Tuesday, September 28, 2004

Industry Experts Debate The Future of Real Estate

The nationwide boom in housing over the past few years has fueled a run-up in prices that can't last. Or can it?

It depends on whom you ask.

The pessimists argue, essentially, that the lowest interest rates in almost a half-century have ignited an unsustainable level of sales activity that will subside as rates creep inexorably up again, as they started doing the past few months.

But the optimists say so many baby boomers have hit their full earnings stride that demand for homes is going to remain strong for the foreseeable future, with run-ups continuing in pricey locales like San Francisco where severe housing shortages persist. The San Francisco Bay area is one of the most expensive markets in the country, in large part because there is little available land to build on.

To hear both sides of the argument in more detail, we invited a noted housing bear and housing bull to participate in a debate on the health of the U.S. housing market. The bear, John Talbott, 49 years old, is a former investment banker at Goldman Sachs Group Inc. in New York and author of "The Coming Crash of the Housing Market: 10 Things You Can Do Now." The bull, David Lereah, 50, is chief economist of the National Association of Realtors, the industry trade group based in Chicago.

Here are excerpts from their exchange:

The Outlook

The Wall Street Journal: Do you think housing prices will continue to rise nationwide, and why or why not?

Mr. Talbott: Many so-called housing experts believe that because the housing market is so big, it must act like a true economic market. They therefore conclude, wrongly, that the high prices we see for homes today are market-determined and, as such, are very good indicators of their true worth. If true, this would make them very unlikely to ever crash, as irrational bubbles rarely happen in efficiently priced markets. Thus they spend much of their time analyzing supply and demand for housing as if it were a perfect market, not subject to possible manipulation, corruption and collapse.

But housing, and specifically home mortgages, do not act at all like perfect markets, and so the public should not gain any comfort that these prices being paid for homes today are sustainable. First, home buyers are not that sensitive to high prices because they are financing most of the purchase price. Lenders don't care about the price paid or the amount of leverage on the home because they sell most of their mortgages to Fannie Mae and Freddie Mac. And Fannie Mae and Freddie Mac aren't concerned that much with credit quality because they have an implied guarantee from you, the American taxpayer.

So, we find ourselves in a period of very loose mortgage credit, with home purchases being completed at very high prices and with very aggressive borrowing terms, and interest rates beginning to rise from a 40-year low. How long can prices continue to rise? According to the National Association of Realtors, prices have already peaked and have begun to fall from their peaks in much of the country. Nationally, NAR reports that prices are off some 4% [seasonally adjusted] since July of 2003, and the Southern states are off approximately 10%. A portion of this decline may be due to seasonal factors, but realize that this decline is beginning after housing prices have increased some 35 years in a row. And this is for data reported as of March of this year, and so does not include any effect of the recent rise in interest rates.

Where are prices headed from here? Further down. The best case: Housing prices nationally will drop approximately 10% to 15% from their peaks. Worst case: They will fall between 15% and 25%. Changes of this magnitude are large enough to wipe out many people's entire equity in their homes. Under this scenario, major players in the mortgage business -- such as the primary mortgage bankers, providers [of private mortgage insurance], second-mortgage issuers and even Fannie Mae and Freddie Mac -- will run into financial trouble due to credit problems on their loans.

Mr. Lereah: Yes, housing prices are expected to continue to rise nationwide. Why? Because housing demand will continue to exceed housing supply, exerting upward pressure on prices. The real problem in the nation's housing sector is supply, not demand. The inventory of homes, as measured by [the amount of time a house is on the market], has hovered in the 4.3- to 4.8-month range for the past year, tight by any historical standard. In fact, in the fourth quarter of last year there were 19 major metropolitan areas in which the months' supply was less than four [months]. It is not a coincidence that most of these metro [areas] also experienced double-digit price appreciation.

Looking forward, I expect a growing economy [with job gains to] exert upward pressure on mortgage rates. Modestly higher mortgage rates are expected to slow the pace of home sales from last year's record pace.... The concern some housing analysts have that house-price growth in some areas of the nation has risen considerably faster than income growth is justified, but exaggerated. It is true that if demand falls off sharply in these areas, there could be some price softening -- maybe even a correction in some cases. However, large price corrections are unlikely. Sharp price declines are usually driven by a substantial loss of jobs in a local area. Thus, it is very unlikely that prices would drop on a national scale. Price corrections are a local phenomenon, not national.

WSJ: How much longer will the U.S. remain in this low-interest-rate environment? And how much of a spike in rates would it take to slow down housing sales?

Mr. Talbott: While no one can predict interest rates accurately, it is true that measured by historical norms interest rates are at relatively low levels. Do they have to rise? Not necessarily. The world economy could stumble if China continues to have problems with managing its growth, or oil prices remain high.

