What Bubble?

By Daniel Kadlec

Your house seems to be acting like Cisco in early 2000. Home values surged 17% or more during the past year in cities hardly known for their flash, such as Tucson, Ariz., and Topeka, Kans. Many buyers are waving bids around without even inspecting the property. And money is flooding into McMansions and vacation homes, reminiscent of the cash that rushed into technology-stock funds that were all the rage a few years back. So the bubble police are on full alert, sensing another NASDAQ-like flameout.

But don't let it concern you. Bubbles are for tech stocks, not homes.

Real estate is an incredibly steady investment. Not once since the 1960s, when records were first kept, has the nation's median home price declined in a calendar year. There have been plenty of regional busts, as in Texas following the '70s oil boom and in New England during the late '80s. Yet overall, home prices have risen an average 6.3% annually. Part of the appeal is that even when supply and demand turn sour, home economics makes sense. Mortgage interest is deductible, and when they sell their home, a couple can walk away with $500,000 of their gain tax-free.

Some softening is inevitable. Select markets such as Baton Rouge, La., and Philadelphia dropped 1% during the 12 months that ended last March. Existing-home sales and new starts fell nationally in June. So there are some cracks. "I don't think it's inappropriate for people who are getting battered on their stocks to look around and ask, 'Where else am I vulnerable?'" says Eric Belsky, executive director of the Joint Center for Housing Studies at Harvard. But economists say that when the housing boom finally ends on a broad scale--and that could be a year or more away--most homeowners will see merely stunted appreciation, not declines. "Real estate is the place to be," proclaims Melvin Barney, an attorney from Cleveland.

The housing market's foundation is solid. On the supply side, the inventory of houses for sale is lean and buildable lots in desirable neighborhoods are scarce. On the demand side, an increase in immigration, the coming of age of baby-boomer children, and affordable-loan programs for low-income families are fueling the market for starter homes. Boomers are in their prime earning years and are eager to move up to larger digs or acquire a vacation home. And best of all, interest rates are low. "We've looked at the bubble question, and we've concluded that it is most unlikely," Federal Reserve Chairman Alan Greenspan told the House Financial Services Committee on July 17.

It's true that home values have been rising faster than family income for years, a trend that can't last. Since 1990, family income has grown 3.8% a year while home prices have risen at a 4.5% clip. The median home now sells for 2.8 times the median family income--up from 2.6 in 1990. But this ratio has historically ranged from 2.5 to 3, so the current reading puts housing squarely in the fair-value zone.

Still, anyone who has experienced a frothy market like San Francisco may find the fair-value argument difficult to accept. That's because in the past few years the hottest markets have been rebounding from declines in the early 1990s. Measuring from trough to peak will always show unsustainable growth. A better snapshot comes from measuring from peak to peak. Take San Francisco again. The median home price has surged to $482,000 as of the first quarter of this year, from $254,000 in 1995. That's an 11.3% average annual return, double the historical national average. Yet the median Bay-area price in 1989 was $261,000. A typical buyer at that time has seen home values rise just 5.3% a year.

Those who fret about a bubble point out that housing prices did not even hiccup during last year's recession, suggesting that they exist in their own inflated orbit. After all, more than a million jobs were lost, and homes still sold at a record pace. Greenspan was worried enough to study the issue, as have numerous other economists, including Kevin Hassett for his new book, Bubbleology. But like the Fed chief, Hassett concluded that the rise in home prices made sense even through the recession. "A bubble is when there is no right answer," Hassett says. "In this case, there is no mystery."

The single biggest factor for the rise in residential real estate has been mortgage rates at 35-year lows, Hassett asserts. Low rates keep housing affordable despite hefty price increases. He hastens to add, though, that "no bubble" and "no vulnerability" are not the same thing. If mortgage rates jump one-third, "all bets are off" and house prices would be likely to fall.

That concern is widely echoed in economist circles--and widely ignored on Main Street, where millions of people have soured on the stock market and gone sweet on real estate. Even last week's 489-point one-day rally won't do much to change that view. Darren Scheid, 32, and his wife Paula live in a north Dallas suburb in Texas, and last year sold their first home for $80,000, 66% more than they paid for it just three years earlier. The gain prompted the Scheid's to stop sulking over their sunken stocks and focus on building wealth through real estate. They quickly bought two nearby fixer-uppers that they will sell when repairs are complete. "I expect to make, after three years with each house, between $20,000 and $30,000 per house," Darren says with confidence. That translates into an annual return in the high teens, about what many blithely came to expect from stocks just before they tanked.

