Housing's Threshhold of Uncertainty

What to expect when higher rates finally put the brakes on soaring home prices? Anything from a gentle cooling to a burst bubble

By Amey Stone

In Providence, R.I., where home prices are rising at one of the fastest rates in the country, a tidy 2,500-square-foot, three-bedroom house on the city's east side is on the market for $585,000 -- a price realtor Ron Phipps expects it to fetch soon. The house sold for $500,000 a year ago, so the current owners' potential gain is $85,000, minus the expense of some improvements and costs incurred during the sale.

That's a huge leap from the annual rate of return earned by the prior owners, who paid $410,000 in 1991. "Essentially it took the former owners 11 years to realize about the same gain," says Phipps. "That indicates how robust the market is."


  Repeat that same trend in select neighborhoods across the country and you have a picture of a housing market moving at warp speed. Last summer no less than Federal Reserve Chairman Alan Greenspan pooh-poohed the idea that a housing bubble was building. He may have a different view now (although he hasn't said anything recently on the subject.) National figures for sales growth and home-price appreciation continue to hit record levels this summer, even as factors that fueled the boom started heading in the wrong direction.

Home buyers, beware. As the U.S. economy recovers strength, you're jumping into a real-estate market that's peaking. And anyone worried whether the U.S. economic recovery has staying power will keep a close watch on the housing market. It has been one of the supporting pillars of the comeback, yet it could soon buckle under its own weight.

Propelled by a spike in mortgage rates that convinced many home buyers they had better act now or pay more later, the pace of existing-home sales in July smashed its prior record. According to data released by the National Association of Realtors (NAR) on Aug. 25, July's existing-home sales reached an annual rate of 6.12 million (seasonally adjusted), up 5% from June and 14% from July, 2002.

New homes are being built at a frenzied pace, too. In July, housing starts hit a 17-year high, according to the Commerce Dept. Even though sales of new homes dipped a bit in July from June's record pace, according to Commerce figures released Aug. 26, they were still at a robust 1.165 million annual rate -- way beyond expectations. That rate equals a 21% jump over the 961,000 new homes sold in July, 2002.


  Meantime, the inventory of available homes is falling. Commerce reported a record low supply of new homes in June and July of 3.5 months, down from 4.2 months in July, 2002. The NAR puts housing inventory in July at 2.39 million, a 4.4% drop from June.

Combine motivated buyers with low supply and you get home prices on a tear. The national median price for existing homes jumped 12.1% in the past year, to $182,000 from $162,000, according to NAR. That's the biggest increase since November, 1980, says David Lereah, NAR's chief economist. Prices are the highest in the Northeast, where the median home price was $194,000, up 16.3% from a year ago. In the South, the median price jumped even faster -- at a 17.6% rate -- to $178,000.

The second quarter was the first time on record that home prices increased in every metropolitan area, vs. the year before, with a record number of cities reporting double-digit gains, says NAR. The strongest increases were in the Riverside-San Bernardino( Calif.) area, with a 24% jump to a median price of $212,600. Providence prices experienced a 23% spike, to a $228,900 median. The most expensive metro area now is the San Francisco Bay area. There, the median price is $560,200, up 3.6% from the second quarter of 2002.


  None of this is expected to last much longer, however. "There's no doubt that the record numbers...reflect people jumping off fences and trying to get in before mortgage rates rise," says Lereah. The average rate paid for a 30-year fixed-rate mortgage in July was 5.63%, up from a record low of 5.23% in June. Bankrate.com's Aug. 20 survey of lenders -- its most recent -- pegs the current rate at 6.35%, which is still low by historical standards.

The problem: The combination of rising rates and higher prices have made homes a lot less affordable than they were a year or two ago. According to NAR, affordability reached a 30-year high in the first quarter of the year and slipped in the second quarter. Lereah expects affordability to decline this quarter, but says it's still favorable for home buyers.

Most troubling for the long-term health of the housing market would be if homes become too expensive for first-time buyers. A typical entry-level buyer in the second quarter could afford a home of $118,800, yet the median starter-home price was $143,600, according to NAR. That means fewer home owners will have the equity to trade up to all those McMansions being built.

Lereah's hope is that, later in the year, home-price increases will slow to a more normal level -- about 4% -- while more new homes will be added in the most overheated areas. "I'm not thrilled with 12% appreciation," he admits. And while he believes a national decline in home prices will never happen, he admits there could be local markets where prices decline temporarily. If it's taking longer for homes to sell and there is more inventory available, that could be a sign that prices may dip locally, he says.

John Lonski, chief economist at Moody's Investors Service, doesn't rule out the possibility of national home-price deflation, but he thinks that as long as 30-year mortgage rates don't increase to 8% by the end of the year, the housing market should stay afloat. A rise to even 7.75% by the fourth quarter -- which he considers unlikely -- would mean a 25% jump in monthly mortgage payments.


  "Home-price deflation would be very damaging to the U.S. economy," warns Lonski. "It would reverberate throughout the entire economy, damaging consumer confidence and bringing consumer spending to a stall."

Phipps -- who says Providence's price gains are partly because it remains so much more affordable than nearby Boston -- believes the fundamentals of his corner of the market are healthy for now. He doesn't see the kind of speculation that fueled the '80s real-estate boom-and-bust in the Northeast, and he doesn't expect a commensurate price decline in the near future.

That doesn't mean there won't be a dip, however. "It may not be the best strategy right now to anticipate trying to sell in a short period of time," he concedes. For people thinking of plunking down $585,000 for a three-bedroom house, that's something to ponder.

Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

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