Prudence is needed in robust housing market

Double, double, toil and trouble: Is there really a bubble?

With apologies to Shakespeare, this is a good question. A bubble traditionally has been defined as a situation where the price of an object rises because of an expectation that it will keep rising, not because the rise is based upon fundamental economics. The “tulip craze” was such a phenomenon in early 17th century Holland.

Obviously, there is concern about the potential impact if there were a bubble in real estate. If there is one, and if it were to collapse, the effect would be significant. Consider the drop in stock market values a few years ago. That was a bubble, and its popping had severe repercussions throughout the economy.

In a column I wrote six months ago, I said the declines in housing values were because of the introduction of other negative factors, not just that housing prices had risen rapidly. In the 1970s, a huge increase in oil prices affected oil patch states. In the early 1990s the loss of 200,000 aerospace jobs in the Los Angeles area caused value declines of about 10 percent. And, a few years ago, the dot.com implosion affected values in Silicon Valley. Let’s look at the current state of affairs.

In the six months since I wrote that column, prices have continued to increase. Housing prices in my neighborhood are up more than 80 percent in the past seven years, so this is something I think about a lot. So it was with interest that I read a report from the Federal Reserve Board of New York that discusses this issue in detail. The report is at :

http://www.newyorkfed.org/research/epr/forthcoming/mccarthy.pdf

The authors, Jonathan McCarthy and Richard W. Peach, studied mountains of housing data published by trade organizations and governmental bodies. They found that traditional measures, accepted as gospel, may be inaccurate. For example, the indices may not give proper effect to the increase in housing quality over the years.

Paying more for a better home is different than paying more for exactly the same home 20 years later.

The indices also do not measure accurately that people don’t just buy houses, they buy houses and land. In fact, where I live, the land is always more than half of the value of the total package. Inflation in total value is more a function of increase in land value than in the value of the structure. In more rural areas, large amounts of land are available, whereas in urban areas, the land is simply not as available.

Those urban areas are precisely where demand is highest and thus the volatility in those markets is highest.

They also show that the affordability of homes is based upon personal income and interest rates. Over the past 20 years, the combination of these factors has increased faster than the prices of homes. This means that, in general, homes are more affordable today than during some periods in recent history. The percentage of family income required to support a home today is still reasonable by historic standards.

Thus, the authors maintain there is no bubble, that the current increase in prices is healthy and are consistent with the strength of the economy.

I would characterize it this way: The growth in personal income and the reduction in interest rates have meant that families can afford to buy more expensive homes, and the market has willingly obliged them.

Having said all that, there is no question in my mind that certain people are acting as if there were a bubble. I hear stories from different markets and in some of them you can find individuals who are acting stupidly. Most of the buyers may be acting rationally, making sound decisions about their housing. Yet a block away another buyer may pay too much for a home because his agent says, “If you just add a pool and fix it up, you’ll be able to sell if for $300,000 more in six months.”

That non-thinking is what gets people in trouble. A year from now, when that prediction does not come true, they may find themselves over their heads and having to sell at a distress price. A year from now, they will tell their story at cocktail parties and it will not sound anything like what really happened. They’ll say the bubble burst, but what really happened was a result of their own poor judgment.

These are times to be careful, but those who exercise prudence will be in good shape.

Randy Johnson has funded more than 3,000 loans as a mortgage broker and is author of "How to Save Thousands of Dollars on Your Home Mortgage." For more information and past columns, visit http://www.savvyborrower.com.