For years, I've been getting little queries from frustrated homeowners about deserted houses or commercial buildings in their neighborhood. Since buildings take work and care and money, neglected buildings end up looking like forlorn pets, abysmally treated by their owners. "Can you find out what's going on with it?" the neighbors ask about a particular property. "It's such an eyesore."

So, recently, I began following up on such buildings, trying to discern any patterns that turn valuable, often-desirable properties into derelicts. Here are thumbnail sketches of a few of the unused-building tales I've collected:

Garage for the Ultra Rich:

Located in a residential neighborhood, surrounded by single-family homes and duplexes, a forgotten tannery on York Street between 25th and 26th streets in San Francisco has been boarded up and essentially unused for years. My friend, who lived behind it, decided it would be the perfect purchase for a theatre/school/social experiment. He contacted the title company that had handled the previous purchase, and it offered to pass along a letter to the owner inquiring whether he might be interested in selling. The owner declined, explaining that it was where he kept his collection of old cars.

Sometimes, it seems, that financial motivation has little influence when it comes to keeping your fleet of vintage automobiles dust free.

A Godly Project Waiting for Angels:

On the 1600 block of Stuart Street, in a rapidly changing south Berkeley neighborhood, a residential building has stood empty for more than five years. On an otherwise sweet street of single-family homes, its boarded-up windows and "No trespassing" signs seem ominous and a little perplexing. "I heard it was a crack house," wrote one reader about the building. "But now it's just been sitting there empty for years." It turns out that the building is owned by its next-door neighbor, the McGee Avenue Baptist Church, which once rented out the single-family home, a property that had been hacked into several code-violating apartments. The pastor, D. Mark Wilson, said that the church wanted to get out of the residential-property business and that it needed to bring the building up to code. Now, he said, there are plans to turn the building into a center for the church's social-services programs, like feeding the homeless and helping young people. How or when might that happen? Wilson is vague: "Well, if anybody comes to us with the energy, we would be happy to work with them. You need a team of people to do something like this."

Does the church need capital, or is it just initiative to do the project that is lacking? "A little bit of both, I guess," Wilson said. "But if anyone wants to join up with us, we're interested in working with others."

Why wouldn't the church sell it? Once buildings are owned by a community, it's easy for them to languish in the netherworld of differing opinions. According to some of the neighbors, church leaders have had not always agreed about what the fate of the building should be, so it remains in a fateless state.

So Clean It's Toxic!:

A dry-cleaning business on 24th Street in San Francisco's Mission District closed several years ago, and, since then, the building has gathered dust as storefronts all around it have been renovated into new restaurants, businesses and bars. Broker Arthur Goldman said gas stations and dry cleaners are two types of businesses that are most likely to become toxic-cleanup sites. "That's why you see a lot of old gas stations that stop selling gas but just become car garages," he adds. "The same thing happens with dry cleaners."

A spokesperson for the Jackson Group Property Management, the company that manages the property, said the business wasn't informed about any code violations or toxic issues regarding the lot, but she said that there are no plans to rent the building in the future. "It's just a vacancy," said Nicole Castaneda, an assistant property manager. "It's a matter of convenience."

I wasn't able to get ahold of the building owner before press time, but, in general, dry cleaners often stand empty for years before the owner or an incoming tenant has deep enough pockets to do the necessary cleanup to bring the building up to code.

Government Ex Machina:

Once a local bank branch, a corner storefront on Park Street in Alameda, Calif., had been rented to a check-cashing joint and a retail chain called Cigarettes for Cheaper. The tenant had received a business license from the city and had already signed the lease when the community got wind of the plans and people lobbied city hall to put the kibosh on the project. (Local activists contend that Park Street should have more nice restaurants and shops and family-friendly businesses, and that a check-cashing office is not part of the plan.) The city was able to stop the project, but only after a lawsuit and an expensive settlement that required the city to pay the rent to the owner for the full five-year lease. Since then, the city has tried to sublet the place, but, because its leases now ask tenants to indemnify the city against possible lawsuits, most tenants cannot afford the cost.

