Where is the Bursting Bubble?

By: Giesler & Kim, LLP - [legal]
We are lawyers not economists. But the predictions of the residential real estate market crashing and the ''bubble'' bursting just seem at odds with our intuition about the residential real estate market. And since the value of residential real estate is important to nearly everybody, we decided to test our intuition against some research and analysis. We report our thinking, guesses, etc. in the following piece. We conclude that our intuition seems to be justified.

While reading this article please keep in mind that, as William Poole, the President of the Federal Reserve Bank of St. Louis pointed out in a recent report on the housing market, ''Forecasting the near-term prospects for the U.S. housing sector has always been difficult because the housing industry fluctuates a lot, and the fluctuations depend on changes in income, interest rates and other conditions that are themselves difficult to forecast.'' So please bear in mind that this article represents merely an opinion on the subject and does not purport to foretell or guarantee future events.

The bursting of the housing price ''bubble'' is a hot topic of this year whether you're at a cocktail party, on the golf course or at work. But are fears of a housing market meltdown exaggerated? Doom and gloom advocates claim that a real estate crash is imminent. Others are expecting continued double-digit appreciation for years to come.

So who's right? A survey of the facts and housing statistics offers a glimpse of a healthy slowing market that is stabilizing, rather than crashing.

According to an April 19, 2006 Wachovia Economic Commentary, titled The Outlook for the Housing Market, the number one thing to remember when it comes to real estate is that ''..the demand for all types of real estate is derived from the underlying growth in the economy.'' And that economy is expected to remain strong for the next few years, according to the same report. Furthermore, ''Demographics also remain solidly positive. The U.S. population will continue to add around 3 million new residents a year, and possibly more if congress can reach a deal on immigration reform. In addition, the baby boom generation continues to age up into their peak homeownership years, which should drive the overall homeownership rate to the low 70 percent range by the end of the decade and keep demand for second homes quite strong,'' reports the aforementioned Wachovia Economic Commentary. Therefore, the predictions and discussion in this article are based on the premise that while the economy remains strong, the outlook for the residential real estate market remains positive.

Although figures by DataQuick Information Systems indicate that unit sales have been dropping in Los Angeles County for the past few months compared to a year ago, median prices have nevertheless increased during that same period.

In response to reports of declining unit sales, California Association of Realtors (''C.A.R.'') Vice President and Chief Economist Leslie Appleton-Young has said that ''..we're seeing price appreciation trend toward a more sustainable rate for the California housing market. Increased inventory levels are moderating the rate of price appreciation, but are still below what we experience in a more traditional market when the long-term supply of unsold inventory is about seven months.''

"The slowdown in sales appears to be most noticeable in the move-up category, which was expected. Prices are flattening out in that market. Entry-level and mid-market homes are not seeing as much of a sales slowdown, and prices are still going up, although at a slower pace," said Marshall Prentice, DataQuick president, recently.

Alan Nevi, the chief economist for the California Building Industry Association thinks that there is plenty of demand, but homes have to be priced right. According to Nevi, the large inventory of homes on the market is due to the fact that many sellers are pricing their homes based on the double-digit appreciation they have come to expect during the past few years.

The foregoing discussion and figures suggest that there is still demand for residential real estate but double digit appreciation is over. The market has stabilized. This normalization means that it is no longer a seller's market. However, we agree with David Lereah, chief economist of the National Association of Realtors, that appreciation of 4-5 percent per year is still expected in the coming years due to demand and a strong economy.

Doom and gloom advocates cite rising interest rates, increasing foreclosures, low affordability rates and rampant speculation as the reasons for the allegedly impeding real estate crash. However, in the face of a strong economy, such a prediction is unlikely to become reality.

Rising Interest Rates
It is no secret that the Federal Reserve has been raising interest rates. However, according to Joseph Gyourko, a real estate and finance professor at Wharton and director of the school's Zell/Lurie Real Estate Center, over the long haul, interest rates and house prices do not correlate. When interest rates rise, there has typically been no dramatic fall in house prices, even though mortgage debt service payments increase, and vice versa.

