The blazing-hot topic at suburban cocktail parties this spring is whether there’s a bubble in the residential housing market. No wonder. In 2004, existing home prices rose faster than in any year since the 1970s. Some markets are going bonkers.
The power of fear. But while such signs of speculation are troubling, there is little solid evidence that a real estate bubble is puffing up. One reason for optimism is that so many people are worried. Fear puts a lid on prices.
Another reason is history. Since 1950, according to data gathered by Freddie Mac, which provides financing for mortgage lenders,
Certainly, individual housing markets can suffer boom-and-bust cycles. (Look at
As a result, though existing-home prices rose faster in 2004 than in any year in a quarter-century, they were up just 8.3%, according to the National Association of Realtors. Since 1950, residential real estate prices have increased an annual average of 5%, says Freddie Mac. That’s only a little more than 1% per year after inflation.
In other words, if you buy a house expecting to get rich, you’re a fool. Real estate is very different from stocks. With stocks, you get a high reward as a payoff for high short-term volatility. With real estate, you get a lower reward but a smoother ride — a good thing because most people own just one home at a time, so they don’t get the risk-dampening benefits of diversification.
No free shelter. But let’s be clear: The house you live in is not an investment. It’s an asset that produces nontaxable personal income, in the form of comfort and joy. When you sell your home, you have to buy another one. By contrast, if you sell your General Electric stock, you can do anything you want with the cash. And selling a home when prices are relatively high inevitably means buying a home when prices are relatively high.
Of course, you could sell your house and rent, which The Economist prescribed, only slightly tongue-in-cheek, in a recent editorial. Yes, rentals are cheap these days compared with home values. Owning your own house, however, provides not only extra security (the landlord can’t boot you out when the lease is up) but also tax breaks.
And don’t forget the consumer’s best friend: the glorious 30-year fixed-rate mortgage. You can get a loan that’s only slightly above the rate at which the
Getting back to bubbles: In his book Bubbleology: The New Science of Stock Market Winners and Losers (Crown Business, 2002), economist Kevin Hassett defines a bubble as “a period when the price of an asset (stocks, real estate, tulips, etc.) suddenly soars for irrational reasons and then collapses.” The key word is irrational. Prices often rise for good reason. For example, the price of a share of eBay rose from $8 in 2001 to $32 in 2003. A bubble? Not at all. The increased value was rooted in fundamentals. Revenues nearly tripled over that period, and profits quintupled. In fact, eBay kept rising and now trades at $38.
What can you afford? In a bubble, prices get divorced from reality — though reality, in financial terms, is often in the eye of the beholder. One measure is affordability. “If people are paying a realistic portion of their income for housing,” Marc Louargand of Babson Capital writes in a letter to clients, “it is hard to see conditions as a bubble.”
Louargand cites the housing-affordability index calculated by Economy.com. If the median family income in a market is exactly the amount needed to qualify for a loan to buy a house at the median resale price, then the index is 100. If the median income is more than sufficient, then the index rises above 100. Louargand found that of the 318 metropolitan areas tracked, only 29 had affordability indexes less than 100. “In fact,” he writes, “the average index value as of year-end 2004 was 180, which indicates that the median family income can qualify for nearly twice the median home value.”
How can so many Americans afford houses at a time of rising prices? High incomes and low interest rates. Rates may rise, but they won’t necessarily cause prices to tank. As Louargand points out, “The last time we had high interest rates [in the 1970s], home prices were soaring.” High interest rates indicate inflation, which tends to be good for hard assets like real estate. And even if rates jump a full percentage point, the number of sub-100 markets would rise from 29 to 43 — still a small number.
Even in places where prices are soaring, worries of a bubble could be overblown because higher prices appear grounded in good old fundamentals. Garrett Thornburg, who heads Thornburg Mortgage, pointed out to me that in hot markets, such as
On the demand side, purchases of second homes are rising as baby-boomers get close to retirement, and “the rapid influx of new immigrants has enlarged the home-buyer pool,” writes Value Line Investment Survey‘s William Ferguson.
Investing alternatives. I am, however, annoyed and concerned when I hear my friends, who have made big, unrealized profits on their condos, talk about putting together pools to buy and sell real estate. As if it’s so easy! Sure, consider buying a few rental properties for income and holding them for 20 years. But making money in real estate is no cinch. You’re up against some very smart competitors who do it for a living. If you’re convinced that prices will continue to climb, it’s better to join the experts than to try to outsmart them.
You can, for example, buy stock in homebuilders, a course I’ve advocated for several years now.
Among the stocks rated 1 for timeliness by Value Line are Beazer Homes USA (symbol BZH), which concentrates on entry-level and first-move-up buyers; KB Home (KBH), because its PEG ratio (the price-earnings ratio divided by the rate of earnings growth) is just 0.6, and anything below 1.0 is generally considered a bargain; and Ryland Group (RYL), which has seen its share price triple in two years but still trades at a P/E of 10.
The REIT alternative. One warning, however: Although homebuilder P/Es are low compared with the market as a whole (the S&P 500 has a P/E of 20), they’ve escalated significantly in the past few years, from about 8 to about 11. As a hedge, it may be time to look at the sector that ranks 96th on Value Line’s list: real estate investment trusts. If housing prices start to weaken with rising interest rates, then rentals will come back into fashion, and apartment REITs should benefit. Among them: Archstone-Smith (ASN), AvalonBay Communities (AVB), Equity Residential (EQR) and United Dominion Realty Trust (UDR). Each of these REITs currently carries a dividend yield of 4% to 5%.
But the main question about a real estate bubble is, why should you care? If you own a house for the right reason — to live in it — then short-term fluctuations are meaningless. If you are thinking about a first purchase or a trade-up, then the main issues are whether you can afford what you want on your income and whether you want to spend the dough on a house or on something else. If you do buy, don’t expect the value of your house to rise much faster than inflation. Remember, it’s not an investment. It’s something better.
For more on “housing bubbles” see this article.