The Dangers of Buying
At the Top of a Bubble
June 26, 2002 -- Buying a new home or investment property at the height of a real-estate market bubble can be a financial blunder that leaves lasting scars -- sort of like shifting all of your retirement savings into technology stocks in March 2000.
In the wake of decade-long housing boom, some areas of the U.S. are working through a long-anticipated cooling-off period, most notably in the once white-hot Silicon Valley region. But many locations are still seeing the same frenetic bidding wars and double-digit home-value appreciation experienced in the late '90s.
Right now, sales of new and existing homes continue to be spurred on by historically low interest rates, aggressive mortgage lending, the desire to shelter rising income levels from taxes, and the sharp selloff in the stock market. That potent mix has spurred many shaken equity investors to seek out more traditional, and relatively less risky, investments such as real estate.
But "relatively" is relative. Make no mistake: home values can depreciate. And given the rather lengthy boom in real estate, the obvious question is: How long can it last? Some think the end of the real-estate boom may be in sight, especially since interest rates are widely expected to start heading higher later this year. Depending on your time horizon and location, investing in real estate right now may be as precarious a wager as betting on Wall Street.
Okay, first, a reality check. If you're planning on buying a home and staying put for the foreseeable future -- say, if you're an empty-nester looking to downsize to the retirement home of your dreams -- then the ebbs and flows of the real-estate market shouldn't worry you too much. Your new home may not appreciate as much as it would have had you not purchased it at the height of a market bubble, but since you're planning on living out your life in that home, its paper value may not be as much of an issue.
But investors hoping to purchase a home and turn around and sell it for a fast buck, or to rent as a source of fixed income, are far more vulnerable when buying in a market bubble, says Frank Cagnetti, a certified public accountant and personal financial specialist at Cagnetti Financial Planning Inc. in Cincinnati. "Everyone goes into real estate with the expectations that the homes will always be rented, and that maintenance costs will be low, and that's obviously not the case whether you're in a bubble or not," he says. "But when you overextend yourself to buy a property in a hot market, and then you incur the additional unexpected costs associated with being a landlord, you put your entire investment at risk."
You may be thinking, hey, a brief economic slump might crimp home prices for a while but they'll quickly rebound and start roaring higher '90s-style once the economy resuscitates. Yeah, right ... just like the Nasdaq.
In fact, history shows that a real-estate market rebound in a location that's seen an intense runup in prices may take longer than you think. A dramatic boom in home prices in Boston between 1983 and 1988 -- where homes increased in value at an average nominal rate of 18% a year, and roughly 16% annually in real terms -- was followed by a painful and protracted bust, according to a 2001 study the Joint Center for Housing Studies at Harvard University. (Nominal rates refer to the rate of interest or return without adjusting for compounding or inflation).
People who purchased homes in that region near the peak of the bubble in 1988 saw prices fall a nominal 16% annually on average over the next four years, while in real terms the homes on average lost a third of their value. Valuations for mid-to-high-end homes reversed course again in 1992 and began moving steadily higher, but by 2000 homes at the lower end of the spectrum had yet to recover the ground lost over that four-year stretch.
"We did another paper that looked at changes in home prices in four major metropolitan areas -- Philadelphia, Boston, Chicago and Denver -- between 1982 and 1999 and were surprised to find a large number of people lost money [on an inflation-adjusted basis]," says Nicolas P. Retsinas, director of the Joint Center for Housing Studies.
If you're a first-time homebuyer who will probably look to upgrade in a few years, or you're looking for investment property, and your seriously considering diving into the market in a region that's still seeing heated market activity, here are some things to consider.
Choose Wisely
Prospective buyer Nick Ravo's not afraid of pulling the trigger on a quick-flip investment property because he's looking in an area that he feels will be bubble-proof over the next couple of years. He and his wife started scoping out investment properties in Boca Raton, Fla., after the value of a three-bedroom vacation home they purchased there had increased to $305,000 from $265,000 in just 18 months.
"We're not concerned, because we're looking at good homes, in good areas," he says. A former real-estate journalist turned private investor, he's witnessed the formidable force of a bursting bubble before in the recessions of the late '80s and early '90s. But he's convinced this time around things are different. "I can see things slowing down in fits and stops. But do I foresee a 30% bubble-bursting plunge in [home prices] in Boca? No. No way," he says. "At worst, we'll get stuck with the property for a couple years longer than we wanted."
Benjamin A. Tobias of Tobias Financial Advisors in Plantation, Fla., begs to differ. Mr. Tobias and his wife also are looking to buy a home in the region as an investment property -- but they're waiting for the bubble to burst first. "The tide will turn when interest rates move higher, as I expect they will later this year or early next," he says. "I've been recommending to my clients to stay away from real estate as an investment for the time being. If they purchase a piece of investment property I really suspect it will be worth less in two years than it is today."
You'll have a better chance of recouping your investment, and perhaps even make a respectable profit, if you choose your home wisely. Buying too much house, or too little house, with the intention of selling in a few years leaves you at financial risk: If yours is among the most expensive properties in your neighborhood, you'll probably have a very difficult time selling at a profit and may even lose your initial investment if home prices drop precipitously.
Getting caught up in heated bidding war now also may require you to overextend yourself financially to obtain an already overpriced home. One ill-timed financial bombshell, say, a layoff or a major illness, could put you at risk of foreclosure.
"Increasingly people are putting less and less down as a down payments, so they start with a smaller cushion, which increases vulnerability," says Mr. Retsinas of the Joint Center for Housing Studies.
Conversely, if you're planning on upgrading to a bigger home in less than seven years, buying too little house puts you at risk of not having its value appreciate enough in that period of time to provide a large enough down payment for your dream home -- forcing you to either put more of your savings on the line when you're ready to buy up, or put off moving to a new home far longer than you had hoped.
Another unfortunate side-effect of depreciating home values in your neighborhood may be that you won't be able to tap as much equity -- or any equity at all -- in a line of credit or home-equity loan if you intend on purchasing fixer-uppers with the intention of reaping big financial returns after making substantial home improvements.
Can You Say 'Pop'?
I bet you thought you finally were going to manage to get through an entire article about real estate without coming across the insufferable: Location, location, location. But sadly, you were wrong. Right now, where you live, or where you're planning on investing, may be key to whether a bubble exists or not.
"There's some question whether there's a bubble or not a bubble, but we're clearly near the top of a market for much of the nation," says Mr. Retsinas of the Joint Center for Housing Studies.
The localities with the greatest likelihood of a significant decline in home prices over the next two years, according to a recent survey by PMI Mortgage Insurance Co., include the Austin-San Marcos, Texas, region; San Jose and Oakland, Calif.; the Portland, Ore., and Vancouver, Wash., areas; Denver; San Francisco; the Salt Lake City-Ogden, Utah, area; the Seattle-Bellevue-Everett, Wash., region; and Phoenix, Ariz. These regions, which were graded as "high risk" areas that previously experienced strong home-value appreciation, are heavily dependent upon manufacturing, particularly high-tech manufacturing.
Manufacturing, which has suffered the heaviest job losses through the current recession, has only recently begun to show signs of picking up, but with economic data sending mixed signals on the outlook for job growth -- a leading indicator of the real-estate market -- it's tough to say whether these localities will avoid the bursting bubble or not.
"It's kind of like trying to time the stock market, most people can't," says Mr. Tobias of Tobias Financial Advisors. "But if you look at the real-estate market and see that prices for most of the U.S. are at or near all-time highs -- and interest rates are near all-time lows -- you have to anticipate a turn."
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