Did Someone Say Bubble?

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Author: Zuckerman, Mortimer B.

AMERICANS HAVE A CASTLE COMPLEX. They love their homes. Their place of residence is the largest and single-most-valuable asset of the vast majority of Americans--especially recently, when homes have soared in value in the most steep, durable, and geographically widespread boom of the past 35 years.

Over the past five years alone, housing prices, adjusted for inflation, have jumped at a remarkable 6.8 percent rate annually. That's significantly higher than the historical 1 percent, and in many markets, the five-year gain has exceeded 50 percent!

So how could Americans not be optimistic about this bull market, and how could real estate not be their preferred financial holding? They still bear the scars of the stock market crash of five years ago, when investments in stocks and bonds melted away. These days, the question is, can this boom last? Are current prices being sustained primarily because investors believe they'll be even higher tomorrow? That's the very definition of a bubble. If we are in a bubble, however, it is sure taking an awfully long time to pop. Why? Several reasons.

• Long-term interest rates have gone up over 1 percent in the past year alone. That's not just a deterrent on the demand side; it's also a force for making people stay where they are. Higher rates on more-expensive homes with larger mortgages have raised the cost of owning a home in New York from 25 percent of median income in 2000 to 38 percent today. In Miami, the numbers are 21 percent and 43 percent. In Los Angeles, the cost of home owning has doubled over the past five years, rising from 31 percent to 55 percent of median income. That means only 2 percent of the homes sold there are affordable by families earning the area's median income of about $47,000 a year. To qualify for conventional financing of a median-price home of $500,000, with a 20 percent down payment, buyers would need an annual income of about $120,000. In New York, only 6 percent of those who earn a median income can afford to buy a median-price home. In San Francisco, the number is 7 percent, Miami 14 percent, Boston 24 percent, and Washington, D.C., 27 percent. For 30 years the ratio of housing price to income hovered around 4 to 1, but in the past five years it doubled, to about 8 to 1, as the cost of new homes increased so much faster than compensation.
• Another factor is in the ratio of rent cost to ownership cost. It is now much more expensive to pay the mortgage than to rent a comparable place, tax considerations included. Sooner or later, people are going to decide not to spend $500,000 on a house they could rent for $1,000 a month.
• Finally, there is satiation. The number of homes for sale has climbed by about 30 percent over the past year, and properties are remaining unsold for about 40 percent longer than a year ago. Global Insight and National City Corp. estimate that more than 40 percent of the top 300 metro markets are substantially overvalued and at serious risk of a price correction--especially in Florida and California. The HSBC banking group has identified 18 states and D.C. as bubble zones where values are also overstated and likely to drop. It must be remembered that the housing market has strong regional differences, with some areas much more vulnerable than others.

A significant real-estate correction would have serious consequences for our economy. Housing has become a more critical proportion of our productive effort than at any other time since 1950, when we were in the postwar housing boom. Home building has accounted for about a quarter of the jobs created since the 2001 recession. In the past five years, housing has also provided about $2.5 trillion in cash for owners refinancing through home equity loans ($751 billion last year, twice the high point reached in the late 1980s). If prices flatten or decline, this flood of new money will become a trickle.

Caution. Another danger looms from the large number of loans with an initial period of three to five years at low rates and no principal payments. Upon "reset," monthly payments on these loans will rise as much as 50 to 100 percent. In the next two years, about $2 trillion in mortgage debt will be reset in this fashion so that millions of Americans will get a financial shock that they can ill absorb. Why? Because 22 percent of borrowers in the past two years have negative equity in their homes, and 40 percent have less than 10 percent equity. A third of those who got adjustable-rate mortgages in 2005 have negative equity, and 52 percent have less than 10 percent equity, meaning that even a slight decline in prices would endanger their entire investment.

The result could be the vicious cycle of declining home prices, less consumer spending, a slower economy, and more foreclosures. This would detonate the easy assumption that everybody can make gobs of money in real estate and that real-estate prices will never fall. This is a good time for caution.

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By Mortimer B. Zuckerman, Editor-in-Chief