FOOL ON THE HILL
Is Real Estate Safe?

For most Americans, our home represents our largest asset and our largest debt. Naturally, we fear a housing bubble. No matter what the market, we should plan to own a house for five or more years. If we plan to sell in the next few years and are counting on the current value of the home to sustain us, we should research our local market's vulnerability.

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By Tom Jacobs (TMF Tom9)
August 22, 2002

Two-thirds of Americans own their homes, and for most of us, that home will be the largest percentage of our lifetime net worth -- and the largest debt we ever take on. With every media outlet screaming "housing bubble," we take notice.

Do we really face a widespread decline in residential housing values? The kind of deflation that, with the bear stock market, makes economists point to a Japan-style decade-long malaise? And if so, what does this mean for the individual homeowner or homeowner wannabe?

To reduce price risk, buy a home you plan to keep for a long time. If you must sell within a few years, do your homework now (so to speak!).

What's a bubble, and is it happening now?
Let's define "housing bubble" as "a dramatic run-up in prices such that a dramatic decline ensues." On our Berkshire Hathaway (NYSE: BRK.A) discussion board, Fool Community member gdefelice mentions the article, "The Run-Up in Home Prices: Is it Real or Is It Another Bubble?" by Dean Baker, co-director of the Center for Economic Policy and Research. The center's website suggests a left-of-center bent, but the 19-page analysis is all numbers and no political tilt. What follows is only a brief summary. Interested readers should read the full report.

Baker's thesis -- backed up by 50 years of data -- is that housing prices over the long run increase only at the rate of inflation, represented by the consumer price index (CPI). This persists despite occasional fluctuations in supply and demand, regardless of rising incomes or changing mortgage rates. But currently, average housing prices have outstripped inflation by 30%, and Baker asserts only one-third of that is due to the increased price of renting. He examines the increased demand and higher prices, and dismisses popular theories that an increasing population, lower mortgage rates, and new loan programs are to blame.

Over the long run, he says housing prices will come back to growth in inflation. Baker projects a possible 11% to 22% decline in average housing prices nationally, recognizing this will mean little or no decline in some areas, and large declines -- as much as 40% -- elsewhere. He believes this will increase unemployment up to 1.5% and reduce GDP by 1.4% to 2.9%, with a decline in residential construction responsible for lowered GDP of 0.6% to 1.3%.

Serious stuff, if right.

Vacancy rates up, landlord costs increase
For more thoughts, I turned to Fool Community member and long-time real estate investor Jim Locker, who piqued my interest when he posted on the Real Estate Investing board that he has "a lot of property for sale." He explains why.

Jim believes the market for investment real estate is a better indicator of a housing bubble than residential housing. Currently, the 9.1% national rental vacancy rate in Q1 2002 is the highest since 1960, when the Census Bureau began collecting the data. Locker says the lower the vacancy rate, the lower the turnover, and the lower a landlord's costs. Conversely, higher vacancy rates mean higher turnover and more costs from finding tenants, cleaning and updating between tenants, and paying at least minimum utilities for vacant units -- you don't want the pipes to freeze. If you own a vacant rental house, you're responsible for all the exterior maintenance too (such as mowing the lawn). So expenses increase, income may even decrease, and the mortgage payment -- your largest cost -- likely remains constant. A business can cut costs, but Jim argues a real estate investor doesn't have the option -- in fact, the opposite is true. Unavoidable costs increase.

Locker says it's important to remember that the real estate investor is in the business solely to make money. He wants money left at the end of the day, after income minus expenses, exclusive of any equity paydown or capital appreciation. And at least two factors squeeze Locker tightly. First, his property insurance rates have jumped 100%, despite the fact that he is a low-risk insured. (Residential homeowners have undoubtedly watched their rates increase, too. Ours is up 50% this year.) Second, his vacancy rates are sky-high. So Locker is forced to sell a number of properties. They have simply become uneconomical.

