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Is There a Housing Bubble? The Great Debate
Home prices are definitely headed for a crash! Or are they? Two of FORTUNE's in-house experts battle it out. Plus: Do you think there's a real estate bubble?

by Shawn Tully and Jon Birger
The Great Real Estate Debate
Everyone from grizzled real estate execs to first-time homebuyers wants to know what’s next for home prices. So we’ll tell you. Twice. In the bear corner is veteran senior writer Shawn Tully, who’s been sounding the alarm about irrational exuberance in real estate since 2002. In the bull corner is new senior writer Jon Birger, who just joined us from Money and thinks comparisons between stocks in 1999 and homes in 2005 are hogwash.
The huge rise in prices is happening precisely because people believe prices will be higher tomorrow. It's true that a drop in real interest rates does raise home prices. But that drop only explains a 20% or so increase. Prices have jumped around 100% in New York City, Miami, Los Angeles, and most other coastal markets in five years. The real problem is that it can’t happen twice. Inflation-adjusted rates will not drop from 1.2% to zero. They’re far more likely to go back to their historical average of 2.7%. In that case, prices will suffer a one-time shock in the opposite direction. As for the fundamentals driving the boom, the biggest fundamental in housing is rents—it’s what earnings are to share prices. Eventually people won’t spend $1 million on a house they can rent for $2,000 a month. Historically the ratio of housing prices to rents in the U.S. has been around 12.5; since 2000 that number has jumped to over 17! Expect the number, once again, to go back to the mean. And it’s obvious that housing on both coasts is becoming increasingly unaffordable, even with the help of exotic interest-only or reverse-amortization mortgages. The California Association of Realtors says that less than one-quarter of California households can afford a median-priced house. America is a fluid society—eventually jobs and residents will flee from the high prices.
QI’ll grant you that there are a couple of markets where the ample supply of undeveloped land makes it hard to justify the huge price increases—Las Vegas comes to mind. And like you, I’m no fan of interest only and other mortgage exotica. But frankly, I’ve never understood why people are so surprised by the idea that the prices of homes—an asset that is usually financed via a mortgage—are rising faster than incomes. Isn’t that the definition of leverage? From 1999 to 2003 income grew at an annual clip of about 5% in California, according to the Federal Reserve. So let's take a California family whose income in a given year rises from $200,000 to $210,000, leaving about $6,000 in extra cash after taxes. Say the family chooses to put 30% of the money—$1,800—toward improved housing. Well, at today’s 30-year fixed rates, that would mean that they could carry $25,000 more in mortgage costs. In other words, each $1 in extra income translates to $2.50 more for housing. I know, I know, you’re going to say that even if incomes in California were rising at a 5% annual clip, according to my math that would account for only half the annual gains we’re supposedly seeing in places like Southern California. But I’d argue that the statistics trotted out by bubble mongers grossly inflate the actual price appreciation taking place. For instance, I’d have to pay 45% more today for my Larchmont, N.Y., home than I paid five years ago—not the 75% reflected by the OFHEO home-price index for my region. The problem with OFHEO numbers is that they include only homes purchased with mortgages below $360,000 that can be bought or backed by Fannie Mae or Freddie Mac. That’s a big distortion, considering that the low end of the market is where most of the speculation takes place. The median price of properties bought for investment is $148,000—versus $236,000 for all existing homes, according to the National Association of Realtors. So it seems to me that the OFHEO numbers over-represent the very segment of the market that is most affected by real estate speculators. It’s like judging the equity market based solely on $5-or under stocks. There’s another, even more comical, flaw in the OFHEO data: These geniuses make absolutely no adjustments for property improvements! If I buy a home for $250,000, spend $100,000 on renovations, then sell it for $380,000, the entire $130,000 difference would be treated as appreciation. © 2006 | Privacy Policy | Terms Of Use