But home buyers, especially those utilizing adjustable-rate mortgages to finance their purchase, should do the appropriate planning to allow if, indeed, rates do continue to rise in the future. The use of ARMs is increasing and now accounts for 31% of all mortgages [being originated.] Short-term interest rates used to reprice adjustable-rate mortgages are much more volatile and much more subject to increasing as the [Federal Reserve] raises rates.

Homeowners who have fixed their interest-rate exposure by borrowing long term are not completely out of the woods. Home prices could begin to decline as rates increase, and homeowners who thought they had removed their exposure to interest rates may be forced to sell into a down market due to unforeseen circumstances -- a divorce, job loss or medical emergency in the family.

If the 10-year Treasury rate gets to 6%, watch out! And this is still quite low by historical standards. To get there, we don't have to have a booming recovery and rising demand for investment funds. With annual government deficits of more than $500 billion and no effective plan to provide for the retirement of the baby boom [generation], it would be rational for bond investors to demand higher returns if they expect inflation to creep back into the picture as the government faces greater pressure to inflate its currency rather than borrow in the future.

Mr. Lereah: As the U.S. economy continues to gain momentum, the Federal Reserve is expected to be less accommodative, creating an environment for interest rates to rise a bit. According to the Labor Department, the economy added 308,000 jobs in March, which bodes well for future economic activity. I now expect 30-year mortgage rates to rise to 6.4% by the fourth quarter of this year, damping the demand for home buying. Home sales will slow to a 5.8 million annualized pace in the fourth quarter, from the record 6.1 million-unit pace set in 2003. However, for the year, existing home sales are expected to register 5.9 million, which would be the second-highest number of sales on record.

Mortgage rates would have to spike a great deal higher for there to be a meaningful slowing of home sales. My best guess is that the 30-year mortgage rate would have to climb above 7% for sales to fall a bit more. But remember, the reason rates would be climbing is that the economy is growing and adding jobs, a positive for housing demand. Further, if long-term mortgage rates are rising, some home buyers will turn to adjustable-rate mortgages to keep their mortgage costs relatively low.

From a larger perspective, I believe the U.S. economy will remain in a low-interest-rate environment for the remainder of this decade. Inflationary pressures remain low, and there is little indication of any serious future inflation. The only potential time bomb for the interest-rate outlook is the nation's swelling budget-deficit problem. If the federal government does not address the deficit problem in the near future, interest-rate pressures will rise.

Economic Impact

WSJ: If the economy slows down again, would that burst the bubble in the housing market? Why or why not?

Mr. Talbott: Economic slowdowns are what usually cause problems in the housing market. The reason is that until people have real difficulty making their mortgage payment, they are unlikely to be willing to part with their family's home. Loss of a job in an economic downturn is an event that might lead to foreclosure and possible personal bankruptcy. If there were an economic slowdown, the associated job losses would be catastrophic to the housing market and the bubble would most definitely burst.

Instead of a weak economy causing a retraction in housing prices, which is the typical phenomena, here a collapsing housing market nationally...would dramatically lower house prices. This would increase foreclosures, cause greater bank losses and threaten major industry players. [This would be followed by] a general decline in the economy as banks retrenched in all areas of lending and labor mobility shrunk as workers were unable to sell their homes in order to move to new jobs.... The bill, in essence, would come due for all the carefree spending due to the home-refinancing wave that occurred when housing prices were booming, rates were low and credit was easy.

Typically, economic slowdowns are regional in nature, so Houston has a housing-price decline when oil prices contract and San Francisco and Boston have problems when the high-tech market stumbles. For there to be a truly national housing-price crash, there would have to be factors that are national, not regional, in scope. Higher interest rates, a corrupt mortgage system and our increasing reliance on a shaky global economy are all exactly those type of national factors, any one of which could cause a serious decline in housing prices.

Mr. Lereah: I truly believe that if the economy slows down again, the housing sector would be the beneficiary. A weak economy means an accommodative Fed and falling interest rates. Mortgage rates would drop back toward their 45-year lows, reducing homeownership costs and stimulating the demand for home buying.

Supply and Demand

WSJ: Is housing construction running ahead of demand, setting up the potential for an oversupply of homes in the market? If so, how close are we to an oversupply situation?

Mr. Talbott: People mistakenly point to the boom in house construction as a sign that the housing market is healthy and that prices are reasonable. Just the opposite is true.

Home builders are arbitrageurs. They see that home prices are overvalued in a particular area, and they quickly turn fairly priced wood and nails into overpriced homes to sell. Home builders need not be bullish on home prices. Home builders are sellers, not buyers, of homes. They depend on you to purchase the home, many times before construction has even started, and to bear the risk going forward [in regard to whether] the housing market is overvalued. Secondly, the amount of homes that can be built in any one year is a small percentage of the total supply outstanding. So the overall impact of the supply of new homes is greatly overexaggerated.

