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.


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