"It's a case of the city being able to stop bad development but not being able to encourage good development," said James Silva, co-owner of Silva Books on Park Street, who recently withdrew a proposal to rent the space. "It wouldn't have been possible for us to make it work. The lease was triple net lease – meaning we would have had to pay mortgage, property insurance and property taxes. It's not feasible for most small businesses."

Are there any patterns behind what makes buildings fall into the abyss? "Every property is different, and every owner is different," said Arthur Goldman. Indeed, the tales behind such buildings are as multifarious as our species' neurosis. At times, they are the visible manifestations of the dark side of living on Earth – where things fall apart, death arrives unexpected, goodwill crumbles in internecine warfare, governments meddle and muddle, and profits go to those who are willing to hold out for a market peak.

So, whenever you walk by a boarded-up building and wonder, "What's the story there?" just let your imagination wander.

Friday, July 09, 2004

Why Home Prices Are The Next Bubble

Recently two economists from the Federal Reserve Bank of New York completed a study contending that despite the dramatic rise in housing prices there is no housing bubble. Raymond Sabat of has examined the report written by these two economists and discovered a glaring error which caused them to reach faulty conclusions

San Francisco, CA (PRWEB) July 9, 2004 -- Will real estate prices crash the way internet stocks did? Recently two economists from the Federal Reserve Bank of New York completed a study contending that despite the dramatic rise in housing prices there is no housing bubble. Raymond Sabat of has examined the report written by these two economists and discovered a glaring error which caused them to reach faulty conclusions.

Sabat explains that the record climb in housing prices is, indeed, a bubble and that the Federal Reserve study fails to consider past declining interest rates as a cause of the bubble. The faulty conclusions reached by Federal Reserve economists Jonathan McCarthy and Richard W. Peach may make many potential new home buyers comfortable about a purchase, when, in fact, we are very near the top of a housing market that will experience substantial declines in prices.

In his analysis Sabat explains why the housing price boom is a bubble and what to watch for to determine exactly when it will collapse. He explains that new structural features in the current housing finance market will make matters even worse. He forecasts that many new homeowners will walk away from their homes and their mortgages.

“The faulty analysis,” Sabat says, “ by Federal Reserve economists McCarthy and Peach may go down in financial history as the greatest forecasting error since Irving Fisher declared in 1929, just prior to the stock market crash, that stocks prices looked to be at a permanently high plateau.”

The complete analysis by Sabat is available at the web site: is an online daily report on finance, the stock market and the economy, providing links and original analysis for businessmen, political leaders, investors and those who desire to be well informed. Raymond Sabat is Editor & Publisher of

Thursday, July 08, 2004

Are Home Prices the Next Bubble ?

Jonathan McCarthy is a senior economist and Richard W. Peach
a vice president at the Federal Reserve Bank of New York.

(Read the entire PDF, by clicking on the link above.)

Recapping a forthcoming article from the Economic Policy Review.

* Home prices have been rising rapidly since the mid-1990s. Many analysts view the increase as symptomatic of a bubble that will burst, thus erasing a significant portion of household wealth. This decline in wealth could have a negative effect on the broader economy as consumers reduce spending to increase saving and protect their vulnerable financial condition.

* Authors McCarthy and Peach argue that no bubble exists and present evidence that the marked rise in home prices is largely attributable to strong market fundamentals: Home prices have essentially moved in line with increases in family income and declines in nominal mortgage interest rates.

* The authors begin their analysis by pointing out flaws in the two measures often cited to support the theory that a bubble exists—the rising price-to-income ratio and the declining rent-to-price ratio. Specifically, the measures

o do not account for the effects of declining nominal mortgage interest rates and

o fail to use appropriate home price indexes that control for location and changes in quality.

* McCarthy and Peach contend that a weakening of economic conditions is unlikely to trigger a severe drop in home prices. In fact, aggregate real home prices historically have fallen only moderately in periods of recession and high nominal interest rates.

* Nevertheless, weakening fundamentals could pressure prices along the east and west coasts, where an inelastic housing supply has made prices more volatile than elsewhere in the United States. However, previous home price declines in these regions have not had devastating effects on the national economy.

Wednesday, July 07, 2004

Foreclosure Sales Offer Deals on High-End Homes


July 07, 2004 -- Alan Shams just bought a 7,700-square-foot lakefront Las Vegas vacation home with five bedrooms, a pool and a waterfall in the backyard. But the best part of all was the price: At $1 million, the house cost $600,000 less than the previous owner paid three years ago, in one of the country's hottest real-estate markets.