Why the high vacancy rates?
Vacancy rates are high, not because of overbuilding, in Locker's opinion, but because lower interest rates have reduced the monthly carrying cost of owning a home, increasing the demand. Low or no down-payment mortgages have proliferated, too. As vacancy rates increase, landlords can't raise rents, and may have to reduce them. And again, as vacancy rates increase, so do landlords' expenses. 

So where does that leave us? Unlike residential homeowners, who, as long as they have jobs and a fixed-rate mortgage, can stick out a price decline, full-time real estate investors will likely be the first to unload their properties. This will reduce prices and increase foreclosures. Banks will then be stuck with under- or non-performing rental properties. That brings to mind the savings-and-loan debacle of the early 1980s, when among other things, tax incentives for commercial real estate led to increased lending for urban overbuilding -- and then defaults.

Rents would then decline further, and at some point, the after-tax cost of owning a home becomes less favorable than renting, even including equity build-up and possible appreciation. No one's sure where that point is. But that possibility is what leads people to talk about Japan-style deflation -- and why the Federal Reserve has been pumping up the money supply like nobody's business.

After we spoke, Jim posted his thoughts on the Real Estate Investing board. Check them out. 

Know your market
If you are a current homeowner, stay calm. Think carefully. If you live in a house you're keeping for five or more years, and you don't need your home's current value for financial security, you can probably ride out any decline. As with stocks, you lose nothing until you sell. All things being equal (quite a qualifier, but true), time favors the long-term holder. Have an emergency fund so that if you lose your job, you can better survive the job search without taking drastic measures, such as selling your house.

But if you know you absolutely must sell within a few years, get to work. Knowledge is power. Real estate is local, local, local, so you must learn about your local market. 

How? If Jim Locker persuades you, find out about the local rental vacancy rates. Are they trending higher or lower? Call a real estate professor at your local university. Follow your newspaper. Call or, better yet, email the real estate writer. Do searches on Google.com. Follow the real estate classifieds. Keep your eyes open -- see many "For Rent" signs? A lot of new multi-family construction mean added supply and possibly reduced rents. Builders must obtain permits -- find out the trend in permit numbers.

The worse the trend in vacancy rates, according to Jim's thesis, the worse the portent for residential housing prices. You may want to consider making the move today that you know you would make in a few years. But don't do it based on this column or one person's advice. Gather as much information as possible from many sources.

Prospective buyers should study, too
People tend to make buying a home an emotional, not a rational, decision. Refuse. Resist. The minute you fall in love with a house, they've got you. You'll pay anything.

If you're looking in a very hot market, buy like you buy stocks: Use only money you don't need in the next five years. Plan to own the house for at least five years, and longer is better. Ask yourself honestly if the house is within your means. What if the value of the house were to drop? If you had to move but didn't want to sell at then-current prices, could you afford to rent it? That takes you back to researching the local rental market.

Just as you study any individual stock you might want to buy, study the housing market where you are looking. Check out recent sales prices in the neighborhood using a free service, such as Yahoo! Real Estate Home Values. Get help from a real estate agent you trust, but do not become your real estate agent's buddy. Maintain a respectful professional relationship. No matter how good a real estate agent (like "stock broker") is -- and there are many excellent ones, like ours -- agents are like full-service stockbrokers. The agent doesn't get paid one red cent until there's a transaction. In many states, even the buyer's agent owes a legal obligation to the seller. Remember that anyone paid by commission is a salesperson.

A last word on your home, a.k.a. your personal bank
Finally, be honest with yourself when you refinance. Are you using the money you take from that process or from a home equity line for essential and important expenses that add value (or pleasure, if you plan to own for many years)? Or are you using the value of your home for current consumption -- such as vacations? Would you do that if the money were labeled "retirement fund"?

You don't have to worry about a housing bubble if you plan to own as long as possible. You can ride out a housing price decline. Be as informed as possible. Knowledge is power.

Let us know what you think about the real estate market in our poll.

[Know a friend who's considering a home purchase or a homeowner close to retirement? Click on "Email This Article" below.]

Tom Jacobs (TMF Tom9) reveals all in his profile, meticulously prepared according to The Motley Fool's disclosure policy.