Saturday, April 02, 2005

After The Housing Boom

Business Week
What the coming slowdown means for the economy -- and you

Admit it -- you've done it. You've surfed Web sites such as and to get a sense of the real estate values in your city. On weekends you skim local real estate ads to check asking prices. And at neighborhood dinner parties you steer the conversation to find out what price that four-bedroom colonial down the block fetched when it sold last month.

In today's ownership society, few investments have been so lucrative for so many as homeownership. Since 2001 extremely cheap mortgage rates have fueled a record-setting level of home sales. Frenzied demand caused home prices to jump at rates not seen since the 1980s and generated 10% gains each year in housing wealth for many Americans, who quickly used refinancings or home-equity loans to convert some of the windfall into cash.

With millions of Americans still eager to get into the housing bonanza, it's no wonder signs of overheating are popping up. At building sites from Florida to California, househunters stand in line just for the chance to buy a home. Investors are flipping properties almost overnight. For some lucky folks, home values have doubled in five years. And in early 2005 the boom was in full swing. New-home sales surprised many economists by jumping 9.4% in February, to an annual rate of 1.2 million. And starts rose to a yearly pace of 2.2 million in the month, a level not seen consistently since housing's go-go 1970s.

But hold on. Despite February's strong numbers, 2005 looks to be the year that housing finally cools off. Thanks to tighter monetary policy and a stronger-than-expected economy, mortgage rates are on the rise. In just six weeks, rates have jumped by almost half a percentage point, to over 6%, by Mar. 25. By 2006 they will likely hit 7%. As a result, economists surveyed by Blue Chip Economic Indicators see housing starts slipping by about 5% this year and more in 2006. Sales are likely to fall by the same amount. On a national level, home prices aren't going to plunge -- they just won't rise very much. "Home prices will rust, not bust, for the next few years," says Richard Berner, chief U.S. economist for Morgan Stanley (MWD ).

Housing's slowdown will be relatively mild compared with past downturns, though there are pockets of froth. Why? It's taking place at a time when the economy is expected to grow by over 3.5%. In the past 40 years, national new-home prices have fallen only twice, and both times were during a recession.

Besides the good job and income growth associated with a healthy economy, there are other compelling reasons that the market won't soften too much. Baby boomers continue to fuel demand -- especially for second homes -- and immigrants are increasingly becoming first-time home buyers.

Even so, the new reality will have a big impact on homeowners who have begun to look at 10% annual gains in home values as a birthright. Consumers who made a habit of tapping into their home equity will find that their home is no longer a personal ATM. Anyone counting on continued home appreciation to fund their retirement or pay for their children's education may face a big shortfall when the bills come due. The new ways that housing is financed also shift the risk of rate changes from banks to homeowners. That could squeeze some families who have adjustable-rate mortgages.

Rising Rates
For the economy, a slowdown in home demand and prices could crimp consumer spending. In just three years, from 2002 to 2004, homeowners who refinanced their mortgages took out a phenomenal $400 billion in extra cash, most of which was pumped back into the economy. That source is going to dry up. The loss will come on top of the eventual softening in construction activity and mortgage lending, both big sources of employment in this expansion.

A cooler housing market could even have an impact on the ability of the U.S. to finance its enormous current account deficit. Since 2000 foreign investors have poured $400 billion to $500 billion into mortgage-backed securities, which seemed safe and attractive. But that money could go elsewhere if the U.S. housing market turns sluggish and fewer mortgages are written.

Of course, predictions that housing is about to peak have been made repeatedly over the past few years. So why does the turn look certain now? "The slowdown is all because of higher rates," says David A. Lereah, chief economist at the National Association of Realtors. True, mortgage rates have bounced up before -- most recently in the summer of 2004 -- but this time economists expect them to keep rising, in part because of the stronger economy. Plus, inflation has picked up, and not just from higher oil prices. In its last survey of regional business activity, the Federal Reserve found that "a number of districts indicated greater ease in passing along price increases."