But Mr. Shams bought his new luxury home in a foreclosure sale. A local bank had acquired it from the previous owner after he defaulted on his mortgage. Mr. Shams, a Virginia commercial-property investor, says buying a home this way was much easier than going through a regular sale, since he didn't haggle over price or move-in dates with the seller. "You buy. It's yours," he says.

In some places these days, the best spot to look for a million-dollar mansion may be the bank or the courthouse. Foreclosures are running at 1.27% of all mortgage loans, up 14% since 2000, according to the Mortgage Bankers Association. In the first five months of this year, 113,362 foreclosed homes came on the U.S. market, up 56% from the same period last year, according to ForeclosureFreeSearch, a Boca Raton, Fla., firm that tracks foreclosed homes for sale.

And with interest rates expected to rise, mortgage rates are likely to follow, putting pressure on financially overextended homeowners. "People have been borrowing way too much," says Chief Executive Officer Tim McGee. "We're experiencing the effects of yuppie fatigue."

Distressed Mansions

While the stereotype is that foreclosures don't happen in the best neighborhoods, they actually occur in every price range -- and foreclosures on high-end homes occur in about the same proportion as they do on other homes. So, when foreclosures overall rise, high-end ones do, also. In Silicon Valley alone, says that only one home was listed on its site last year for more than $1 million; now, there are 16.

Island Park, Idaho $1.5 million

Foreclosures can mean some surprising bargains, primarily because banks don't want to be in the real-estate business and price their properties to move fast. In Calistoga, Calif., a bank is asking $1 million for a six-bedroom house that sold three years ago for $2.6 million. In Fort Worth, Texas, a bank has just lowered the price of a 7,700-square-foot home to $1.3 million, down from the bank's original asking price of $1.5 million. And in Las Vegas, a five-bedroom home was just sold by a bank for $1.5 million, $400,000 less than the original asking price. In foreclosed million-dollar-and-up homes, "the deals are out there," says Portland, Ore., broker Jim Doak.

There are drawbacks to buying a house that came on the market due to hardship. In some situations, former owners are bitter and even sabotage the house, removing appliances and fixtures. Dan Humeston, a Las Vegas broker, says he's found holes punched in the walls of million-dollar homes, and concrete poured down the toilet.

In other cases, financially strapped owners have allowed the home to fall into disrepair. The foreclosure process typically takes about four months, sometimes leaving the grass uncut and the pool a slimy green. The Calistoga, Calif., six-bedroom home that's on the market for $1 million has no insulation -- and termites. As for Mr. Shams, he says he'll need to spend $150,000 on his house upgrading the old carpet, worn tile floors and out-of-date kitchen.

There are several ways to buy a house in foreclosure. Bruce Venturelli, a Santa Barbara, Calif., broker, says that typically 10 properties priced over $1 million fall into default in his market each year, but only one or two get as far as being sold at auction or by the bank. Most are actually sold in "pre-foreclosure" sales to individuals who scour legal postings for Notices of Default (homes with mortgage payments in arrears).

Buyers can get first crack at homes this way but they have to be prepared to make an offer immediately. And they must deal with emotional owners who may not want to leave and who may be warring with a sibling or spouse. Or there may be angry tenants to evict.

Atlanta $1.5 million

Armed with a Checkbook

Though laws vary, owners generally have four months to pay their debts. If they don't, lienholders can force the house to go on the auction block -- not some fancy venue like Sotheby's, but rather the courthouse steps. Anyone can buy there (such sales are advertised in the classifieds of local newspapers), but most people don't, since bidders usually have to come with a check equal to at least 10% of the expected purchase price. Most of the time, the successful bidder is the bank, which takes over the house for what it's owed. At this point, the house officially turns into a "foreclosed" home. Foreclosed properties are available through brokers who specialize in so-called REO's, or real-estate-owned properties, and are listed on Web sites like

Right now, bargains in luxury homes are easiest to find in overbuilt or resort areas, particularly in Colorado, Arizona, Texas and Utah, brokers say. Four years ago, Park City, Utah, developer John Benson built an 8,500-square-foot second home with seven bedrooms, nine baths, a home theater and a panoramic view of the Deer Valley ski area. Then, Mr. Benson says, business reversals and serious medical problems caused him financial problems. "Everything hit me at once," he says. Last year the house went into foreclosure.

