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How to protect yourself from a housing bubble

A reader -- we'll call him Ralph Marino because he didn't give permission to use his real name -- wants to buy a house on Long Island, where real estate prices have rocketed into orbit in the past couple of years. He needs $20,000 just to make a 5 percent down payment. He can scrape up only $10,000 -- and that's if he borrows against his 401(k) retirement account.


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"It would take me at least another year or two to save another 10-15K," he e-mails, "and frankly, I want to purchase a house before the costs are out of my reach."

The way Long Island real estate prices are going, Marino has reason to worry. The Office of Federal Housing Enterprise Oversight reports that home prices on Long Island jumped an average of 4.08 percent from July through September and by 14.69 percent in the 12 months that ended Sept. 30. If you're in Marino's shoes, you look at today's $400,000 house and worry that it will cost $460,000 a year from now. That's what would happen if home appreciation on Long Island remains at about 15 percent.

Compare his anxiety about rising home prices to the frenzy that drove the speculative bubble in Internet stocks in the late 1990s. People rushed to buy stocks in questionable companies, certain that prices would inexorably rise. Then stocks crashed.

Is a similar speculative bubble inflating under real estate? A few economists warn that home prices could collapse, just as tech stocks did. But most experts say you can't really compare houses to stocks. After all, you don't reminisce wistfully about the cozy share of stock you grew up in.

"What is really different about housing is that, if the market weakens, people don't start selling homes like they do stocks when the market weakens," says Jeff Fisher, professor of real estate and director of Indiana University's Center for Real Estate Studies. "They decide not to sell their homes unless they have to. They take their homes off the market so that you don't have panic selling, resulting in further price drops."

If the bubble pops
Panic selling is exactly what economist Dean Baker, co-director of the Center for Economic and Policy Research, worries about. Baker says confidently that we are in a nationwide housing bubble, and that when it pops, average home prices could drop between 11 percent and 22 percent nationwide. Prices in some regions could fall by 40 percent, he says, as homeowners rush to sell before prices drop even more.

Most economists say a nationwide housing bubble is virtually impossible, but that local and regional bubbles can happen. What if you live in one of those regions where there's a housing bubble? How do you know? You probably can't know for sure until prices tumble. Given this uncertainty, here are two pieces of advice:

  • Don't buy your home primarily as an investment.

    Your home first of all is a place to live, so pick a dwelling that suits your needs. Are you going to live there for just two or three years? Then maybe it's better to rent than to buy. Are two bedrooms sufficient? Then don't let a real estate agent bully you into buying a three-bedroom house "because they make a better investment."

    "Whenever you decide to own rather than rent a home, you are making a housing investment," Fisher says. "Perhaps the most important thing is to not buy a house that is much more expensive than you would be willing to rent to satisfy your needs."

  • Be careful about how deeply you go into debt.

    Housing economists worry about what will happen to people who have little equity in their houses if values plunge. Many people are buying homes with down payments of just 5 percent or even 3 percent. Other homeowners take out home equity loans and home equity lines of credit and end up owing almost the entire purchase price of their homes. If values drop, these deeply indebted homeowners could end up owing more than their houses are worth.

"If the value of their home drops unexpectedly with a collapsing housing bubble," Baker says, "then many families will suddenly find themselves with considerably less wealth." That might not matter to a family that expects to stay in the home for several years but could play havoc with people approaching retirement, he says.

In a paper titled "The Run-up in Home Prices: Is It Real or Is It Another Bubble?," Baker cites two main pieces of evidence to justify his belief that there is a national real estate bubble. First, housing prices generally have kept pace with overall inflation in the postwar years. Since 1995, though, "home sale prices have risen far more rapidly than the overall rate of inflation." In those seven years, he says, home prices have increased by 47 percent, while overall inflation has been 17 percent.

Baker's other piece of evidence is rents have increased much more slowly than sales prices in the past seven years. "As tenants are able to get better deals on rent, they will be less anxious to rush out to buy homes," Baker argues -- and that could retard or reverse home appreciation.

Baker says there is no rational explanation for the run-up in prices. Not even demographics explain it, he says, arguing that baby boomers exert less demand for housing as their kids move out. People in the housing industry vehemently disagree, and point out that we're in the midst of an immigration wave. Aging boomers are buying many vacation homes, and their offspring are forming families and buying houses. All of these demographic shifts result in greater demand for homes and higher prices.

Bubble or nothing?
Len Zumpano, professor of real estate at the University of Alabama, dismisses the notion that there's a nationwide housing bubble: "If the prices have quadrupled in the past four months, you're in a housing bubble," he quips.

On the other hand, Zumpano says the trend of rapidly rising house prices "has been encouraged because of the bear market over the past three years. People get burned in the stock market and try to invest in tangible assets that can't decline in value."

Zumpano laughs derisively at the notion that real estate can't decline in value. It has happened before in large regions. Home prices collapsed in Houston, Dallas and West Texas in the mid-1980s during an oil bust and the savings-and-loan crisis.

California, a boom-and-bust state since at least the Gold Rush, has had periods of rapid rises and declines in housing prices. According to OFHEO, prices continue to rise in much of Northern and Southern California but have actually dropped slightly in the San Jose area in the last year.

While Zumpano doesn't believe home prices will crash -- at least not nationwide -- he does think the pace of price increases will slow. He's just not sure when that will happen. He doesn't rule out price declines in some local markets, "but I don't think you'll see a correction like you saw in the stock market."

Most experts agree. Doug Duncan, chief economist for the Mortgage Bankers Association, predicts that home prices will increase about 6 percent nationwide this year and by 3 percent in 2003. "In the broad market, we do not believe there is a price bubble," Duncan says, but he adds that falling prices in a few markets show evidence "of a bit of a bubble" in those regions.

Duncan says he expects more foreclosures in 2003 as the rate of price increases slows down. If prices decline in some areas, foreclosures will probably take a big jump, especially among homeowners who owe more than their houses are worth.


-- Posted: Dec. 23, 2002




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