(FORTUNE Magazine) – Jim and Diane Smith are homeowners on the edge. For the past several months they have been taking mental notes on every new housing statistic in the papers: existing-home sales, housing starts, inventories, and so on. They're not real estate pros--Jim is an information technology executive with Marriott International--but they have a ton of money at stake in the form of a lovely Alexandria, Va., brick colonial they purchased seven years ago for $410,000. It's now worth just north of $1 million.

On the one hand, the Smiths can hardly believe their good luck. "In 2000, when the first house on the street went for $600,000, everyone [in the neighborhood] was high-fiving," says Jim. "By the time one went for $950,000 this summer, we all went, 'Holy cow! What happened?'" But their euphoria is accompanied by a healthy dose of anxiety as they worry about how long the good times might last. The Smiths have decided to make the most of their opportunity and cash out: They've put their house on the market. Yet the wisdom of this seemingly shrewd decision weighs on them. "I'm afraid prices will come down," Jim says. "Or it could be that this market may continue." Has the real estate boom really lost steam--or would it be smarter to hang in there and reap ever greater rewards?

The Outlook

Everybody from Los Angeles to Boston--your mom, your doctor, your dry cleaner--is puzzling over which way the nation's real estate market is headed. Up or down? Bubble or not? It's a debate that's been raging for years. Those who sounded the alarm early looked like a bunch of Chicken Littles (FORTUNE has been sounding that alarm for a few years, in fact). Now signs are flashing everywhere that those chickens may be coming home to roost: October's building permits saw their biggest monthly drop in six years; pending-home-sales figures have dipped; an index of builder sentiment hit its lowest level in two years; sales of existing homes have declined; and housing inventories have risen.

It's unlikely that the housing market will come to a screeching halt. Mortgage rates, while rising, remain near their historically low levels, and the economy is strong by a number of measures. But the days of the equity-crazed suburban real estate mogul seem to be coming to an end. For homeowners, prospective homeowners, and anyone invested in real estate--indeed, anyone with a stake in what has unquestionably been a real estate--fueled domestic economy in recent years--understanding the risks and opportunities in the residential housing market is critical.

That's why FORTUNE turned to Moody's Economy.com and home property-valuation service Fiserv CSW for specific guidance. Using their proprietary figures and models, the researchers crunched numbers on the 100 largest metropolitan regions in the country, from New York City to Albuquerque to Atlanta (metro areas can include nearby towns and suburbs). The latest results of their analysis appear on pages 82--83. Nationally, the overall outlook seems reasonable: 7% appreciation for 2006 and flat for 2007. Looking closer to the ground--despite all the talk of a "national bubble," local is what really matters in real estate--a mixed picture emerges. Markets that have seen the greatest appreciation over the past five years appear to be vulnerable.

Indeed, at some point in the next two years, according to the forecast, a third of the nation's 100 largest metro areas (accounting for 60% of the U.S. population) are expected to see modestly falling house prices. That's not Armageddon, but it is a change in direction-- and a disquieting harbinger. Real estate bear markets often come in the form of steady declines over many years, rather than sudden sharp drops. As inflation gradually gnaws away at the value of nominal home prices, regular folks might not take much notice. But in the long run the loss of wealth becomes all too real. From 1989 to 1997, for instance, Los Angeles residential real estate dropped more than 40% in inflation-adjusted terms.

The nation's most perilous regional market, according to the forecast data: Las Vegas, a speculator-infested hot spot. Prices there are projected to deflate by 7.9% next year, the year after by another 5%. Granted, the Sin City metro area saw prices rise by 44% in 2004 alone, and they are on track to post 14% gains in 2005. But for newcomers to the market and those with low-money-down deals who may have overleveraged themselves with adjustable-rate mortgages, even a modest downturn could mean financial jeopardy.

The upshot: If you live in one of these overheated places, you may want to make some new calculations and assumptions about your property. On the other hand, markets at the other end of the spectrum--lower-priced areas that have seen less froth lately, such as Rochester, N.Y., Albuquerque, and Tulsa--are more likely to see expanding home values. What follows are four questions you should consider in managing what may be your biggest asset.

