Wednesday, March 02, 2005

Fresh Pricks In Housing Bubble


Dan Ackman

There is a sharp debate over whether there is a bubble in the U.S. housing market generally or in certain localities, or whether there is a bubble at all. But the past two days have brought fresh warnings that home prices are unsustainable.

First, a new study by the National Association of Realtors shows that 23% of all homes purchased in 2004 were for investment, while another 13% were vacation homes.

Traditionally, one of the bulwarks against a sharp decline in housing prices has been the fact (or belief) that most people live in their homes and would be unlikely to sell even if the market heads downward. But the same logic would not apply to investment homes or vacation homes. While there has long been anecdotal evidence that non-occupant buyers are fueling the rise in home prices, the NAR study claims to be the first to thoroughly analyze the phenomenon.

The study, based on 2003 census data, says there are 43.8 million second homes in the U.S. While 6.6 million of these are vacation homes, far more, 37.2 million, are investment units. This compares with 72.1 million owner-occupied homes. About a quarter of last year's home sales were for investment homes, NAR says.

Nearly 80% of investment buyers rent their homes. While an owner-occupant is unlikely to sell his or her home (except to buy a new one), for an investor, the decision to sell is much more purely economic: If rents can't sustain a mortgage, there is no point in owning an investment property, except for the hope that home prices will inevitably rise, as they have been.

So far, there has been no problem. Since 2001, the median price of an investment home has risen 25.4%, from $118,000 to $146,900. (In most markets, the average price is much higher than the median.) But if prices start to fall or if mortgage rates start to rise, there could be a rush to sell and a crash.

Otherwise, some investment buyers could find themselves unable to get renters at all, as rental vacancy rates are near historic highs. With many buyers putting down almost no cash, they could simply let their bank foreclose and walk away.

Investment buyers could be made even more sensitive to interest rate increases than is normally the case. The reason is the increasing popularity of adjustable rate mortgages. According to the Mortgage Bankers Association, more than 32% of mortgages are now adjustable. The popularity of ARMs is on the rise even though the spread between the so-called teaser rate and the fixed rate on a standard 30-year mortgage has narrowed.

An adjustable mortgage is most attractive to a borrower who figures he won't own the house for long. That could be a person who figures he will move to a different area or will soon be able to afford a better home. Or it may be a person who figures he'll unload the place to a greater fool.

All these trends are playing out against a larger trend of double-digit price increases for the average new home nationally, and 20% or more price jumps in many markets, including some of the most populous markets in the Northeast, Southern California and Las Vegas. At the same time, the share prices of home builders like Toll Brothers (nyse: TOL - news - people ), Centex (nyse: CTX - news - people ), D.R. Horton (nyse: DHI - news - people ) and Pulte Homes (nyse: PHM - news - people ) are all up by 25% to 100% in the last six months. Top mortgage lenders Countrywide Financial (nyse: CFC - news - people ) and Bank of America (nyse: BAC - news - people ) have increased their lending by 40% and 31%, respectively, in a year.

Most studies of housing markets are conducted by people with a vested interest in keeping spirits high. As a result, even those who issue warnings tend to mute their gloom. For instance, a study reported in yesterday's Los Angeles Times warns that Southern California home prices "could be at or near a peak," noting they are likely to level but are unlikely to fall by much.

That study is by Christopher Cagan, an economist for First American, a title insurer. Cagan notes that since 1998, prices in Los Angeles-Long Beach, Orange County, Riverside-San Bernardino and San Diego have been climbing by about 20% to 40% above their long-term average annual growth rate of 3.2% to 6.2%.

He notes that in the last downturn, from 1995 to 1997, prices dipped 10% to 25% below their "historical averages." Cagan is quoted as saying, "We won't be seeing 20%, 25% or 30% appreciation rates anymore," and he's allowing for a 5% decline.

As with all bubbles, it's fun to ride up and scary to get off while the roller coaster is still climbing. But if prices have doubled in four years, unfueled by income gains of anything close to that level, what's to stop, say, a 30% or 50% drop?

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