Higher borrowing costs are already pricing potential home buyers out of the market. In housing, affordability is determined by monthly payments, including taxes and insurance. Take a home buyer with an income of $100,000 and a $40,000 downpayment. At a 30-year fixed-mortgage rate of 5%, the buyer can bid as much as $421,000 for a home. At a 6% mortgage, that falls to $390,000. At 7%, the upper limit is only $362,500. Spread across all income levels, that 13% drop in affordability whittles away at demand and cuts down on bidding wars, which helped drive big price leaps in some areas.

As higher rates dampen demand, the effects will spread to the rest of the economy. In the past three years homebuilding has made an oversize contribution to the growth of real gross domestic product and employment. Residential construction makes up less than 5% of the U.S. economy but accounted for over 12% of average yearly growth since 2002. Similarly, construction jobs tally just over 5% of all payrolls, but hiring at building sites has accounted for 16.6% of all new jobs in the past two years.

For 2005 homebuilders are still optimistic about demand. There's a backlog of unfilled orders for new homes, and Los Angeles-based KB Home (KBH ), for example, recently raised its fiscal 2005 profit forecast. Ryan Brown is one real-estate investor who remains upbeat. He and his business partner, Jeffrey Lewis, buy and remodel homes in the Los Angeles area. Their latest project is a three-bedroom, three-bath house in the Hollywood Hills that is listed for $1.49 million. "The whole bubble thing is really overrated," Brown says. Yet even he has reduced his price expectations, figuring appreciation may slow to about 3% or 5%. For the industry as a whole, higher mortgage rates will inevitably cut orders. By 2006 home construction will become a drag on the economy.

More important than housing's direct effect on the economy will be fallout from the slowdown in home-price appreciation. This is where the economy will be most vulnerable. Thanks to the easy availability of refinancings and home-equity loans, consumers have gotten used to tapping into the equity built up in their homes. In a 2002 study the Federal Reserve found that the average household extracted $26,700 in equity with each refinancing. One-third of that money was used to pay off old debts or add to savings; the other two-thirds was spent. The Fed estimated that the extra spending added a quarter- to a half-percent to consumer spending. That provided a welcome boost to demand as recession, terrorist attacks, and a sagging stock market were dragging down household purchases.

Now the refi windfall is going away. Freddie Mac (FRE ) forecasts that these cashouts will fall from $139.2 billion last year to $95.9 billion in 2005 and $61.2 billion in 2006. Luckily, stronger wage growth will take up some of the slack. But any brake on consumer spending at a time when households are already dealing with ever-higher energy costs will be a big deal given that household demand accounts for two-thirds of the total U.S. economy.

Financing Shift
Assessing the psychological impact on homeowners is more difficult. This time around, price weakness is happening when the economy is strong, and that's highly unusual. "The last time we had outright price declines, we were in recession," notes David W. Berson, chief economist at mortgage lender Fannie Mae (FNW ). So when it comes to gauging consumer confidence, "it's hard to disentangle the job-loss effect from the home-price effect." What does seem certain is that, if prices level off or rise only a bit, owners, especially on both coasts, may feel less wealthy, even though they will not have actually lost money. That could be another drag on consumer demand since studies show about 5.5% of new housing and stock wealth is spent.

Another danger to the household sector has been the proliferation of adjustable-rate or no-money-down loans. These new financing vehicles have enabled more people to buy homes. But the negative effects of rate changes will hit these consumers more than their lenders. Bert Ely, a bank consultant in Alexandria, Va., doesn't see a cause for concern as long as the economy keeps expanding. But he does worry about one thing: If interest rates rise much further, the combination of higher payments for adjustable-rate mortgages coupled with rising property taxes from past appreciation could make it difficult for some homeowners to meet their monthly obligations. "We're going to see some people get burned," Ely says.

Banks, though, should avoid most of the suffering. For all of the mortgage frenzy of the past few years, banks aren't carrying more exposure to housing than in past periods. About one-third of banking-industries' assets are in housing-related assets, such as mortgages and home-equity loans. That's the same ratio as in 1995, before the current housing boom. Barbara A. Ryan, associate director in the Federal Deposit Insurance Corp.'s research division, notes that many of the outstanding mortgages have been repackaged into mortgage-backed securities.

