Ranch Houses on Fire
By James K. Glassman

Here we are, full circle. A quarter century ago, I wrote a piece for The New Republic about soaring home prices. The cover featured a cartoon of a husband and wife entering a dinner party, the husband saying under his breath, “When they start talking real estate, let’s leave.”

 

They’re talking real estate again, and no wonder. USA Today recently reported on a community in San Jose called Friendly Woods, where a modest ranch house cost $17,600 in 1963. Recently, an immigrant couple from India beat 25 other bidders to purchase the same house for $880,000.

 

In June, total sales of new and existing homes nationwide set all-time records, and median prices rose at an annual rate of 14.7 percent—the fastest increase since November 1980. But back then, inflation was 12 percent, so the actual jump was just a few percentage points. Today, with inflation under 3 percent, the real annual increase was around 12 percent. That is gigantic.

 

It’s easy, at a time like this, to forget that home prices have a history of stability. Between 1975 and 2003, average home prices rose an average of less than 1 percent yearly (after inflation) in 29 states, and between 1 and 2 percent in 11 other states. At the same time, U.S. home prices overall have never declined since 1950. By contrast, even a broadly diversified portfolio of stocks like the Standard & Poor’s 500 Index has dropped in 12 different years since 1950, and Treasury bonds fell in 16 specific years.

 

So what’s going on with real estate prices today? First and foremost, interest rates are low—averaging 5.5 percent on a 30-year mortgage. My first mortgage in 1981 was 14 percent! At 5.5 percent, the monthly mortgage payment on the average- priced home ($219,000 as of June) was $1,243—eminently affordable for the typical two-earner American family.

 

If rates rise, will home prices fall? Possibly, but more likely they will level off, or not rise so much. Some of today’s chitchat makes an analogy between the stock bubble of the 1990s and high home prices today. But there’s a big difference. Homeowners won’t stampede out of their houses. Where would they live? Higher rates will simply slow down the rate of new purchases. Even if prices do fall in some markets, the decline will be meaningless to most homeowners—who will continue to pay their fixed-rate mortgages and live in their homes, whatever the value.

 

There is a legitimate worry in the present real estate excitement—record purchases of homes by people who aren’t using them as their primary residences. In the first four months of 2005, investors accounted for almost 10 percent of all purchases that involved a mortgage, compared with less than 6 percent in 2001. And the share of mortgages used to buy second homes is now above 7 percent, up from just over 2 percent in 2001.

 

The danger here is that, if rates rise or economic times get tough, the owners of these homes are far more likely to cut and run than owners who live in their homes year-round. Investors and second- home buyers often buy on speculation, hoping for a greater fool to come along and create big capital gains—so their purchases can, indeed, resemble ’90s-era high-tech stock purchases.

 

In some markets, participation of investors is frighteningly high. Investors account for more than one fifth of all mortgages in markets like Medford, Oregon; Punta Gorda, Florida; and Redding, California. And second-home prices in certain parts of Colorado, Florida, Arizona, California, and the islands off Massachusetts are hitting absurd levels.

 

But does this mean we are in a national housing bubble? No. Demand is rising because of low interest rates, rising incomes, and changing demographics (Baby Boomers buying second homes, immigrants buying first ones). And don’t get the idea that there’s something uniquely wild about the U.S. housing market. Prices have also soared in Europe, Australia, and parts of Asia.

 

Valuing a house is not easy. You can compare the returns on home-buying to investments like stocks or bonds, but living in your own home (not paying rent to a landlord) carries certain psychic rewards, like certainty and history, that are impossible to price.

 

While bubbles can certainly pop up in individual markets, the depth and breadth of today’s rising housing market should cause any critic to pause and stifle the urge to find fault. Why should an observer’s view on whether homes are overvalued be better than the considered judgment of millions of buyers who put up their own money?