Unmaking the myths
Real estate survival guide: The sudden shift in the nation's housing markets is exploding some long-held beliefs. Here's the conventional wisdom you should ignore.
NEW YORK (FORTUNE) - The sudden shift in the nation's housing markets is exploding some long-held beliefs. The first is that a scarcity of buildable land on the coasts keeps a cap on supply and prevents prices from falling.
But high prices inevitably work their magic, encouraging more people to sell existing homes and sparking new construction. Sure enough, prices are already tumbling in Boston, where a swarm of downtown condos is swelling the number of properties for sale and punishing the price of all housing.
A second myth is that today's big homebuilders learned their lesson in past downturns and now launch projects only when they have firm buyers lined up. But housing starts are still running at near-record levels of some two million units a year.
A third tenet holds that home values never drop in areas where employment is rising. But today some of the hardest-hit regions rank among the strongest job machines, notably Northern Virginia and San Diego. The reason: Young buyers filling those jobs can't afford the houses for sale. (See a gallery of markets that are due for a fall, and ones that will hold up.)
The current boom has spawned one new myth of its own: Hot markets will glide to a soft landing. The National Association of Realtors and the National Association of Home Builders argue that housing is simply returning to "balance" and that prices across the country will resume "normal" increases of 4 percent to 6 percent this year and next.
"It's a good sign to see home sales holding close to the level of a strong rebound in the month before," said David Lereah, the NAR's chief economist, in a statement accompanying the latest data. "This is additional evidence that we're experiencing a soft landing."
But the housing bulls are relying on wishful thinking. The total inventory of homes for sale, new and existing, stands at a staggering 3.8 million units, 70 percent higher than in 1999. The modest price increases they are predicting would make today's houses more unaffordable, adding to the already huge supply of unsold units and forcing an even more severe adjustment in the future.
Birth of the bubble
To understand why prices became so unhinged, it's worth revisiting the extraordinary policies that inflated the bubble.
In the aftermath of the stock market crash of 2000, Federal Reserve Board chairman Alan Greenspan feared that the huge, sudden loss of wealth could throw America into a severe recession. To spark the economy, he cut the Fed funds rate from 6.5 percent in late 2000 to 1 percent by mid-2003.
The impact on mortgages was profound. The rate on 30-year fixed-rate loans, the most popular type, plummeted to a 50-year low of 5.1 percent. The monthly payment on a $250,000 mortgage dropped to $1,350.
Cheap money turned the real estate boom into a frenzy. In the coastal cities, homes were already expensive by 2001, having appreciated by 65 percent or so since the early 1990s. Between 2000 and 2005, prices in most hot markets - Miami, San Diego and the like - soared by 55 percent to 100 percent (on top of inflation).
Trying to keep pace, buyers increasingly resorted to riskier loans to lower monthly payments. Two types became the rage: adjustable-rate mortgages and exotics. Homeowners who took out ARMs in 2003 or 2004 started with extremely low rates - at one point lenders were offering one-year adjustables with initial rates of as little as 3.5 percent. But many borrowers will face much higher monthly payments as the loans adjust.
A second, even more dangerous category is the exotic loan. The most extreme example - a true symbol of the bubble - is the negative-amortization loan, which allows borrowers to pay less than the interest due. The unpaid interest is tacked onto the principal, so the size of the loan grows every month.
In 2004 and 2005, no less than 75 percent of all mortgages issued in the hot markets were either ARMs or exotic loans, compared with 20 percent in the late 1990s. By mid-2004, with inflation looming and demand for capital growing, the Fed started raising rates. But Greenspan's gambit had started a speculative rampage that took on a life of its own.
Homes had become America's investment vehicle of choice. Prices became totally detached from the fundamentals - chiefly rents and incomes - which were growing only modestly. It couldn't last.
Next: Who will be hurt most?
Additional reporting by Matthew Boyle, Nadira A. Hira, Julie Schlosser, Christopher Tkaczyk and Jia Lynn Yang.