NEW YORK (Money Magazine) - Everyone's talking real estate these days, and it's no wonder why. With stocks down for three years, the outlook for bonds pretty poor and money markets paying next to nothing, Americans have taken to stashing money in their homes.
Home ownership rates are at record levels, as easy credit and historically low interest rates have expanded the ability of average folks to buy rather than rent. The value of our homes -- and the debt we've taken on to buy them and to fix them up -- just keeps rising. At year-end, our homes were worth $13.64 trillion, 92 percent more than a decade ago, while our mortgage debt totaled $6.05 trillion, more than double, according to Federal Reserve data.
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"What's going on is portfolio adjustment," says Karl Case, a professor of economics at Wellesley College and co-founder of Case Shiller Weiss, the country's premier housing researcher.
Which can't help but make you wonder: Has that adjustment gone too far? With all that money shifting into real estate, could what happened to our Cisco stock a few years ago happen to our homes? In other words, is this a bubble -- or might it become one? And what can we expect to happen over the next few years to the value of our largest asset?
Let's state this right off: Over the past three decades, national home prices have never declined from one year to the next in nominal terms, though their rate of growth has sometimes lagged that of inflation. So the chance that homes everywhere in the country would suffer a simultaneous precipitous decline seems close to zero.
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But real estate is an inherently local asset: What's happening to the high-end housing market in San Jose (where prices are overheated) has little relevance for home buyers in Kansas City (where they are not). Though there hasn't been a national price crash in recent years, numerous places -- among them, Boston, Houston, Los Angeles -- have suffered substantial price declines in the past, while others have seen prices stagnate for years at a stretch.
In Los Angeles, for example, prices rose 147 percent from 1980 to 1990 -- then fell 27 percent by 1996 as cuts in defense spending hit the region hard. Likewise, in Houston, prices climbed 24 percent from 1980 to 1983, then dropped 25 percent by 1987, corresponding with the years of the oil boom and bust.
Today, similarly, there may be bubbles in some parts of the country -- "bubblettes," Mark Zandi, chief economist of Economy.com, calls them, pointing to California, the Northeast corridor and South Florida -- and opportunities for snapping up undervalued homes in others.
For some big-picture understanding of what might happen to home prices in the future, let's first look at what's been propelling them upward. Across the country, average housing prices rose 6.9 percent in 2002, and a total of 38.3 percent from 1997 to 2002, according to statistics from the Office of Federal Housing Enterprise Oversight.
Those numbers are hardly the stuff of Internet stock rises during the dot-com bubble, but for actual home buyers the real returns are magnified because of leverage. That is, for a home buyer who put down 20 percent and borrowed the rest, that 7 percent price increase represents a return of 35 percent. (Of course, if you buy a home you also effectively get a dividend -- that is, the rent that you would have paid to live there.)
A home's true value
Housing historically weakens during a recession. Yet during the 2001 recession and sluggish economic recovery, real estate has remained strong. Economists cite many reasons for this, from demographics to constrained supply, but the single biggest factor was interest rates.
As the Federal Reserve kept cutting rates to stimulate the economy, mortgage rates dropped to 40-year lows. Today the average rate for a 30-year fixed-rate mortgage is below 6 percent. Consider: At 6 percent, the monthly payment on a $150,000 mortgage is $900 vs. $1,100 at 8 percent. That's made it a lot easier for home buyers to afford a higher price tag for the same monthly carrying costs.
But fundamentals like low interest rates can't explain all recent price increases. In certain markets, a degree of speculation has also entered the picture. As Case puts it, "If what you mean by bubble is, 'Is there a psychological element to the market?' Yes. If you mean that psychology explains it all, no."
Is there a way to put a psychology-free value on your home? Appraisals don't, really, because they're typically based on other houses that have sold recently in your area. That tells you what someone might pay for your house today but little about its underlying value. But some economists think that there are more accurate yardsticks.
Eric Belsky, executive director of the Joint Center for Housing Studies at Harvard University, thinks that the best way to gauge the housing market is in relation to income growth -- and that over the long term, in most areas of the country, the two seem in line.
"It is unusual to see rapid price declines unless there is substantial job loss, and that kind of job loss did not take place over the 2001 recession and it is unlikely to take place," he says.
Meanwhile, Edward Leamer, an economist and the director of UCLA Anderson Forecast, argues that we should value our homes much as we do our stocks -- by using a kind of price/earnings ratio.
With a house, the "price" is the market value, and the "earnings" part of the equation is what the home would rent for on the open market. Leamer points to the San Francisco Bay Area for an example. "The 'E' is very weak as rents are starting to decline substantially, yet home prices have been very strong," he explains. "That's a bubble not unlike the dot-com bubble."
Follow the data
To better understand what's really going on in the real estate market, we asked Case Shiller Weiss to run the numbers for us on the largest metropolitan areas for which the firm has access to data.
What's interesting is that even in areas where prices have soared in recent years, none zoomed up the way Cisco or Yahoo! did during the tech craze (when they were up some 3,500 percent and 6,000 percent, respectively).
Consider the best-performing metropolitan area during 2002: In Nassau and Suffolk counties, on New York's Long Island, the average price of a single-family home rose 22.6 percent. The hottest metropolitan area over the past five years: The Vallejo-Fairfield-Napa area of California, where home prices increased by 106.8 percent.
Similarly, on the downside, the drops have been relatively moderate. The worst decline for any four-quarter period since 1990, for example, was 11.9 percent in the Los Angeles-Long Beach area of Southern California.
Still, because of leverage, your loss could be far worse. Say you bought a house at the peak for $295,000 (today's median), put down 20 percent and then had to sell your home after an 11.9 percent drop.
Not accounting for any increase in equity from paying down the mortgage and excluding transaction costs, you'd have lost more than $35,000 -- a painful 60 percent of your down payment.
That said, as long as you can keep paying your mortgage every month, you'll probably hang on to your house -- after all, you can continue to live in it -- rather than sell it for such a substantial loss. Which is one big reason why the boom-bust cycles of real estate don't look the same as the rises and falls of the stock market.
During a real estate downturn, economists explain, transactions dry up first, as sellers refuse to lower their prices and the gap between what sellers will accept and what buyers will pay widens. Only later, as selling times drag out and sellers slowly lower their asking prices, will prices drop at all.
Those who get squeezed in a housing bust are simply those who can no longer afford to keep paying their mortgages and so lose their homes to the bank. "A slowing of sales does not necessarily mean a collapse or even a decline in prices," says Harvard's Belsky. "Prices may grow very slowly, perhaps not even as high as inflation, so you would have a slow deflation."
As the current housing boom winds down, that gives some cause for comfort. For even in those places where there is a housing bubble, there is unlikely to be a deafening pop.
Additional reporting by Linda Berlin, Donald Caplin, Joan Caplin, Tara Kalwarski, Michael J. Powe, Aparajita Saha and Kathy Shayna Shocket.