In fact, Gyourko does not see a widespread bubble in the US housing market. In Gyourko's view, local economic factors, including job growth and supply restrictions on residential real estate, explain rising real estate prices in many cities, particularly on the coasts.

According to Gyourko, the most important factor driving housing prices is income. "Basically we've been growing rich people in the U.S.," he said. In 1940, less than 1% of families earned $100,000 in today's dollars. By 1970 that income level rose to about 5% of families. By 2000, about 12% of families were in that category.

So our belief is that reasonable interest rate increases will not significantly decrease house purchases and prices. As long as there is demand for housing as well as sufficient household income to support home purchases, the residential real estate market will remain stable, despite rising interest rates.

Foreclosures
Doomsayers also claim that rising interest rates will lead to increased foreclosure activity as homeowners who purchased their homes using adjustable rate and interest only loans will be unable to keep up with rising mortgage payments. To support their contention, these doomsayers cite to recent reports such as the one published by USA Today, which states that as many as 1 million of the 7.7 million adjustable loan products issued in the past two years may be foreclosed -- a rate that is 13 times higher than normal.

However, according to an April 18, 2006 report by DataQuick, ''Foreclosure activity is edging up from its bottom, but is still low.''1 And according to a June 20, 2006 Business Week article2, ''If you're looking for truly good news on housing, it's that foreclosure rates remain reassuringly low. The Mortgage Bankers Assn. said on June 19 [2006] that just under 1% (0.98%) of all loans were in foreclosure as of the end of March [2006], vs. 0.99% at the end of December [2005]. Foreclosures are low because the economy has been strong, enabling most people to keep up with their payments. And because home prices have been rising, even those people who fall behind can usually get enough money from selling or refinancing to cover their debts.''

Furthermore, according to figures from the Mortgage Bankers Association, 40 percent of all homes are mortgage-free while 30 percent have fixed-rate loans. This means that 70 percent of all property owners are not directly affected by rate changes. That leaves 30 percent of all owners with adjustable-rate and interest-only loans who will feel the effects of rate hikes.

Moreover, relatively few homeowners are likely to suffer from negative equity even in the unlikely event that rising interest rates drove up defaults because about 94 percent of home owners have equity of more than 10 per cent.

These figures indicate that not only is a significant increase in foreclosures unlikely in this strong economy, but also that few homeowners would actually be affected by rising interest rates. Therefore, we do not expect foreclosures to play a significant role in the residential real estate market in the near future.
Affordability
Housing bubble enthusiasts also rely on affordability indicators to support their forecast of an impending real estate crash.

In fact, according to a national survey released by the California Building Industry Association on May 17, 2006, California is now home to the nine least affordable metro areas in the nation. However, in order to figure out what this may mean for the future of the housing market in California we must understand what housing affordability really means.

Housing affordability is basically the ratio of median family income to the income needed to purchase the median-priced home, based on current interest rates and underwriting standards. It is supposed to be a primary driver of housing demand. Key factors for housing affordability measures include house prices, interest rates and income, according to a report by William Poole, President of the Federal Reserve Bank of St. Louis.3

Indeed, the recent housing boom was in part possible because as interest rates decreased home ownership became more affordable. Rising family income has also made housing more affordable for a lot of families nationwide. However, because of the recent run-up in house prices, in certain regions of the country, including California, as well as rising interest rates, home ownership has indeed become less affordable during the past year according to the National Association of Realtors' composite Housing Affordability Index.

Nonetheless, as NAR's Affordability Index fell, housing continued to boom. In fact, according to a March 1, 2006 article by Bob Sperber, Senior Editor of Professional Builder,4 since 1999 there has been little correlation between housing affordability and existing home sales because assumptions behind the numbers did not reflect market realities. Limitations on affordability indexes include the fact that declining affordability mainly affects whether first-time home buyers will enter the market and do not reflect existing homeowners' ability to buy.

However, even if there were a correlation between housing affordability and existing home sales, according to ''Explaining Recent Changes In Home Prices,'' an analysis of home affordability published in the Federal Reserve Bank of Chicago's July 2005 Chicago Fed Letter, home prices are more affordable now than they've been since the mid-1980s and even large interest rate hikes may only moderately increase the cost of housing.