Is It Time to Cash Out?

The Smiths of Alexandria have put their house on the market (for about $1 million), in part because they are about to become empty-nesters. (Their daughter is in college; one son joined the military; another son is moving to Atlanta.) Jim and Diane, both 50, have long planned to buy a home about half the size of their 4,400-square-foot colonial. But the truth is, they've moved up their timetable. Says Jim: "We want to get out ahead of the other guys who will be retiring in their 50s."

Edward Leamer, an economist at UCLA, applauds this kind of thinking. "If you're choosing between selling now and selling in two or three years, do it now," he says. Leamer is not predicting a market collapse, but he does not see the upside in taking the risk.

What about the notion of cashing out, waiting for the market to fall, and then buying back in at a discounted price? It doesn't often make sense. Your transaction costs are high, and so are the odds of guessing wrong. "A lot of people had already concluded three years ago that the housing market was in a bubble and therefore didn't purchase," says David Stiff, chief economist with Fiserv CSW. "They missed out on three years of very strong appreciation." A cautionary example: That $579,660 median-priced San Francisco home you passed on in 2002 because you thought it was inflated is now selling for $766,000.

Could Renting Be Smarter?

The story of Andy and Kacey Olson is a familiar one. They moved to The Woodlands, Texas, in 1998 to be close to the biotech firm Andy worked for, and they budgeted $750 a month for rent. Before signing a lease, though, they wanted to see if they could buy for the same monthly payment. After doing the math on a small townhouse, it turned out they could--so they bought and built equity for themselves instead of someone else.

Four months ago the Olsons and their four children moved to San Diego, where Andy had accepted a new position at a small biotech called GeneOhm Sciences. They had $60,000 saved for a down payment. But when they toured one $750,000 home, they couldn't believe how small and unappealing it was. "Everyone told us to just get in and the rising market would take care of us," Andy says. "But I thought, who is going to buy this house from me for $850,000?" Once again they crunched a few numbers. This time they decided to rent--and they're saving a bundle. For $2,350 a month, they have a four- bedroom, 2,100-square-foot home. If they were to purchase that same home today for $700,000 (the going rate for a similar house in the neighborhood), the monthly payment on a 30-year, $630,000 mortgage at 6.1% would run them more than $3,800.

The rental market, in fact, can be an excellent tool for gauging the health (and risk) in a local market--particularly in cities where home prices have risen much faster than rents.

Some experts look at the ratio of home price to rental income as a valuation tool, like the P/E for stocks. The statistics highlight some potential trouble spots. In New York, for instance, house prices have climbed to 24 times rental rates, up from 12 in the mid-'90s, according to calculations by Mike Sklarz, a real estate analyst with title insurer Fidelity National Financial. In Los Angeles the ratio has grown to 20, up from ten. And in San Diego, where the Olsons live, the ratio now stands at 27, compared with 13 ten years ago.

The Olsons are already glad they didn't jump in. They've noticed that houses in their neighborhood are staying on the market longer, and they've seen asking prices in real estate circulars come down. Come spring, they say, they might try to make a few low-ball offers to see what comes of them. "We'd rather be homeowners," says Kacey. "But we'll rent for as long as it makes sense financially."

Should You Rethink Your Mortgage?

Once upon a time, almost everybody took out conventional 30-year fixed-rate loans and dreamed of the day when the house was not only bought but paid for. Today, about a third of new mortgages are nonstandard, fuzzy-math loans that have allowed many Americans to reach for more home than they can really afford.

It's been awhile since adjustable-rate mortgages, or ARMs, became popular, offering a low, fixed interest rate for a set period, after which the rate fluctuates based on interest rates at the time. Then came interest-only ARMs, allowing more adventurous borrowers to pay just interest in the beginning.The hottest new mortgage has been the option ARM, which allows the borrower to pay just part of the interest in the beginning and tack the rest onto the principal--something called negative amortization.

For some buyers, these are great techniques. Perhaps you're a sales executive who receives a chunk of your income at the end of each year. Taking out an interest-only loan keeps payments low to match your monthly cash flow; you can then use that annual bonus to pay down the principal at the end of the year.

