On the Bubble

“I AM ASKED ABOUT THE HOUSING bubble at least once a day,” Eric Belsky, executive director of Harvard University's Joint Center for Housing Studies, told a conference audience in November. He's not alone: The bubble debate, which popped up in 2002, rages on. Each quarter, it seems, new data and reports both prove and disprove the theory that the housing industry's incredible ride could screech to a halt at any time.

Two groups of economists have emerged on the issue, with one camp pointing to dramatic house price increases outpacing wage increases as evidence of a bubble bound to burst. Others have refuted the bubble theory, arguing that changes in mortgage finance, constrained land supplies, and demand driven by demographic trends will continue to support the housing market's strong performance.

The two factions haven't found much to agree on—until recently. Data have begun to validate suspicions that in some regional markets speculators have pushed demand—and prices—beyond their natural limits. Increasingly, economists discuss the possibility of price declines in a handful of hot markets if investors leave, taking their excess demand with them. Whether those declines happen or price increases simply slow hinges on larger economic trends, namely continued job growth and rising interest rates.

Economic bubbles occur when prices are no longer supported by fundamentals, and consumers are motivated to buy only by the hopes of further appreciation. Technology stocks in the late 1990s created a perfect example of a bubble. The NASDAQ stock exchange doubled its value between the third quarter of 1998 and the first quarter of 2000—bolstered by irrational stock purchases—only to return to its original level 18 months later.

You can count among the antihousing–bubble group, Jeff Meyers, president of Hanley Wood Market Intelligence (formerly Meyers Group, recently purchased by Hanley Wood, LLC, publisher of Builder). Even in markets that are described frequently as overheated, such as Washington, Las Vegas, and Southern California, Meyers says basic tenets of supply and demand—restricted land supply, relatively low inventories of homes for sale, job growth, and population growth, coupled with reasonable interest rates—continue to support high prices. “These are not bubble conditions,” he says. “The fundamentals are there for good markets.”

Builders are quick to point to demographic projections as they reject the idea of a bubble. “Over the long term, this is the largest, steadiest market demand any industry can expect,” says Al Hoffman, CEO of Bonita Springs, Fla–based WCI Communities, which targets more affluent buyers. “I don't expect a long-term bubble burst, based on demand.”

Those demographic projections center around three groups: baby boomers, their children (commonly called echo boomers), and immigrants. Builders expect baby boomers to drive the second-home and condo markets during the next decade, while echo boomers and recent immigrants will become homeowners for the first time.

They're particularly encouraged by the Joint Center for Housing Studies increasing its estimates of household growth between 2005 and 2015 to 13.3 million households, based partly on high immigration levels in the 1990s. “We have generally been bullish and optimistic about the [housing] sector,” says Nicolas Retsinas, director of the Joint Center.

And then there's the supply side. Large stocks of developable, affordable land are tough to come by in high-demand areas, particularly on the East and West coasts. Couple that with the time it takes to get the parcels through the entitlement and permitting process, and builders say they can't come close to meeting demand.

“Demand is phenomenal, but the supply is restricted. That's the part of the formula that too many people don't consider. That's the safety net,” says Ara Hovnanian, president and CEO of K. Hovnanian Enterprises, headquartered in Red Bank, N.J.

Even those who disagree with the bubble notion describe a slowdown—but not an explosion—of the market as inevitable. “Even in a supply constrained environment, I don't think you can sustain 25 percent increases,” Hoffman says. “Salaries don't increase that much per year. Sooner or later, you're going to eat up the market that doesn't care what the price is.”

David Berson, chief economist for Fan-nie Mae, agrees. “In general, I'm expecting price gains to slow, and we may see some losses,” he says, adding that his projection is for 3 percent average appreciation over the next few years.

Economists have been expecting that slowdown for some time now, and some even thought it had arrived as far back as mid-2003, when the House Price Index tracked by the Office of Federal Housing Enterprise Oversight (OFHEO) showed decelerating increases for four quarters. Then, in the third quarter of 2003, appreciation unexpectedly picked up steam.

