Real Estate: The state of the bubble
Will it go pop? Or will there be a slow leak?
By Cybele Weisser, MONEY Magazine staff writer


NEW YORK (MONEY Magazine) - Rory Moore, semiretired and a self-described "dabbler" in real estate, bought his neighbor's house in Los Banos, Calif. last May for $499,000. Make a few fixes, he figured, and flip it a couple of months later for a six-figure profit.

But then the property, listed at $699,000 in July, failed to attract even one buyer in the first 30 days.

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"I could feel it in my gut that the market was changing," says Moore, 54. "The market had been crazy here, with 25 percent appreciation in a year. I could see the handwriting on the wall." By December, Moore had dropped his asking price twice, to $565,000, and he was dangling incentives like covering a year's worth of gas or utilities and 12 months of lawn service.

He's given up the notion of making a profit on any deal. In fact, he's eager to be rid of the place: "I don't want to get stuck with a property that's a financial drain on the family. We'll do what we have to do to get it sold."

Uh-oh. Signs are a-popping that the era of explosive price gains -- 20 percent to 30 percent annually in some markets -- is kaput for at least the next few years. In the past four months, the median asking price has fallen 5 percent or more in Boston, Cleveland, Los Angeles, Miami, Phoenix and Washington, D.C., reports blogger Ben Engebreth's Housing Tracker website, which compiles weekly data on 49 cities.

Across the U.S., the number of existing homes sold fell 2.7 percent in October, according to the latest figures from the National Association of Realtors, while the supply of homes available for sale hit a three-year high. Real estate agents in formerly redhot markets like San Diego and Boston say that open houses are getting little traffic.

"Toward the end of the summer I noticed a shift," says ReMax realtor Mary Kaljian, whose Los Banos office is 75 miles southeast of San Jose. "At the height of the frenzy, properties sold after one to three days on the market, with multiple offers. Now we are looking at six to eight weeksó or longer. It's becoming a buyer's market."

What the heck is happening?

Two words: Alan Greenspan. Or, more precisely, 20 words: Thirteen Federal Reserve Board rate hikes in 18 months have pushed adjustable-rate mortgages, or ARMs, into price-correction turf.

"The Fed took away the ARM punch bowl, creating more buyer resistance to higher home prices," says Stuart Gabriel of the University of Southern California's Lusk Center for Real Estate. Add in bubble fears among many would-be buyers -- after all, how long can prices continue to defy gravity? -- and you get a drop in demand that "seems to be real this time," says Wellesley

College economist Karl Case. "Housing on the coasts has gotten too expensive, mortgage rates are headed up, and people have gotten spooked by the bubble talk," Case says. "There just aren't a lot of good arguments that real estate will continue to boom."

The good news is, there aren't a lot of sound reasons to think real estate is ready to bust either. Home prices are what economists call "sticky" -- unlike stocks, homes can't be unloaded with the click of a mouse. And huge demographic forces continue to favor real estate: Baby boomers and first-generation Americans are still buying, and demand exceeds supply in many places.

In addition, local job markets remain healthy in most major metro areas, notes David Seiders, chief economist with the National Association ofHome Builders. "Local home price booms are generally followed by a pretty orderly simmer-down unless there's some serious economic downturn," he explains, "and I don't think we are anywhere near the next recession."

It's not clear yet to most experts what effect, if any, the tremendous popularity of nontraditional loans such as interestonly mortgages will have as real estate shifts from boil to simmer. Adjustablerate, interest-only loans are held by more than half the new homeowners in hot urban and suburban areas.

Here's the big fear: If enough of those homeowners are forced to sell quickly when faced with interest-rate adjustments that raise their monthly mortgage payments, the rush to sell could intensify any bust in their local market. In addition, condo-crazed towns like Phoenix and Fort Lauderdale -- where more than 15 percent of recently purchased homes are owned by investors -- could be more vulnerable to steep declines than areas heavy with owner-occupied homes, since investors may be more likely to sell at the first whiff of trouble. "We don't have a lot of historical guidance on the potential downsides for some hot markets," says Seiders.

Thinking of selling?

Go ahead, sell. If you want to move on in the next year or two, consider selling sooner rather than later. Obviously, don't cut and run in a panic.

But if you're fairly sure you won't want to be in the home -- you're on the cusp of retiring, say, or the kids are leaving the nest --it can't hurt to pocket your gains. "Prices aren't likely to go up from here," says Wellesley College economist Karl Case.

Same goes for investment property you don't think you can afford to hold on to during a sustained period of slow to no growth.

Price it right. Just because the neighbor sold his house for $450,000 six months ago doesn't mean yours can fetch $500,000 today. "In a seller's market, you can push the envelope on pricing," says agent Robert Byrne of Needham, Mass. "But if there's a lot of competition, you need to look like a good value."

Crowd psychology can be crucial, so consider pricing a notch under what comparable homes in your area have sold for lately. "Properties that are undervalued get pushed up to value or above because there will be more than one person interested," Byrne says. "Once buyers get drawn into a negotiation, they get focused on winning the house and often lose track of the price they pay."

Thinking of Buying?

Go ahead, buy. Whether the housing market is up, down or sideways shouldn't be the deciding factor for purchasing. "Think of a home as another consumer durable, like a refrigerator," suggests Case. "When you need to buy a new fridge, you think about the service it'll give you, not whether the price is going to go up or down while you own it."

If something in your life is pushing you to buy now -- baby on the way, job transfer -- do so with peace of mind. In a flat market, you're still getting value out of your home simply by living there. Even if prices plummet, all's well as long as you can keep making your mortgage in tough times. "The people who get hurt in a falling market are the ones who need to sell as it's falling," says ReMax chairman Dave Liniger.

Again: Price it right. You no longer need assume a seller's asking price is the final price. But don't expect a slew of fire-sale bargains right away. As long as the local economy is in good shape, sellers are typically in no hurry and can hold on for months before dropping their prices.

"Unless you know from recent comparable sales in the area that something is really mispriced, offering 20 percent less than asking will often just piss off the seller," says New York City real estate consultant Kathy Braddock.

Adds Roy Grimm, a Sedona, Ariz. broker who only represents buyers: "If something is priced well, I'm delighted to settle at 3 percent to 4 percent off the asking price."

Thinking of Staying Put?

Cash out with caution. When interest rates were low and home prices soaring, you could cash out a big chunk of equity and get much of it back (on paper, at least) within a few months. Kiss that good-bye. If you're going to borrow against the value of your home in the near future, make sure it's for things that create long-term value, like a child's education, not a TV.

Don't bet your retirement on the ranch. Pouring your savings into real estate instead of stocks may have seemed smart when home prices were soaring in the double digits. But historically, real estate has appreciated at a lower rate than stocks -- 5 percent to 6 percent a year, only a percentage point or two above the rate of inflation.

All the equity you've accrued over the past few years won't suddenly disappear, but you should temper your expectations for how much more you'll see in the future.

Don't over-renovate. In a soft market, a top-shelf renovation isn't going to pay for itself. There's nothing wrong with buying a high-tech European dishwasher if you like and can afford it, but do so for yourself, not because you think it'll add $5,000 to the value of your home.

Make sensible improvements to your home -- and then sit back and relax. "Enjoying your house and community," says Gabriel of USC, "is the most important, legitimate reason to be a homeowner."

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.