Brad Olsen, the agent handling the sale, says the home has been on the market for more than five months because the Park City region was so overbuilt after the 2002 Winter Olympics. Appraised for $2.6 million upon completion in 2001, it is now available for $1.7 million, furniture included. "You can get a bargain," he says.

Thursday, July 01, 2004

Will housing bubble burst?

INTEREST-RATE INCREASE: The best days for the real estate market are over, expert says

- Kelly Zito, Chronicle Staff Writer
Thursday, July 1, 2004

Click to View

CORRECTION: A front-page box Thursday contained several errors on the Federal Reserve's move to raise interest rates. The key rate the Fed increased, the federal funds rate, is the one banks charge each other for overnight loans. The Fed itself lends to banks infrequently and usually does not do so overnight. The increase was 1/4 percentage point. The Fed has implied that this is the start of regular increases but has not said so explicitly. The Fed has never cited rising deficits as a reason why it is increasing rates. The Fed acted to check inflation that is rising because of rapid economic growth. Most experts agree that mortgage rates are likely to rise in the months ahead. But fixed rate mortgages don't automatically go up when the Fed raises short term rates. Student loan rates fell effective Thursday for next the 12 months because they are tied to a benchmark that was lower this year than it was last year.

Is the party finally over?

Like an all-night bash threatened by the morning light, the Bay Area housing market now confronts its most important hurdle of the past several years: higher interest rates.

"The best days for the real estate market are over," said Scott Anderson, senior economist at Wells Fargo, one of the nation's largest mortgage lenders.

In the aftermath of the dot-com debacle, the nine-county region has enjoyed record sales and prices, in part because historic-low interest rates have allowed more consumers to afford ever-pricier houses and condos.

Now, with the Federal Reserve beginning what could be an extended policy to boost key short-term interest rates, some experts believe the housing sector could cool as mortgage rates follow suit.

Visions of higher interest rates bursting a Bay Area housing bubble, however, are premature, others argue.

"Going forward, the Bay Area is probably as close to a soft landing as we're going to get," said John Karevoll, researcher at real estate information firm DataQuick.

While mortgage lenders have already moved to raise rates ahead of the Fed's widely telegraphed action, many economists expect rates for most types of home loans to advance further over the next 18 months as the economy improves and the central bank attempts to curb inflation. Though stronger job and income figures could offset higher mortgage rates, there is concern that advancing rates could exacerbate the already wide affordability gap in the Bay Area -- which has some of the most expensive home prices in the country -- and ultimately squelch housing demand.

In the wake of Wednesday's rate increase, rates for adjustable mortgages will climb almost immediately because they directly mimic changes in the federal funds rate. As a result, many homeowners with adjustable mortgages could face higher payments in the months ahead.

Long-term mortgage rates are not directly tied to the funds rate, which is the interest banks charge each other for overnight loans. However, the two rates typically move in tandem.

If the Fed continues to raise short-term rates, as anticipated, one-year adjustable rate mortgage rates could jump from the current 4 percent average to about 5 percent by year's end and 6 percent by the end of 2005, Anderson said. Similarly, the 30-year fixed rate, currently hovering around 6.3 percent, will increase to just under 7 percent by December and rise to a high of 8 percent by December 2005, he added.

While those rates are still historically low, the economics are stark: The monthly payment on a $400,000 loan fixed for 30 years at 6.3 percent is $2, 476; at 8 percent, the payment swells to $2,935, nearly $500 higher.

Those increases may be enough to stall the market, according to some economists.

Stephen Levy, senior economist at Palo Alto's Center for the Continuing Study of the California Economy, said that while more Bay Area companies were posting higher sales and profits, local job creation had lagged behind the nation's, in part because of strong productivity gains here.

If job growth remains slower than average, "I can't anticipate high percent (home) price gains," Levy said.