There is no oversupply of homes in the market, but there very well may be if everyone decides to sell at the same time. Thinking of the housing markets only in terms of supply and demand ignores the fundamental concerns about the mortgage business that makes a correction inevitable.

Mr. Lereah: Housing construction is behind, not ahead of, demand, creating a tight supply of homes in the market. There are government-imposed growth restrictions in many areas across the nation that have inhibited housing construction. Home builders got caught with their financial pants down in the last housing contraction, in 1990 and 1991, and have been a bit more conservative this time around. For example, the supply of unsold homes in 1990-91 was about nine months, or double the months' supply today.

WSJ: What are the riskiest regions of the country, in terms of a pricing bubble bursting? And do you think there is a high likelihood the markets there will experience actual price declines anytime soon? If so, what would it take for that to happen?

Mr. Talbott: At first blush, it appears that the highest-priced areas of the country face the greatest risk if the bubble bursts. The wealthier communities, especially in the Northeast and West, have much higher average prices for homes, even relative to family incomes, and they have had the biggest percentage price appreciation over the past five years. This makes them very susceptible to a downturn.

But housing-price declines will not be limited to the frothy, highly priced communities. The economy will suffer due to labor mobility declining if home prices decline and to bank-lending retrenchment. This means that the more moderate-income neighborhoods will begin to experience abnormal job losses, and foreclosures in those areas will grow, leading to home-price declines. The South is experiencing the greatest price declines in percentage terms right now, even though [that region] and the Midwest already have much lower-priced homes than the Western and Northeastern regions.

What will the trigger be? It could be higher rates. It could be that problems are exposed in the highly leveraged private-mortgage-insurance business. Or Fannie or Freddie may have problems. You can be certain in this kind of incestuous manic market, when it happens, everybody will claim complete surprise.

Unfortunately, unlike other housing downturns, this will be truly national in scope, affecting all regions of the countries and all neighborhoods, both moderate and expensive. The decline has already started in the Midwest and the South, and as rates continue to rise, the [coastal regions] will also begin to decline. Housing markets don't typically realize their losses all at once as homeowners are slow to sell into weak markets. But the decline that has already begun will increase as rates increase and housing prices will fall nationally for three or four years before they stabilize again.

Mr. Lereah: The great thing about mortgage rates is that they don't discriminate. If 30-year mortgage rates are 5.8% in the Northeast region, they are also 5.8% in the South, Midwest and West. Since mortgage rates are projected to stay relatively low -- below 6.4% -- for the remainder of the year, most regions and metropolitan areas of the nation will be spared any price bubbles bursting.

Regions are at risk when there is a concentrated loss of jobs, resulting in a sharp drop-off in home sales. Predicting local economic conditions is difficult from a national perspective. Local areas such as Nassau and Suffolk [counties in New York]; Orange County, Calif., and the Washington, D.C., metropolitan area have experienced several years of double-digit price appreciation. If these areas were to experience concentrated job losses, they could be vulnerable to price corrections. However, since the housing inventories in these areas are very tight, a sharp price decline would be unlikely at this time.

Looking Long Term

WSJ: Long term, do you think housing will remain a safe investment in the U.S.?

Mr. Talbott: Housing will always be a much less volatile asset than other more speculative investments like high-tech stocks or options. But given the enormous amount of leverage in the housing sector, the equity held by the homeowner is a much more volatile asset than the underlying home.

Many people moved into home buying as an investment alternative after having gotten burned in the high-tech boom of the late '90s. They correctly reasoned that homes were built of bricks and mortar and so were much less likely to evaporate in the future than some their Internet investments had. Unfortunately, these home buyers are not asking the fundamental question necessary for intelligent, productive investment: Yes, the home they are buying is beautiful, but what price are they paying for those bricks and mortar?

Housing will not be a safe investment looking forward. Price declines will erode investments and cause a dramatic increase in foreclosures and personal bankruptcies. It never makes economic sense to buy at the peak of a cycle. People who overpay, even for nice properties, end up kicking themselves for having been so stupid when times change -- and, oh, they always do.

Mr. Lereah: During this past decade, real estate has surfaced as a relatively safe, wealth-building asset. The so-called real-estate boom has jumped over many obstacles and is still standing. It had to absorb the international financial crisis of 1998, a recession in 2001 and significant job losses in the 2002 to 2003 period. While many real-estate watchers like to attribute today's real-estate boom to low mortgage rates, that is only part of the story.

Technological advances in how houses are bought and sold, product innovation, and a continued high level of demand for homes by baby boomers, their children and new immigrants are just some of the reasons that the boom will continue into the next decade. Return on home investment will not fade away. Price bubbles are not about to burst. The long-term fundamentals for housing remain excellent into the foreseeable future.