Edward Leamer, director of economic consultants at UCLA Anderson Forecast, thinks Scheid and others like him will be disappointed. Leamer is a bubble believer who expects rising interest rates to sock anyone with grand plans for double-digit housing gains in coming years. "In buying a home now, people should be acting like there will be no appreciation," Leamer cautions. "Don't be building cockamamy ideas about how this market is going to go up forever at 15% a year."

Leamer will be right, eventually. Experts have been expecting interest rates to rise for nearly a year. Instead, after drifting up last fall, rates have settled to where homeowners who missed their chance to refinance a year ago may find even better terms today. That was the case with Scott and Diane DeWenter of Temecula, Calif. They closed last week on a 15-year mortgage at 5.85%, replacing their 30-year mortgage at 8%. The DeWenters cut their payoff schedule in half and will save thousands in interest costs. But they were also able to add $40,000 to the mortgage balance and still lower their monthly payment to $1,974 from $1,998. "Awesome," says Diane, 35. She's spending that $40,000 on home improvements, and expects to get a bigger return for her buck from them than from stocks. "My parents just lost $200,000 in the stock market," she says. "I saw what happened to them. I prefer to invest in my home and pay it off."

The DeWenters have lots of company. In the 12 months that ended on June 30, Americans spent $114 billion remodeling their homes, up from $107 billion in the 12 months that ended March 31, Harvard's Joint Center reports. Some of the money came from stocks. But most was borrowed against homeowners' record $6.7 trillion of equity. Home has never been sweeter. "It's good to invest in your house, to fix it up," says Patricia Chavez, 40, who lives with her husband and three children in Moreno Valley, Calif. The Chavezes just borrowed $20,000 against the house, partly to pay off high-interest credit cards. "The price of homes going up has truly benefited us. Otherwise, we'd be drowning," she says.

Real estate has been a life preserver for the whole economy. With $8 trillion lost in the stock market in the past few years, steady gains in housing--and easy terms for borrowing against those gains--has kept the economy from falling hard. Typically, housing-related activity accounts for $1.40 of every $10 spent in the U.S. But last year housing accounted for about $2 of every $10 spent and for more than half the nation's GDP growth, says David Lereah, chief economist at the National Association of Realtors.

Housing experts measure supply in months, with a six-month inventory considered normal. The national backlog reached 9.2 months in the 1990 recession but today stands at just 4.8 months. The upshot: even if demand slackens, prices can hold if sellers simply wait a normal length of time for the right buyer to surface. Increasingly, that buyer is a new American. Greenspan can get breathless describing "the incredible rise in immigration," which he says accounts for "a third of the rise in household formation" and "has been a major factor holding the price level of homes up." Today more than 1 in 10 Americans is foreign-born, compared with 1 in 20 in 1970. This influx of citizens, mainly from Latin America and Asia, will help drive demand for an additional 1.1 million homes a year, according to Harvard's Joint Center.

Are yellow flags emerging? Sure. Last month's 3.6% downturn in housing starts and 11.7% drop in existing-home sales came just after homebuilding companies like Toll Brothers and Ryland saw their stocks sag for the first time in a year. But keep in mind that contractors and banks became more cautious about overbuilding after they were scorched in the savings-and-loan fiasco of the late '80s.

All of this helps explain why people like Stephanie Riggs, 31, of Dallas are following the money. She just switched from working in ad sales to becoming a residential-loan officer. "This is the only section of the economy that's been doing well," she says. "It's gravy days right now in my industry." Yes, it is. And if you're looking for a pin and trouble, don't bother. There's no bubble.

--With reporting by Leslie Berestein/Los Angeles, Adam Pitluk/Dallas, Marcia Pledger/Cleveland and Eric Roston/New York

With reporting by Leslie Berestein/Los Angeles, Adam Pitluk/Dallas, Marcia Pledger/Cleveland and Eric Roston/New York