The Exchange

The Housing Market Gets Bubbly Again

Thirteen offers. In less than two weeks. This was not the subdued housing market I had been expecting.

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Like many opportunistic Americans, I decided recently that it’s a terrific time to buy a home. The housing bust seems to have ended yet prices are still far below peak levels of 2006. Interest rates are close to record lows. My calculations showed I ought to be able to buy a decent place with after-tax monthly payments comparable to what I pay as a renter living outside New York City.

I looked around for a while, discovering what “low inventory” means: The good properties attract a lot of interest because there aren’t many of them. After watching a couple of appealing homes sell fairly quickly, I placed my own bid on a fixer-upper with “good bones” in a great neighborhood. On my agent’s advice, I went against my instincts and even offered $20,000 more than the list price.

I lost the bid. A dozen others bid on the same house in an auction held to accommodate all the offers. My agent shrugged it off as the latest evidence of a “crazy market” but it made me wonder if I was participating in a new housing bubble.

'A distortion of the marketplace'

Real-estate experts are starting to wonder the same thing, as prices rise by double-digits in some markets, and other signs of a frenzy develop. “I’m definitely concerned about the potential for an emerging housing bubble,” says Stan Humphries, chief economist for research firm Zillow (Z). “We’re seeing a distortion of the marketplace.”

Economists generally agree the housing bust is over but they’re split on how robust the recovery will be. Several indicators are quite encouraging. Sales of existing homes recently hit the highest level since 2009, while permits for new construction are running at the highest rate since the summer of 2008. Home Depot (HD), which sells more appliances and home-improvement supplies as housing heats up, reported runaway first-quarter earnings. Stock prices for homebuilders such as Ryland (RYL), KB Homes (KBH) and DR Horton (DHI) have risen by more than 25% so far this year.

Still, it’s nothing like a normal housing market. The recovery has been fueled by artificially low interest rates engineered by the Federal Reserve, and virtually all new mortgages these days are underwritten by the back-from-the-dead federal agencies Fannie Mae and Freddie Mac. Strict underwriting standards have left many people with less-than-stellar credit unable to get loans.

Worse, more than one-quarter of all homeowners with a mortgage are still “underwater” on their homes, owing more than the property is worth. Since those people would lose money if they sold their homes, they tend to keep them off the market, which constricts the supply of homes and pushes up prices for those that are on the market. Homeowners with negative equity also find it difficult to downsize to save money, or move to an area where job prospects are better. In that way, the housing bust is still holding back the overall economy.

The real test

Those types of distortions are what may be causing another bubble. It may not be apparent now, but the test will be what happens if interest rates rise by 2 or 3 percentage points, which many economists think is likely during the next several years. Mortgage rates of 6 or 7 percent, compared with less than 4 percent now, would still be in the normal historical range, but they could dramatically change the equation for buyers.

“No doubt you can buy a house today and get a really good price and a low-interest loan,” Jeff Greene, president of Florida Sunshine Investments, said at the recent Milken Institute Global Conference in Los Angeles. “But if you want to sell that house to somebody two or three years later and he doesn’t have a 3 percent loan, how much is he going to pay for that house?”

Zillow has calculated housing affordability in several cities under a range of interest rates, and projected that, if mortgage rates were to hit 6 percent in 2014, Los Angeles, San Diego, Denver and a few other markets could be new bubble cities where the affordability of homes — based on a ratio of the median sales price to the median income — would be well above historical averages. If rates hit 7.1 percent (the long-term U.S. historical average), cities such as Miami, Washington, D.C., and even Pittsburgh would join the list.

Bubbles, of course, can form on a neighborhood-by-neighborhood basis. To spot one, Humphries suggests using mortgage calculators and other online tools to calculate the affordability of a home you might be interested in at a range of different interest rates. If monthly payments seem affordable to you at a 4 percent rate but not at 7 percent, then a future buyer might feel the same way. In that way, rising interest rates could crimp demand for homes, which would force prices down and undercut the recovery.

Buyers should also be wary of bidding wars and others signs of a frenzy, circa 2005. “When people start to blindly say they want the house and price be damned, that’s a recipe for prices becoming detached from fundamentals,” Humphries says.

The good news is that buyers planning to settle down in a new home and grow roots don’t really need to worry about bubbles. As a long-term purchase, well-priced homes are probably a solid investment that will hold their value and perhaps do a bit better than that, especially if inflation picks up. That’s why I kept looking after losing out on the 13-bid home, eventually finding a nice place nearby that seemed like a good buy. This time, there were no competing bidders to contend with, as if my local housing bubble had suddenly played itself out. I’m hoping to close by early summer and stay there for a long time.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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