Stephen Schurr

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Why Bubble Talk Doesn't Hit Home

Stephen Schurr

Bubble, schmubble. But still, housing may cause trouble.

The residential real estate market, buoyed by record lows in mortgage rates, has played Atlas in this anemic economy. The 1997-2002 period witnessed a 27% increase in inflation-adjusted housing prices, the strongest five-year run going back to 1945.

Meanwhile, anecdotal evidence suggests money is moving from the stock market to the housing market, leading some observers to proclaim a "housing bubble."

Robert J. Shiller, Yale economics professor and author of Irrational Exuberance, is among those using the "B" word in connection with housing. "People say, Alan Greenspan doesn't think there's a housing bubble," says Shiller. "Well, he said there was no stock market bubble, too."

The housing market does show signs of leveling off, as evidenced by Wednesday's surprise 1.3% drop in sales of existing homes. And the refinancing boom, especially the cash-out deals that have fueled consumer spending in a tough economy, isn't expected to last.

Still, key differences between the housing and stock markets undermine the housing-bubble argument and the inevitability of a destructive collapse. Indeed, household incomes have largely kept pace with household prices, making a sharp decline in home prices highly unlikely.

Holes in the Bubble Argument

Even with historically low mortgage rates and aggressive lending practices, homeowners can't get approved to pay for homes too far beyond their income levels. Housing also has inherent value as shelter, and because of the time and money it takes to sell real estate, excessive speculation and turnover are discouraged.

Moreover, the rise in dual-income households means families can afford bigger homes. And finally, the National Association of Realtors has never reported a year of decline in nationwide housing prices since it began keeping score in 1968. (On a regional basis, however, there have been some steep declines that lasted several years.)

Where the Bubble Isn't 'Housing P/E's' -- the ratio of average home price to average household disposable income -- have remained well within historical norms

Source: Standard & Poor's.

Banerji says his leading index of housing prices indicates they will continue to rise. "The housing index was not fooled by the economic recession -- it remained on an upward trend -- and still suggests a cyclical downturn in prices is not imminent."

The realtors association, in fact, projects that existing home prices will rise 6.6% to $157,000 in 2002 and 4.2% in 2003. The association sees new home prices rising 5.5% to a median of $184,800 this year, and another 5% next year.

Another key signal that housing won't collapse is tight inventories. Unlike the 1980s, when a run-up in prices fueled a building spree and supply glut, the inventory of existing homes stood at just five months at the end of August -- ticking up from 4.6 months. That's still on the low end of the historical grid. Back in 1990, when home prices came close to declining on a national level, the inventory of homes on the market rose to nine months.

And despite the tough economy, "personal incomes have grown very strongly as well," says Chris Mayer, a real estate professor at University of Pennsylvania's Wharton School. Mayer recently studied rising housing prices in relation to household incomes and found that, with a few regional exceptions such as Silicon Valley in California, and parts of Florida, they have moved in tandem.

"In the aggregate, house prices have not gone up so fast," Mayer said. "This was not the case in the late 1980s," when housing prices outpaced personal-income gains.

Indeed, Standard & Poor's, which tracks "housing P/Es" -- the average home price compared to average household disposable income -- finds that what people are now paying for their homes is well within historical norms of about 2.5 to three times household income. That stands in marked contrast to the equity bubble, which sent P/E multiples well above normal levels.

Of course, the biggest explanation for increases in housing prices is low mortgage rates. With mortgages around 6%, people can reasonably finance more expensive homes.

"It's not ludicrous for people to pay a higher price now," says Terrance Odean, behavioral finance professor at University of California in Berkeley. Even if they thought they were overpaying, "if they pay $400,000 today and in a few years sell it at $380,000, they may be better off with the lower loan."

Where There's Trouble

But despite the many factors that likely could prevent a housing collapse, most forecasters do see the housing market easing, with rising prices tapering off and sales activity slowing.

"The housing sector will be a drag on the economy in 2003," said Lawrence Yun, economist at the National Association of Realtors. "Having done its job, it's hard to move up."

Forecasters also expect mortgage rates to rise. The National Association of Realtors expects mortgage rates to rise from 6.3% at the end of 2002 to 7.3% by year-end 2003. "Mortgage rates have probably already bottomed," says NAR's Yun.

While mortgage rates remain at the low end, even a one percentage-point rise in rates would slow the housing market and slow the refinancing boom that has boosted certain sectors and lined the pockets of many homeowners.

1. Naples, Fla.

2. Monmouth Ocean, N.J.

3. San Jose, Calif.

4. San Diego, Calif.

5. Orange County, Calif.

6. Colorado Springs, Colo.

7. Baltimore

8. Denver

9. Sarasota, Fla.

10. Miami

Cash-out refinancing, when homeowners refinance and take equity out of their home, "is just soaring," says Celia Chen, senior economist at Economy.com "People are either paying down existing debt or buying things they need."

Economy.com estimates that cash-outs from refinancing will total $138 billion this -- or 1.33% of the total GDP. That's up from $100 billion in 2001. The money is being used for a variety of things -- paying down debt, remodeling homes, buying cars. (Consumers increasing use of cash-out refinancing to keep spending like it's 1999 has raised some concerns. See the accompanying article Refi Redux here.)

This cash spigot has been a key component to consumer spending strength. "What we've seen in the past eight weeks with refinancing is unprecedented," Phil Colling, economist at Mortgage Bankers Association.

Another cause for concern are overheated regional housing markets. Some housing experts and economists say several regional markets do look and smell like a bubble. Parts of California, Colorado and Florida are cropping up on several watch lists.

While "the popping of those bubbles will not have a major national effect," Banerji says, it may serve to further erode the economic outlook in Silicon Valley, Denver and other business centers.