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Housing: Red Alert, or a Wake-Up Call?

By Peter Coy There's an old saying that nobody rings an alarm bell at the top of a market. But luxury homebuilder Toll Brothers (TOL) came awfully close on Nov. 8, when it warned investors of "some softening of demand in a number of markets" and that "it appears we may be entering a period of more moderate home price increases, more typical of the past decade than the past two years."

Investors took the statements as a carefully worded clarion call -- boom times for the housing biz are finally coming to an end. Toll Brothers shares fell 12% on the New York Stock Exchange, closing at $33.91. And the fallout was sweeping. Not only did stocks drop for other homebuilders, including Pulte Homes (PHM) and Centex (CTX), but the reaction also reached deep into the housing market, hitting do-it-yourself remodeling centers such as Home Depot (HD) and Lowe's (LOW) and furnishings and appliance companies such as Ethan Allen (ETH) and Whirlpool (WHR).

OUT OF WHACK. Time to panic? Not really. But the market's reaction is understandable -- and justified. It has been obvious for a long time that housing had to cool off. Residential construction has been running at an unsustainable pace over the past few years, at a rate that has outpaced that of household formation. (see BW Online, 10/5/05, "Housing: Less Bang than Whimper").

The formation of a housing bubble is clear in the latest government data on gross domestic product. Residential investment -- i.e., homebuilding and remodeling -- is running way above its historical average share of economic output, according to the latest numbers.

Home prices, too, have clearly gotten out of whack. They've risen far faster than family incomes. People have been able to buy because mortgage rates have been low. But now rates are rising again. And with the Federal Reserve determined to squelch inflation, they're likely to keep going up well into 2006.

CHEAPER TO RENT. Many people have squeezed into homes with creative financing -- including exotic mortgages such as "option ARMs" that allow buyers to skip part of their interest payment and roll it into the principal they owe. But even that game has pretty much played itself out. If prices fall, many recent buyers may find themselves owing more on their houses than the dwellings are worth (see BW Online, 6/27/05, "Mortgage Bankers: Desperate to Lend").

A cottage industry of people predicting the end of the housing boom has sprung up, and by chance a report by one of them came out the same day as the Toll Brothers warning. It's by Dean Baker and David Rosnick of the Center for Economic Policy Research, a Washington (D.C.) think tank. The study is called "Will a Bursting Bubble Trouble Bernanke: Evidence for a Housing Bubble" (Bernanke being Ben Bernanke, the next chairman of the Federal Reserve).

The study notes that house prices have gone up much more than rents in recent years. In many cities, it's far cheaper to rent a house than to buy it and pay the mortgage and other homeowner expenses, even taking into account the generous tax break for mortgage interest payments.

SPENDING, NOT SAVING. When people are willing to pay extra to own vs. rent, it's often a sign that they're speculating on future appreciation. Baker and Rosnick say the pace of construction in the past three years has been 40% higher than the average for the 17 years before the price run-up began. That's despite population growth that's slowing and the baby boom moving past its peak years for homebuying.

The authors also point out that people have been relying on the rising tide of housing wealth to do their savings for them -- the personal savings rate, which excludes fluctuations in wealth, is actually in negative territory, which means households are spending more than their disposable income (see BW Online, 11/7/05, "A Consuming Health-Care Conundrum").

Not everyone believes the Toll Brothers statement is all that alarming. (see BW Online, 11/9/05, "Don't Let Housing's Seasons Scare You"). Toll Brothers itself said "we remain optimistic," adding that the U.S. has a growing number of affluent households -- the company's target market.

SIGN OF PRUDENCE? Michael Youngblood, managing director of asset-backed securities research at Friedman, Billings, Ramsey Group in Washington, D.C., says there's still no sign of a big drop in either construction or prices. Youngblood says the ratio of home prices to per-capita income is only a bit above the long-term average, and the trend in employment growth -- which underlies demand for housing -- remains strong despite a weak September report.

"Housing has had just a terrific run.... Any pullback might be healthy," says Chuck Dannis, president of Crosson Dannis, a Dallas-based appraiser and real estate consulting firm. Dannis considers it a sign of prudence that Toll Brothers is revising downward its construction forecast while it still has a backlog. In past cycles, says Dannis, "we haven't been able to turn off the supply spigot fast enough" to prevent a big oversupply.

Even many optimists see a correction under way. Youngblood calculates that while there may not be a nationwide housing bubble, bubbles exist in 57 metro areas representing 29% of the U.S. population.

A "MELTDOWN"? The pessimists still are convinced a real fall is coming. Ian Shepherdson, chief U.S. economist for High-Frequency Economics in Valhalla, N.Y., thinks prices and construction won't just go into a lull for a few years -- they'll actually fall, possibly dragging down the overall U.S. economy. He notes that a sharp downturn in a white-hot housing market contributed to the two recessions that struck in the early 1980s. This time, says Shepherdson, housing starts could fall 40% or more. "Meltdown, in other words," he wrote in a recent publication.

"Never send to know for whom the bell tolls; it tolls for thee," John Donne famously wrote. Now the housing industry will see whether the Toll Brothers bell rings true.

Coy is BusinessWeek's Economics editor in New York

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