Dangers ahead as US real estate reaches endgame

The Bottom Line
Published October 12, 2006

Dangers ahead as US real estate reaches endgame

By ROBERT SAMUELSON

AMERICA is at the endgame for housing. Until recently, the national motto has been 'in real estate we trust'. Just last week, the Census Bureau reported that median home prices after inflation rose 32 per cent from 2000 to 2005.

In some places, the gains were huge: 127 per cent in San Diego, 110 per cent in Los Angeles and 79 per cent in New York. But real estate - which has acted as a national piggy bank, with homeowners borrowing and spending against rising house prices - no longer looks so trustworthy. On this, more than falling oil prices or a record Dow, hangs the US economy's immediate fate.

The boom sowed its own destruction. Coupled with modestly higher interest rates, rising home values have priced more potential buyers out of the market. In 2003, a family with an income of US$40,320 could buy the median-priced existing home of US$180,200, estimates the National Association of Realtors (NAR).

By August 2006, an income of US$56,544 was required to buy the median-price home, now costing US$225,700. (The assumptions: purchasers make a 20 per cent downpayment and devote 25 per cent of their income to mortgage payments at the prevailing interest rate.) With fewer buyers, home construction and sales and prices have weakened. In August, housing starts were 20 per cent lower than a year earlier. Last year, sales of new and existing homes totalled almost 8.4 million; next year, the NAR expects 7.4 million.

Construction workers, property agents and mortgage bankers will lose jobs. Consumer spending will also suffer, as the borrowing and buying against rising property values subsides. The end of the cheap credit that fed the boom means that many borrowers will face higher monthly payments. Adjustable rate mortgages (ARMs) represent a quarter of the nearly US$10 trillion in single-family mortgages, says economist Michael Fratantoni of the Mortgage Bankers Association. ARMs typically change rates annually and are 2-2.5 percentage points above, say, a one-year Treasury note. But 'hybrid' ARMs made in 2003 and 2004 gave low fixed rates for three to five years; many of these rates are now rising. Consider a borrower with a 4 per cent ARM of US$200,000 lent in 2003. The monthly payment had been US$955, says Mr Fratantoni. Now, the ARM would reset at 7.5 per cent; the payment rises to US$1,362. Switch to a 30-year fixed-rate loan, and the rate would be 6.25 per cent with a US$1,164 monthly payment.

To service their loans, some consumers will curb their shopping. Susan Sterne of Economic Analysis Associates says that debt payments will absorb a record 15.6 per cent of personal disposable income in 2007. Ms Sterne expects growth in consumer spending and the overall economy to weaken, though she's not predicting a recession. But some forecasters think one is possible.

Uncertainties abound. How much will falling oil prices cushion consumer spending? More important: how much do higher home prices reflect a temporary speculative 'bubble'? Economist Richard Green of George Washington University thinks much of the run-up of home prices is permanent, reflecting lower long-term interest rates.

As rates dropped, buyers could afford to pay more. I largely agree with this view. Growing confidence in low inflation has gradually reduced long-term rates. In 2005, rates on 30-year fixed-rate mortgages averaged about 6 per cent, compared with 7.5 per cent in 2000 and 8 per cent in 1995. Restrictive zoning regulations have also pushed up prices in some areas, Dr Green says. High demand pressed on a limited housing supply.

Still, evidence of speculation is undeniable. For a while, there was a buyers' panic. By one survey, about 40 per cent of houses bought in 2005 were second homes (28 per cent for 'investment', 12 per cent for 'vacation').

Dubious new mortgages - interest only or less - aimed to maximise what a buyer could afford. A survey by Global Insight and National City Corp estimates if home prices in 317 metro areas are reasonable. In early 2000, 63 metro areas were judged overvalued - but by no more than 13 per cent. In mid-2006, 236 were thought overvalued, and 79 by more than 34 per cent. The survey considers interest rates, local incomes and housing densities.

Even a levelling of home prices suggests that Americans will save more from current income and spend less. Up to a point, that's okay, especially if the lost spending were offset by higher exports and business investment. But one recent survey shows a year-over-year price decrease for existing homes of 1.7 per cent.

Moody's Economy.com forecasts falling prices in 100 metro areas and an average decline of 3.5 per cent next year - the first annual drop since the Great Depression, says chief economist Mark Zandi. There's the endgame's true danger: If prices drop too much or too persistently, the damage to confidence and spending won't be easily neutralised. - The Washington Post Writers Group

The writer has been a regular columnist for The Washington Post since 1977