Getting Crushed in a Housing Collapse

As home prices continue to defy gravity, recent history holds a sobering lesson: When what goes up comes down, big-time pain ensues

By Amey Stone

Ask Chuck Dannis about how it feels when a housing bubble bursts and he talks about elevators. A real estate appraiser in Texas for the past 30 years, he well remembers 1986, when crude prices dropped below $10 a barrel, mass layoffs in the oil-dependent economy followed, and the Texas real estate bubble deflated. Home prices across the Southwest fell from 10% to 20%.

"You'd get on an elevator, and it would be quiet," recalls Dannis, president of appraisal firm Crosson Dannis in Dallas and a lecturer at Southern Methodist University's Cox School of Business. "No one would talk." "For sale" signs dotted neighborhoods, with families unable to sell simply mailing their keys to the bank and walking away from homes destined to go into foreclosure.

But there was also a pervasive change in mood, a shift that affected everyone -- even those secure in their ability to remain in their homes -- and which contrasted sharply with the euphoria that reigned from 1982 to 1985, says Dannis. Back then, "everyone was happy and optimistic about the future, and they'd talk to each other on elevators," he says. But after the real estate market fell, "everyone was morose," recalls Dannis. "It felt like there had just been a funeral."


  Dannis' memories are worth revisiting. These are heady days for real estate. First-time home sales hit a record in April. The National Association of Realtors reported on May 24 that existing-home prices climbed 15.1% in the prior year, to a record $206,000 median price, with the strongest gains in the West and Northeast. "We continue to expect that the year 2005 will see the new all-time record," wrote John Herrmann of Cantor Fitzgerald in a May 24 report. He thinks housing will stay strong until at least 2010.

But given that home-price gains running this far ahead of inflation can't continue forever, it's worth remembering that a real estate recession is no fun. All it would take to trigger one is sharply higher interest rates -- and economists are currently scratching their heads over why long-term rates aren't higher given the increase in short-term rates and the signs of inflation. Mortgage rates have actually slipped in recent days (see BW Online, 5/27/05, "The Long Wait for a Housing Slump").

While real estate prices haven't fallen on a national basis in the past 30 years, several regions have seen real estate recessions -- most often sparked by major layoffs in a dominant industry. Almost overnight, families can wake up to find that their largest asset -- the one they figured would keep on growing and provide a retirement nest egg -- has dropped in value. It can hurt older folks close to retirement. It can bankrupt young people who stretched to buy their first home or speculated on rental properties.

Even for homeowners who can comfortably meet their mortgage payments, it means suddenly spending less on other things. It can put a damper on the whole economy.


  That's why economists -- even Federal Reserve Chairman Alan Greenspan -- are worrying lately about "froth" in the housing market. It's not that they expect home prices to plummet across the country or mass foreclosures to ruin banks (although, if things were to get really bad, that's a possibility in some regions). Rather, they see that an almost inevitable retrenchment in home price appreciation will act like rain on the economy's real estate-fueled parade.

"Housing has been a huge support for the economy ever since the 2001 recession," says Dean Baker, co-director of the Center for Economic & Policy Research, in Washington, D.C. "If the housing bubble bursts, it basically flips in reverse." If people lose jobs and can't pull cash out of their homes by refinancing, they will also feel the need to save more. While increased savings is a good thing over the long run, it can slow the economy in the short run.

That's what happened in Massachusetts in the early 1990s, when the economy slowed and tech companies that had spurred regional economic growth retrenched. Peter Cohan, a management consultant and author in Marlborough, Mass., remembers his angst in 1992 when, expecting his second child and wanting a larger home, he put his house on the market, only to find it was worth 10% less than he paid for it four years earlier. He and his wife decided to stay put, adding onto the house instead. The value of the house didn't return to the 1986 level until 1995, he says.


  That's a long time to wait for your house to regain the value you paid for it. "My experience suggests that if you're going to live in a house, then the ups and downs of pricing during an economic cycle should not drive the decision about buying or selling," Cohan wrote in an e-mail interview. "If, however, you're borrowing lots of money to 'invest' in real estate, those price swings can ruin you."

Dannis points out that homes have carrying costs -- taxes, maintenance, and insurance -- that make it much harder for people to carry properties bought as an investment when the market turns south. In 2004, 36% of properties sold were second homes, the bulk of them purchased as investments. "It's not like a stock," where investors mainly have lost opportunity costs to holding a loser. With real estate, he notes, "If prices don't continue to go up, you're 4% or 5% behind every year."

Many homeowners will likely owe the bank money if they sell in the midst of a downturn. Baker bought his condominium in 1992, after prices in the Washington (D.C.) area had fallen. He paid about 15% less than the person he bought it from had paid just a few years before. Last year he sold the unit for three times his purchase price. "After so much time writing and thinking about how a real estate bubble was building, I realized I would feel really stupid if I didn't sell," he says. Today he rents.


  Two things have to happen to pop a real estate bubble: Interest rates have to rise and jobs have to disappear. Baker acknowledges that the capital markets are in a peculiar state with long-term rates remaining low, even though the economy is growing. The Mortgage Bankers Assn.'s May 25 release reported that the rate on a 30-year fixed-rate mortgage dipped to 5.63% from 5.73% the week before. The percentage of total mortgage applications that are adjustable-rate loans climbed to 34.8%, up from 33.9%.

The housing bubble isn't showing any signs of bursting, but the pain likely to be inflicted if it does is increasing, worries Baker. "You keep saying that this can't go on," he marvels, adding: "They can, but then things get more and more out of line."

For first-time home buyers who plan to stay in their homes for the next 20 years, the highs and lows of the real estate cycle don't really matter in the long run. But if you're thinking of betting big on rising prices in your area, remember that for real estate, times this exciting don't last forever.

Stone is a senior writer for BusinessWeek Online in New York

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