Under a more pessimistic scenario -- in which jobs and incomes here stagnate -- Bay Area home prices could tumble as much as 11 percent, or $60, 000, if the benchmark 30-year rate rises to 7 percent, Anderson wrote in a recent report.

"We've seen a huge disconnect between incomes and home prices in the Bay Area," Anderson said in an interview. "Prices did adjust in 2001, but now that gap is widening again. That does raise the probability that you could see some modest price declines, over a short period, as the Fed tightens rates."

In the near term, however, the upward swing in rates may stoke sales.

Indeed, even as mortgage lenders bumped rates up in the last several months, Bay Area home sales counts and median prices hit new peaks.

For May, the median price for a single-family home soared nearly 19 percent year-over-year, from $446,000 to $530,000, according to DataQuick. May's sales count of 12,028 was the highest on record for that month going back at least 16 years.

Anecdotally, at least, that momentum seems to have carried into June. Earlier this week, Mubashera Chaudhry, 32, toured a condo development next door to Candlestick Park in the hopes of squeezing into the market ahead of further rate hikes. "That's why we're buying now, because rates are going up," said Chaudhry, who lives in Santa Clara with her husband Farhan Mahmoud and their three children.

Amid the frenzy, however, some alarming trends have emerged.

For example, there has been an increase in the number of Bay Area homes that fail to appraise for the purchase price, according to Ed Krafchow, president of Prudential Realty of California, Nevada and Texas. In such cases, a lender often walks away from the deal or asks the buyer to pony up more purchase money.

"There's a lack of rationality in the market," Krafchow said.

Such cases lead some pundits to conclude that unlike the more stable national housing market, the Bay Area real estate sector has become untethered from reality and vulnerable to a marked slump in the face of rising rates.

On the other hand, the market may simply downshift as other variables cushion the market from the blows of climbing rates.

For instance, DataQuick's Karevoll forecasts that price appreciation will slow to 5 to 7 percent next year, down from double digit increases this year.

One of the factors feeding the California housing market's frenzy is the dearth of new homes. Scarcity of land, strict zoning regulations and NIMBYism all have played a part. But the building industry also has grown wiser about controlling housing output after learning from the mistakes of the late 1980s, when they produced glut of new construction.

Innovations in the lending industry may also help some buyers afford homes.

As rates climb, a larger share of borrowers typically takes out so-called adjustable rate mortgages, which usually require lower initial monthly payments than fixed-rate loans. In the Bay Area, for example, the percentage of purchasers who chose ARMs rocketed from 44 percent in May 2003, when long- term rates neared 45-year lows of a little more than 5 percent, to more than 72 percent in May 2004, when the 30-year rate hovered around 6 percent, according to DataQuick.

Such loans are riskier than fixed mortgages, however, because while the rate is the same for an initial period, it then floats up or down, depending on the current market rate.

Three years ago, Laura Tauber lost her high-paying job as a health care consultant at Accenture. Since then, she's landed a job at a small Marin County television production firm. Still, her household income is now about half what it was in 2001.

With an adjustable mortgage that will reset this fall, Tauber, 45, worries the current $2,800 monthly payment on her Larkspur home will surge, forcing the family of four to further trim spending.

"We've basically been eating up our savings to live right now, so any increase in our mortgage payment is painful -- even $100," Tauber said. "We'll eke it out somehow, but it's hard."

E-mail Kelly Zito at

Monthly payment for a 30-year fixed rate $400,000 mortgage

5.5 % $2,271.16
5.75 2,334.29
6 2,398.20
6.25 2,462.87
6.5 2,528.27
6.75 2,594.39
7 2,661.21
7.25 2,728.71
7.5 2,798.86
7.75 2,865.65
8 2,935.06

Monthly payment for a 1-year adjustable rate mortgage for $400,000 **
3.5 % $1,796.18
3.75 1,852.46
4 1,909.66
4.25 1,967.76
4.5 2,026.74
4.75 2,086.59
5 2,147.29
5.25 2,208.81
5.5 2,271.16
5.75 2,334.29
6 2,398.20
** Adjustable mortgage rates are based on the changes in bank interest
rates and otherfinancial indexes. Interest and payments on a fixed rate mortgage remain the
same for thelife of the loan.
Chronicle Graphic
Source: DataQuick, California Association of Mortgage Brokers