Housing: Bubble or Not?

by Steve Amyouny

It was Thanksgiving weekend in November 1999, and I can still eerily recall the conversation. My wife and I were attending a dinner party when the discussion turned to the stock market. I sat quietly and listened as the others (none of whom was remotely involved in the financial services industry) fired off the names of technology companies¾including many I had never heard of¾and talked with great enthusiasm about the huge profits they had accumulated in the last year. I heard theories about “doubling down” whenever tech stocks dipped, the astronomical growth projections of Internet companies, and how “it really is different this time.” Finally, one of them asked me for my thoughts. Not wishing to defuse their enthusiasm, I simply stated my opinion that fundamentals did not support the current prices of technology and mega-capitalization stocks and that investors, especially tech investors, might be very disappointed over the next few years.

Just two weeks ago, I had dinner with one of the men from that party. After sheepishly admitting that he had lost a fortune during the stock market decline of 2000-2002, he quickly diverted the conversation to his latest real estate investments and his associated paper gains. Suffice to say, I thought: Here we go again!

Are we in the midst of a housing “bubble” as many believe? The term bubble implies that the condition is unsustainable and eventually will burst or deflate rapidly. However, unlike stock prices, real estate prices seldom collapse, but rather decline gradually or remain flat until prices can adjust to the supply/demand imbalance. This phenomenon can be attributed to two factors: 1) homeowners need to live somewhere and can simply remain in their home until conditions improve, and 2) it may take several price reductions and months (or years) for prices to ultimately adjust to market conditions. To understand the present environment, one must look closely at historical trends and the factors driving the current market.

Investing in Residential Real Estate: First, although many homeowners believe that real estate has been the greatest performing asset class in their lifetimes, residential real estate values in the United States have historically grown at a rate approximately 2 percent above inflation since the end of the Great Depression (versus the stock market, which has grown at about 6 percent above inflation). In fact, despite the recent surge in home prices, the median U.S. house price merely doubled from $92,000 in 1990 to $184,100 in 2004¾an annual return of 5.1 percent before inflation. In addition to the modest after-inflation return, residential real estate also requires substantial expenditures to maintain the property (e.g., property taxes, painting, renovations) and to make it comfortable to live in (e.g., furniture, landscaping, decorations). Thus, after accounting for these necessary costs, by some estimates the true long-term return is close to zero. However, a home is not just an investment, but a place to live, and thus it is impossible to quantify the comfort or pleasure from owning one’s home

The Recent Housing Boom: Notwithstanding the longer term trends, over the last five years the escalation in real estate prices has undoubtedly created enormous wealth for homeowners and investors. In fact, since 2000, the U.S. median house price has increased by more than 50 percent, while prices in some regions have more than doubled. This surge in prices can be attributed to several factors. Since peaking in 1981, mortgage rates have declined dramatically from 17 percent to 5.75 percent currently. To put this in context, a homeowner with a 30-year fixed rate mortgage in 1981 would have paid $1,426 per month on a $100,000 loan versus just $568 today. This steady decline in mortgage rates allowed many homeowners to significantly upgrade their homes without increasing their mortgage payments, and made homes more affordable for first time homeowners. Also, a steady stream of immigration and a strong demand from “baby boomers” purchasing second homes for retirement tightened the supply of homes. Lastly, the poor performance of stocks from 2000 to 2002, accompanied by the low current yields of alternative fixed income vehicles, has led many individuals to seek the higher potential returns that have been achieved in real estate in recent years. These factors have collectively fueled the surge in home prices.

Current Conditions and Speculation: Although real estate advocates continue to point to the tight supply of homes and ongoing favorable demographic trends, there are reasons to be concerned. First, there has been a noticeable increase in individuals purchasing homes for investment or speculative purposes. According to the National Association of Realtors, nearly one-quarter of all home purchases last year were made for investment purposes. Indeed, some surveys indicate that these buyers expect to flip these properties in less than five years at a sizeable profit. Second, the ratio of house prices to median family income has reached an all-time high of approximately 3.4. In red-hot markets, such as San Francisco, New York City, and San Diego, the ratio ranges from 8 to 9. Third, homebuyers have increasingly turned to adjustable rate and interest-only mortgages in order to finance, or in many cases, afford their purchases. This year, adjustable rate mortgages have accounted for close to 40 percent of all new mortgages versus just 10 percent in 2001¾a dangerous trend should interest rates rise sharply. Lastly, although one could argue that some markets remain reasonably valued, even real estate experts would agree that home prices in certain coastal cities and desirable regions may have gotten ahead of market fundamentals.

Future Implications: The good news is that homeownership rates reached an all-time high at the end of 2004 (68 percent of American households now own their home versus just 44 percent in 1940) and countless jobs have been created by the strength in the housing market. The bad news is that housing and related expenditures now account for approximately 20 percent of gross domestic product (GDP), and a sharp rise in interest rates could significantly increase the future monthly payments of all adjustable-rate mortgage holders, thus adversely affecting non-housing related disposable income for many Americans. Since consumer spending still accounts for nearly two-thirds of GDP, the potential reduction in disposable income could erode GDP growth. Furthermore, homeowners have increasingly used the equity in their homes as a source of financing for general expenditures (e.g., new cars, boats, credit card reductions). Economists believe that the wave of home equity borrowing and “cash-out” refinancings over the last five years significantly contributed to the short duration of the 2001-2002 economic downcycle. If interest rates rise or home prices decline, this refinancing trend will likely slow and the associated contribution to GDP may evaporate.

Finally, the surge in house prices has led to two other problems: 1) even with low rates, many first-time homebuyers cannot afford to purchase a home at current prices without the use of adjustable rate mortgages or substantial borrowing, and 2) rapidly escalating property taxes have become a financial burden for elderly homeowners who have limited present income.

Although the debate regarding the existence of a housing bubble will rage on, it is safe to say that the risks within the real estate market have increased significantly. If interest rates rise sharply, the housing market may experience a downcycle, consumer spending may come under pressure, bankruptcies may proliferate, financial institutions may tighten their credit standards, and economic growth within the United States could stagnate. Ignoring the red-hot markets, however, the most likely scenario is a period of relatively flat to modestly declining real estate prices.