Real Estate Review: Subdivisions

Housing remains strong and could get a boost if the Fed pauses. But the 'bubble' has leaks.
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At the height of the current real estate boom, housing of all types appreciated at a record pace. But the boom has shown subtle signs of cooling in recent months, and the market is now looking a lot more fragmented.

Rising inventories, falling mortgage applications, declining affordability levels and a letup in the previously torrid condo market suggest the period of all-encompassing housing appreciation is probably over. Clearly, it's overly dramatic to say the presumptive housing bubble has burst, as demand remains strong for affordable starter homes. Meanwhile,

Federal Reserve

tightening may be less aggressive due to Hurricane Katrina, which should help the housing sector.

But real estate investors will have to be more discriminating going forward. Here is a guide to some emerging developments in the sector.

Something Old, Something New

Recent housing data show an interesting twist. For the first time, the median price of new homes is below that of existing homes. In short, new homes are getting cheaper and more are being sold, while existing homes are getting more expensive and less are being sold vs. the recent past.

The Commerce Department reported sales of newly constructed homes rose 6.5% in July and 27.7% from a year earlier. But the median sales price dropped to $203,800, the lowest level since December 2003, from $219,500 in June.

One week earlier, the National Association of Realtors (NAR) said the median price for existing-home sales was $208,500 in the second quarter, up 13.6% from the previous year. Meanwhile, the amount of existing homes sold fell 2.6% from June.

This conflicting data reflect a "big shift in the kind of homes being built," says Sam Lieber, portfolio manager with Alpine Funds, portfolio manager for the $900 million

(EUEYX)

Alpine U.S. Real Estate fund, which is about 50% in homebuilder stocks, including

KB Homes

(KBH) - Get Report

,

Toll Brothers

(TOL) - Get Report

and

Lennar

(LEN) - Get Report

. Homebuilders are now focusing more on affordable homes for first-time homebuyers rather than high-end properties, he says.

Source: Economy.com

Wachovia economist Jason Schenker echoed this sentiment in a recent research report: "Some downward pressure on

new-home prices was likely engendered by a consumer preference for more affordable housing, which has become more plentiful for developers on a national scale."

But by no means are starter homes cheap. The average starter home is up 14% year on year, but average income for a first-time homebuyer is up just 4% -- an unprecedented gap, according to David Rosenberg, an economist with Merrill Lynch. The last time the gap was anywhere near this high was 1989, when a prior U.S. housing bubble burst.

What happened in 1989 was that bids eventually dried up, inventories rose, and median home prices declined 5.8%, Rosenberg writes. The same story is starting to unfold today in the U.K. and Australia, where national housing booms have fizzled, he explains.

Notably, U.S. inventories have risen of late. In reaction, selling a home is becoming more difficult in certain areas, and condos are becoming riskier investments in markets like Miami.

Test Case: Florida

Nuances in the housing market are best seen in Florida, one of the country's most heated markets. The nation's second-best sales market in July was the Cape Coral-Fort Myers area, where prices rose 45% year-over-year.

Fort Myers and the rest of the west coast of southern Florida still offer plenty of land for developers -- compared with the greater Miami area -- and homebuilders such as

Pulte Homes

(PHM) - Get Report

continue to break ground on new projects.

While economists like Rosenberg worry about the housing sector eventually slowing down because of demand drying up, the Fort Myers market remains incredibly hot.

"Ultimately the Florida market, like any market, is supply-demand driven," says real estate analyst David Dabby of the Coral Gables, Fla.-based Dabby Group. "Florida is fortunate because the demand is primarily due to immigration. It's a growth state. That demand has been fairly consistent for 50 years."

Source: Economy.com

The bulk of buyers in the Fort Myers market are second-home buyers -- think Northeastern baby boomers who want to spend time by the pool in January -- and those looking for a primary residence. Investors and speculators make up less of the market.

The situation is a lot different in Miami, where in some new condo developments, about 70% of the buyers are investors or speculators, better known as condo "flippers."

Condo Cucaracha

In the past few years, condos have been appreciating at a higher rate than single-family homes, on a national basis, according to the National Association of Realtors. In turn, condos became today's equivalent of tech stocks in the late 1990s, and condo flippers -- most notably in areas such as Miami, San Diego and Las Vegas -- the housing market's equivalent of daytraders.

In some Las Vegas buildings, speculators are buying up to four condos in the same building and financing the purchases with risky interest-only mortgages, betting the prices will rise faster than interest rates, says Dr. Delores Conway, director of the Casden Forecast for the USC Lusk Center of Real Estate. If rates rise fairly rapidly, "speculators will probably sell and that will create a flood of supply of condos ... so that eventually it's like all the elephants are racing to the exit at once," she says.

Condos are a good leading indicator of the overall housing market, says John Silvia, an economist with Wachovia. 'Condo prices are going down, inventories are rising," he notes. "For me, it signals not so much a bust

but you're starting to see the turn in the housing market."

On a seasonally adjusted annual rate, the number of condos sold nationally fell 5% from June to July, and inventory jumped 29.3% in one month, according to the NAR. In July, there was 5.3 months of condo supply nationally, 51.4% more than a year ago, NAR reports.

Oh Greenspan, Wherefore Art Thou?

The Fed has raised short-term rates 250 basis points since July 2004, but 10-year Treasury yields remains stubbornly low, near 4%. Following the 10-year's lead, the average rate on 30-year fixed-rate mortgages was 5.71% last week, down from 5.77% a week before, according to

Freddie Mac

.

Although rates remain low, the Mortgage Bankers Association's mortgage applications survey declined 4.5% for the week ending Aug. 26; the new purchases index fell 3.6% while the refinancing activity index slid 5.4%.

Thanks in part to the Fed's rate hikes, adjustable-rate mortgages decreased to 27.8% of total applications, down from the all-time high of 34.5% in June.

Almost everyone expects long-term rates to rise going forward, which would have a dampening effect on housing activity. But those expectations have been repeatedly stymied in the past 18 months, prompting Fed Chairman Alan Greenspan's famous "conundrum" comment.

In its July survey, the Bond Market Association said Wall Street analysts and economists expected a 4.4% median yield on the 10-year Treasury by year-end.

But the market has dramatically changed its expectations due to Hurricane Katrina. Fed funds futures show investors now expect the Fed to raise short-term rates just once more this year, by another 25 basis points. Prior to Katrina, the futures market was pricing in near certainty of three more rate hikes by year-end.

Many observers now predict the 10-year will settle somewhere in the 3.80% to 4.50% range over the next few months. Some of those same experts had previously predicted the 10-year would go over 5% in that timeframe, which now seems much less likely.

Housing should be a major beneficiary if the Fed does pause its rate-tightening campaign; more especially as reconstruction in the Gulf states begins, if energy prices relent and if consumer confidence doesn't suffer lasting damage in Katrina's aftermath.

But that's a lot of ifs for a sector that while still quite strong, is now showing signs of fallibility.