Monday, July 19, 2004

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


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