“All of a sudden it started to reacceler-ate,” says David Seiders, the NAHB's chief economist. “That's when you're looking for special factors.” Among those special factors: an increase in speculators, looking to get in and get out, while getting rich quick. The trend hasn't slowed: OFHEO reported that the increase between the third quarters of 2003 and 2004—the most recent period for which data are available—was 12.97 percent, the largest fourth-quarter increase since 1979.

That level of appreciation simply cannot be justified by the fundamentals, says Christo-pher Thornberg, senior economist for UCLA Anderson Forecast. “We're in the midst of a bubble, no doubt about it. People are buying strictly on the basis of appreciation,” he says.

Thornberg estimates that housing is overpriced by as much as 20 percent to 40 percent nationwide. The over-valuation, he says, leads to the possibility of declining demand, which will lead to subsequent declines in home prices, new construction, and overall market liquidity.

He doesn't expect, however, a rapid downward spiral. “Housing bubbles don't collapse. They slowly deflate,” he says. “It's a two- or three-year phenomenon of the market correcting itself.”

Global Insight, an economic and financial forecasting and consulting firm, has come to a slightly different conclusion—but one still less optimistic than that of many builders. “Except in very isolated markets, we are not in danger of a bubble,” says Philip Hopkins, managing director for the firm's U.S. Regional Services.

Based on indices examining housing affordability and the ratio of the price of housing-to-household income in a number of U.S. metro areas, Hopkins says nationwide, housing affordability has actually increased slightly during the last decade. Lower mortgage rates, which have allowed home buyers to carry higher mortgages, aided that shift.

He also looked at areas where housing historically has been expensive, to see if home prices now are out of line when compared to the long-term average. In that cut, a handful of currently overpriced markets emerged, including areas around San Francisco, Los Angeles, San Diego; and on the East coast, Boston, Washing-ton, and Miami.

Citing a recent Goldman Sachs report that estimated that homes are overpriced by about 10 percent nationally, Hopkins says, “That's not a bad number in some cases for some of the metro markets. There are some areas where I think housing is a little overpriced, and it wouldn't surprise me—though we won't see a collapse in prices—to see a slowdown in prices or some absolute decline.”

Despite their different beliefs about the bubble, industry experts have long agreed that the housing market must cool from its fever pitch. Most say the cool down would be marked by only single-digit, rather than double-digit, price increases and a slight drop in annual housing starts.

Now, though, more have come around to the possibility put forward by Berson and Hopkins: Demographic trends and job growth may not be enough to keep prices from dropping in some local markets.

There has been some evolution in economists' positions, acknowledges Seiders. “I think the new factor in some of our thinking has to do with the investor presence in the markets,” he says.

Until recently, evidence of speculators—buyers who purchase homes only to flip them and make a quick buck—was anecdotal. Then the jump in the OFHEO House Price Index stumped Fannie Mae's models.

“The models could explain the price gains pretty well up to a year ago: job gains, income growth, demographics, and land constraints,” Berson recalls. But nothing in those models matched up with the reacceleration in price appreciation, so Berson looked at what percentage of buyers were investors, a self-reported description.

The finding: In 2003's third quarter, the share of investors taking out mortgages rose from 5 percent to nearly 10 percent.

That helps explain the price jumps, Berson says. “On average, the larger the investor share of the market, the faster home price gains rise,” he explains, adding that investors have driven prices higher because they've added to demand.

In a recent speech before the Mortgage Bankers Association, Franklin Raines, chairman and CEO of Fannie Mae, reiterated his oft-stated position against a national housing bubble. He also said, “We are seeing investor-driven price increases in certain markets,” citing Berson's research. “These markets could soften as investor demand wanes, as it inevitably does.”

Still, economists have yet to come to a consensus on the significance of speculators' role. “It is an added concern about price sustainability in some markets,” Seiders says. But, he says, where larger amounts of speculators are suspected—such as Las Vegas—fundamentals drove rapid price run-ups before, which leaves him unsure how much markets' price structure can be attributed to speculators.

The Federal Reserve hasn't ignored the debate. Alan Greenspan recently downplayed the effect he thinks speculators have on the market. Large transaction costs and the need to find a new home impede widespread housing speculation, he told the annual convention of America's Community Bankers.