Says Doug Duncan, chief economist with the Mortgage Bankers Association: "[This kind of loan is good] for a higher-income, higher-wealth, good financial manager." Or maybe you're a full-time mother who is planning to return to her marketing career three years from now, substantially increasing the household income. Here again, an interest-only loan allows you to lower today's payments, knowing that more resources will be available when the payments ratchet up.

But there's plenty of risk for the unprepared: When the higher bill eventually makes its big debut, the average borrower can succumb to payment shock as he faces the prospect of adding hundreds--sometimes thousands--of dollars to the monthly tab.

"You stuff somebody into the American dream, and it becomes a prison," says Torto Wheaton Research economist Craig Thomas.

Those who see that prospect ahead may consider switching to a fixed rate before the reset comes. "It will cost you some money [in fees]," says Mark Zandi, chief economist at Moody's Economy.com. "But in 2007, when the market is at its worst and your mortgage is resetting and you're looking for a lender to refinance you out, you just may not find one."

A fixed-rate mortgage is, in effect, an insurance policy against future rate hikes.

That's why Doug and Joann Purcell of Downers Grove, Ill., chose a fixed rate when they purchased a 3,600-square-foot home in the Chicago suburb earlier this year. In their previous home they had refinanced with an ARM that offered an initial rate of 4.38% for the first three years. That translated to a savings of several hundred dollars on their monthly payment. Today they think a fixed rate makes more sense. Says Doug, a financial advisor for UBS: "Five years from now, I think I'll be very happy with my decision."

How Valuable Is Your Equity?

The lesson that equity can evaporate quickly is something Brooks and Judy Butler of Coral Springs, Fla., learned the hard way.

In 1989, Brooks, a sales executive for software company DataCore and a former IBMer, bought a condo in Hartford, right around the corner from the Mark Twain and Harriet Beecher Stowe homesteads. Housing prices had soared by more than 90% in the previous four years, and a few weeks after he plunked down $98,000, a similar condo sold for $125,000, which made him feel pretty good. But then the insurance industry went into a slump, and Hartford's population declined. As the years went on, units in his building started to change hands for less and less. Brooks thought about selling when he was $4,000 down, but he couldn't afford to lose that kind of money. The next time he thought about it, he was $25,000 in the hole. When he finally cashed out in 1998, he had to bring a $40,000 check to the table. "It was awful," he says. (The condo, he heard, sold two years ago for $82,000--still short of its 1989 level.)

Which is why, as a matter of family philosophy, Brooks and Judy refuse to believe their current house in Florida is worth a single penny more than $210,000--the price they paid five years ago--even though comparable dwellings on the street are going for close to $500,000.

Their rule: Never allow outstanding loans against the house to surpass the purchase price. In fact, their mortgage and the $9,000 they took out on a home-equity line of credit are considerably less, they say. And where did they put that $9,000? Back into the house. They refurbished the deck and the driveway and purchased hurricane shutters. "That's a conservative approach," says Brooks. "If we stick to it, we'll be safe."

Americans have increased their home equity in the past five years by 60%, or more than $3.6 trillion. They have also tapped it--to the tune of $600 billion in 2004 alone. Some of this cash has been spent wisely: to put the kids through college, for instance. But plenty has gone toward vacations and new wheels. Great for the economy; bad for many personal balance sheets. "A new kitchen is fine because it adds real value to your home," says Leamer. "But to buy an SUV and go out to fancy meals with expensive wines, that's spending money you may never have."

Clearly, the message of the forecast is that appreciation may not always support such spending. Some 60% of homeowners, according to one recent survey, expect at least 5% annual price growth during the next several years. That may not sound extreme, but in dollar terms, on today's already hefty home prices, it certainly adds up.

And--surprise--it's way out of touch with historical norms: Home prices have risen slightly more than 1% annually after inflation. Chances are, appreciation in the future will look more like that, at best, than like the heady figures we've seen in recent years.

The takeaway: "Your home isn't worth as much as you think it is," says Economy.com's Zandi. "So borrow as if it were worth measurably less, because it is."

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