So Doomsayers' reliance on affordability rates in support of their forecast of a housing bubble burst is misplaced.

Baby Boomers
Indeed, demand is affected by more than just affordability rates. According to David Lereah, chief economist of the National Association of Realtors, demographic trends will assure strong demand. Baby Boomers remain in their peak earning years. Their children, the so-called Echo Boomers, are primed as first-time home buyers. Also, a record number of established immigrants are financially equipped to buy property and start building wealth for their families.

The National Association of Realtors reports that a record 40% of all homes bought last year were not a primary residence for the buyer.5 The trend is particularly strong among Baby Boomers - more than a quarter of them own at least two homes. According to the same report, with Baby Boomers at the peak of their earning potential, the push to snap up vacation homes is unlikely to reverse soon.

In addition to a higher rate of homeownership, analysis by NAR shows Baby Boomers are proportionately more active in the second home market, owning 57 percent of all vacation/seasonal homes and 58 percent of rental property.6

This again suggests that demand for housing remains strong despite decreasing affordability.

Strong Economy v. Crash
In sum, the recent slowdown in the housing market represents a ''soft landing'' in the words of David Lereah, rather than a crash. ''Economic growth and job creation are providing a favorable backdrop for the housing market, but rising interest rates have an offsetting effect,'' according to Lereah. Lereah expects total home sales to drop to 6.62 million in 2006, from 7.07 million in 2005. Meanwhile, he thinks prices will continue appreciating this year, but only by around 5%, compared with 12.5% during 2005.

Lereah's forecast is based on the theory that the growing economy will boost the market, offsetting the negative impact of rising interest rates.

''What supports the housing markets are income gains, [low inflation], job creation, consumer confidence, and mortgage rates. We have all of the above still supporting us. Meanwhile, the demographic trends are wonderful. You have boomers buying homes and retirees living longer,'' Lereah says.

Similarly, according to an April 19, 2006 Wachovia Economic Commentary, titled The Outlook for the Housing Market, ''job and income growth are expected to strengthen in the coming year, which should help insulate the economy from a slowdown in the housing sector and eventually pave the way for a rebound in sales and new construction.''

The University of California, Los Angeles Anderson Forecast dated June 21, 2006, likewise predicts a soft landing with a mild economic slowdown and flat home prices rather than a repeat of the 1990s, which saw a stagnant economy and consistently falling home prices.

In a report called ''State of the Nation's Housing'' released by Harvard's Joint Center for Housing Studies on June 13, 2006, Harvard's housing scholars believe that a slowing housing market will be offset by continued employment growth, and, thanks to steady flows of immigration, an increase in the number of households that will buttress demand.

As a result, they subscribe to the ''soft landing'' scenario in which price appreciation cools and the nation's housing stock holds its value. And if the bubble does deflate, the study's researchers believe it will ''deflate slowly rather than burst suddenly.'' ''We don't see any reason for panic, ''says Rachel Drew, a research analyst at Harvard who co-authored the study.

Consequently, we believe that homeowners need not fear losing the value of their homes. Similarly, those wishing to buy, need not hold off purchasing in the hopes that house prices will fall. Sellers on the other hand need to realize that this is no longer a sellers' market and their homes should be priced accordingly. Strong demand and a growing economy will ensure that our homes retain their values and the housing market will not crash. And remember, what other investment is also our ''home'' with interest dedications, capital gains rates and $500,000 income tax exemption on a sale by a couple?

Gary H. Giesler, Esq.
Christine Csizmadia, Esq.

1 ''Southland passes half million mark'' by DataQuick Real Estate News, April 18, 2006.
2 ''Beware False Housing Hopes'' by Peter Coy, Business Week June 20, 2006.
3 ''Recent Developments in Housing Markets: A National and Local Perspective'' by William Poole, March 8, 2006.
4 ''NAR Affordability Index Raises Questions'' by Bob Sperber, March 1, 2006
5 ''Real Estate: The Going Gets Tougher'' by Christopher Palmeri, Business Week, May 22, 2006
6 ''Baby Boomer Survey Shows Big Appetite for Real Estate'' by Walter Molony of realtors.org, May 18, 2006

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