Some builders say speculators aren't keeping them up nights. John Landon, co-chairman and co-CEO of Plano, Texas–based Meritage Corp., says speculators don't amount to a large share of buyers. “I don't think it's a widespread problem. It's not enough to fundamentally affect the market.”

That assertion hasn't kept Landon from including contract provisions to deter and weed out speculators. He knows it's impossible to keep all speculators out, he says, but he says the contract changes can deter them from making a profit.

Many other builders have taken the same approach. They're not taking chances on how big a problem speculators could pose; some call investor buyers “hidden supply,” meaning if they pull back, demand and prices fall.

High-end condos comprise about half of WCI's business. Although the company doesn't begin to build a high-rise condo tower until buyers' deposits cover the cost of the building, it insists that buyers keep their units until the building is done. “That eliminates a lot of people who want to flip,” says Hoffman.

In its contracts, Shea Homes reserves the right to repurchase its homes if the buyers sell within the first year of ownership. That's helped close the door to speculators in its hottest markets, including Phoenix. “The only way investors can play in this market now is to go to the resale market and compete heavily with owner-occupants,” says Buddy Satterfield, president of Shea's Arizona division.

Though a few markets—including Orange County, Calif., and Las Vegas—saw marked slowdowns and even some price drops toward the end of last year, it's tough to use them as harbingers of what's ahead for other hot metro areas.

In a November report on the housing industry, analysts Rick Murray and Paul Puryear of Raymond James and Associates attributed the home price appreciation of the last two years to “significant and escalating levels of speculative buying in many markets across the country.”

The analysts presented two scenarios for the industry, hinging on economic and job growth. Strong growth—which likely will help drive housing demand—could mean stable home prices and builder profitability. More anemic growth presents a substantial risk to current home prices and levels of profitability among the public home builders, they project.

Most projections call for a continued slow decline in the national unemployment rate, with it reaching 5 percent sometime in 2006. If that happens, that factor may buffer against major drops in home values, economists say.

“Where we've seen serious price declines in the past, they have always involved really serious problems in the job market and outmigration,” Seiders says, recalling the collapse of Houston's oil industry in the late 1980s, and its housing market shortly thereafter.

Hopkins—who believes some local markets could see 10 percent price corrections—says a positive employment picture could keep prices flat, rather than negative. “The areas that are overpriced are still places where people want to go. That will keep demand high,” he says.

But job growth isn't the only variable in this equation. The other wild card: interest rates. Retsinas says severe job losses and a quick spike in interest rates could alter all projections for a gradual, mild housing slowdown.

Led by Greenspan, the Fed pushed short rates up 125 basis points last year, but mortgage rates didn't respond as expected. Rates for 30-year, fixed loans refused to budge much above 5.75 percent, while one-year, adjustable-rate mortgages hovered close to 4 percent. Economists revised their rate projections downward slightly, but they still expect rates to rise throughout 2005.

Just how far up they go may determine how far prices drop, says Mark Zandi, chief economist of Economy.com. “In highly overpriced markets [he includes Boston and San Diego in the group], if the fixed rate rises to 6.5 percent to 7 percent, we will get flat prices or modest declines. If the rate hits 8 percent or 8.5 percent, we may see 10 percent to 15 percent price declines in some markets,” he says.

Hopkins says a gradual uptick is important. As rates rise slowly, buyers can incorporate those changes into their plans and adjust their budgets accordingly, he says.

Builders are sensitive to changes buyers may make based on rate changes. “Interest rates dictate what size home people buy,” Landon says. If rates move up, his company might consider offering smaller square-footage home plans. “It's all about keeping the monthly payment in the area that people can afford,” he says.

Whatever happens to home values in the near term, it isn't bad news for homeowners who bought during the frenzy—if they're planning to stay a while. Thanks to that frenzy, buyers who purchased their homes more than a year ago have “equity buffers in their homes adequate to withstand any price decline other than a very deep one,” Greenspan said in his speech to America's Community Bankers.

The number of speculators aside, Hop-kins says, most people buy houses for different reasons than they buy stocks; they're in it for the long run. “If you're planning to be there for some time, you probably are more willing to ride out a decrease in prices,” he says. “A short-term downturn in prices isn't catastrophic.”