The dangers of speculation, too, have shifted from the building industry to individuals. In past housing booms overly optimistic builders flooded the markets with too many homes built on spec. The result was an oversupply that worsened a downturn, triggered bankruptcies, and caused layoffs among construction workers. Now builders typically wait for a downpayment before breaking ground, so the supply of housing is quite lean compared to sales. The speculation is popping up on the demand side. "In a way we've outsourced building speculation," says Michael Carliner, an economist at the National Association of Home Builders. That means the individuals who bought those properties, and not companies, will bear the pain if price gains or demand don't meet expectations.

Still, the pain won't be as bad as in previous slowdowns. In the last big housing recession, in the early 1990s, starts plunged 12.9% in 1990 and 16.2% more in 1991. That's not in today's forecast. And for all the media attention and party chatter about a bubble, there's little evidence that the national housing market is superinflated.

A Chance to Rebalance
Contrast today's home market with the economy's last bubble -- in tech stocks. In the late 1990s the NASDAQ surged 40% a year as people threw billions of dollars into companies that had no profits or coherent business plans. That's a far cry from 2005's housing picture. The supply of housing has not outstripped demand, and price increases have been supported by gains in jobs and incomes.

And the fundamentals of housing -- the health of the economy and demographics -- argue against a widespread drop in demand. Faster job and income growth should help to offset the drag of higher borrowing costs. Plus, even though a record 69.1% of Americans owned their homes at the end of 2004, demand will still be supported by baby boomers and immigrants.

Boomers, in particular, are driving the second-home market with an eye toward both investment and future retirement. Debbie Bockhold, a certified public accountant in Orange County, Calif., and her husband, Tim, a stockbroker, plunked down $450,000 for a new vacation home -- a two-bedroom condo just 15 minutes from the Strip in Las Vegas. Does she think she may be taking a gamble on housing in the city of big bets? Not at all. With other Vegas condos going for as high as $1,000 a square foot, "the price per square foot [$280] is just a great buy," Bockhold says.

Immigration is another trend that will help housing coast to a soft landing. Morgan Stanley's Berner points out that immigrants accounted for one-third of the new households formed in the 1990s, and these families are entering the housing market. Peter Gonzalez, a 32-year-old naturalized citizen from Mexico, is a prime example. In December, 2003, he purchased a three-unit building in Pilsen, a predominantly Mexican-American neighborhood on Chicago's West Side. He lives in one flat and rents out the other two. With demand for rentals strong, he's looking to raise rents. "I'm going to take the money and either build another rental building on property I already own in Pilsen or purchase and rehab another building," he says. But even he has turned cautious about the local market. "I think it's topped out for now," says Gonzalez.

There is a silver lining from the slowdown. Cooling in markets that benefited most from low rates will bring better balance to the national market as a whole. "People forget," says the Realtors' Lereah. "A housing boom does create haves and have-nots. Not everyone is a have. Detroit and Dallas have seen flat housing markets for several years." Slower price appreciation might make housing more affordable for young families. And builders might appreciate a breathing period that gives them a chance to whittle down their backlogs.

A slowdown in refis and home-equity loans might also address the growing problem of too little savings for baby boomers. Although housing wealth hit a record in the fourth quarter, the large amount of refis over the past half-decade means that equity as percent of real estate stood at just 56.1%. That's far less than the equity ratios of the 1980s and '90s. Boomers expecting to retire on the gains from their homes could face problems if they continue to refinance -- ending up with a substantial mortgage at age 65.

For now, homeowners still have faith that housing is a sure thing, even as they've begun to temper their expectations. Multi-homeowner Bockhold sums up the feelings of many: "Real estate's been good for us." And it has been good for the U.S. economy. But with so many families already owning their homes and mortgage rates rising, the party is winding down. Housing is entering a more sober period when it won't be a prime generator of growth. And the phrase "home, sweet home" won't have giant dollar signs attached to it.

By Kathleen Madigan with Christopher Palmieri in Los Angeles, Ann Therese Palmer in Chicago, and Dean Foust in Atlanta


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