What's Next for Real Estate ANOTHER HOT YEAR FOR HOME PRICES HAS SOME WONDERING WHETHER REAL ESTATE IS POISED TO TUMBLE. HERE'S WHY THE ANSWER IS NO
(MONEY Magazine) – Worried about a housing bubble in your hometown? Well, just think how Los Angelenos must feel. Los Angeles and its environs are coming off back-to-back years of 20% to 30% increases in home prices. And Southern California real estate agents like Steve High anticipate little relief for buyers in 2004. The president of Strada Properties in Newport Beach, Calif., High tells the story of a client who had a change of heart after purchasing a $3.7 million mansion last September. High's firm put the property back on the market, and in January the house sold for $4.4 million--a $700,000 gain in just five months. "This is the biggest boom I've seen in 17 years in the business," raves High.
Of course, one man's windfall is another's red flag. These days, there's no shortage of economists and housing analysts who see the hyperactive markets in L.A., New York City and other East and West Coast cities as sure signs that the irrational exuberance that once afflicted stocks has now permeated the market for single-family homes. Throw in the possibility of higher interest rates, and the real estate market could be in trouble. "People tend to forget that house prices in L.A. fell by 40% in the early 1990s," says Stuart Gabriel, a University of Southern California finance professor and the director of USC's Lusk Center for Real Estate. "I'm not predicting a repeat of the early '90s, but at a minimum, I do think the rate of house-price increase will slow."
The good news for most homeowners is that houses and stocks are altogether different animals. In the stock market, a blowup at Enron or Lucent can create a downdraft for the entire market. In real estate, what happens in L.A. or Boston has little bearing on other parts of the country. Indeed, for all the breathless talk in the media about a housing bubble, the fact is that only eight states display bubble-like characteristics, according to Karl Case and Robert Shiller, economists at Wellesley College and Yale University, respectively. "In 42 states, rising personal income explains 100% of the run-up in home prices," says Case. In California, New York and six other states (see "Risky Markets" on the facing page), though, home buyers do seem to be justifying high prices with the rationale that home values can only go up. It's probably no coincidence that many of the news organizations beating the housing-bubble drum loudest are based in those very locales--particularly New York.
Nationally, home prices haven't experienced an annual decline in the 30 years the government has been tracking them, and there's no reason to think 2004 will be any different. To be sure, rising rates may make it hard for the real estate market to duplicate the 10% average gains that occurred nationally in 2002 and 2003. Nevertheless, with the economy improving and a surging stock market putting more money into the hands of consumers, 5% to 7% gains nationally are plenty realistic. "For the bulk of the United States, it's steady as she goes," says Case.
What does this mean for your house--or for the neighborhood where you're hoping to buy? Well, as with most things in real estate, it all depends on location, and the charts on these pages provide region-by-region forecasts for this year. If you live in Kentucky, Wisconsin or one of the many other states where home-price gains have been more modest, the odds strongly favor more of the same. There's a much tighter relationship between home prices and income in middle America than on the coasts. In California and Rhode Island, the correlation between home prices and income is 10 times weaker. The main reason: There's more buildable land away from the coasts, so the balance between supply and demand rarely gets out of whack (the way it has lately in hot markets like Orange County, Calif. and Westchester County, N.Y.).
One region of middle America where prices could appreciate faster this year is the South. The improving fortunes of companies in the energy and airline industries--many of which are based in Texas--are expected to fuel job growth and lead to healthier increases in home prices, according to Case and Shiller's consulting firm, Case Shiller Weiss. The weakest markets could be in Colorado, Utah and other mountain states, where CSW is predicting 3% price gains. Steve Murray, a Denver real estate consultant and editor of the newsletter Real Trends, says prices in Denver have been flat for a year--a byproduct of job losses in the city's technology industry.
Making predictions about the eight so-called "bubble" states is trickier. In the near term, the best bet is that prices will continue to rise, since there remains such a dramatic mismatch between supply and demand. CSW is forecasting 9% gains this year for the West Coast, 5% for New England, and 6% for New Jersey, New York and Pennsylvania. Phyllis Radding, a Coldwell Banker agent in the Westchester County, N.Y. town of Larchmont, says that for every home that goes on the market, there are 40 potential buyers. "The lack of inventory continues to be the big story," she says.
This dearth of inventory is easily explainable. In metropolitan Boston, New York City and L.A., there's not nearly enough property to meet the demand from people who want a suburban home within easy commuting distance of a downtown workplace. Compounding this problem has been the cautiousness of big home builders intent on avoiding the overbuilding of the late 1980s and early 1990s. Tim Eller, the incoming CEO of builder Centex, says his company has only a month's worth of inventory right now. "This is a much more disciplined industry today," Eller says. Any cooling off in states like California and Massachusetts is unlikely to be a reenactment of the severe downturns of the late 1980s and early 1990s.
The risks to real estate
Still, some break in the market is inevitable. Sooner or later there will come a tipping point when many house hunters decide that they're better off taking advantage of the soft rental market--at 9.9%, rental vacancy rates are the highest in 40 years, according to the Census Bureau--or moving to parts of the country where housing is cheaper. Something else to consider is the impact of a rising stock market. Yes, consumers are wealthier. Yet it's worth remembering that the run-up in home prices was precipitated in part by many investors' decisions to shift money out of stocks and into real estate. Now that stocks look safe again--the S&P 500 is up 40% since October 2002--USC's Gabriel expects "changes in portfolio allocation" to translate into softer demand for homes.
That said, any cooling off probably won't mean actual declines in home prices, but rather an extended leveling-off period--one in which home prices stay flat until there are more jobs created and more people getting pay raises. An outright decline is unlikely because the vast majority of homeowners would rather let their homes go unsold for months than lower their asking price.
What about interest rates? If you're a buyer whose monthly mortgage payment limit is $1,900, a rise in the 30-year mortgage rate from 5.5% to 7.5% reduces the size of the mortgage you can afford from $330,000 to $270,000. While lost buying power would impact the housing market, higher rates cut both ways. If you're a would-be seller and 30-year mortgage rates were to rise to 7.5%, you might pull your home off the market rather than give up your comparatively cheap 5.5% mortgage. That, of course, would further constrain supply, partially offsetting house hunters' lost buying power. In fact, Case contends that the sharp price declines experienced by cities such as Boston and L.A. 15 years ago had little to do with the mortgage rate spike that occurred in the late 1980s--or even with the huge price run-up in the years preceding. He attributes those declines to steep regional job losses that coincided with the downturn in home prices. That's why Case isn't worried about a price collapse this time around.
Too great expectations
While a market correction wouldn't necessarily result in lower home prices, it would force many Americans to rethink their retirement planning. The recent housing boom may be leading some Americans to save less, knowing their home's value is appreciating faster than their mutual funds. Indeed, Case and Shiller have found that people expect their homes to appreciate 12% to 15% a year over the next 10 years. That's simply not realistic. "The fact is that in many markets in the country, housing is not a particularly strong investment vehicle," says Gabriel. Over the long term, he adds, "house prices increase at close to the rate of inflation--not much more, not much less."