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In Real Estate Fever, More Signs of Sickness

Some Economists Warn of Housing Bubble

By Daniela Deane
Washington Post Staff Writer
Sunday, April 17, 2005; Page A01

Matt Marshman watched it happen in one Germantown neighborhood in February. Each house that went up for sale cost about $15,000 more than the last. And the houses were all very much alike.

"We could see the prices going up every day," said Marshman, who with his wife Tracy Hernandez managed to buy the third house that they wanted there. The four-bedroom Colonial was listed for $30,000 more than other sellers had asked for a similar house just three weeks earlier. The couple eventually won a bidding war by offering $26,000 more than the asking price.

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"It was downright scary, " said Marshman, a first-time homebuyer.

It's another insane spring in the local real estate market. As the prime season for buying and selling unfolds, very few homes are for sale, prices are climbing rapidly and desperate would-be buyers are bidding feverishly against each other.

It feels a lot like last spring, and the spring before, and the spring before that.

But now the question comes up more and more: How long can this last?

"It feels like we're on the tip of the razor blade right now," said real estate agent Eric Stewart at Llewellyn Realtors in Rockville. "And we can't remain at the edge of this blade very long."

Although there are no official government tallies yet on how much real estate prices have gone up in the Washington area this spring, local real estate agents and builders estimate that prices may have risen about 15 percent just since the beginning of this year. And that's on top of the 21 percent they rose last year, according to the Office of Federal Housing Enterprise Oversight, a federal agency that tracks sale prices. Over five years, according to the agency, prices here have risen 89 percent.

For homeowners, those increases have meant a rapid rise in wealth, at least on paper, and higher property tax bills. But would-be buyers such as Marshman have found that they have to stretch their budgets more than they ever imagined. Homeowners who believed that by now they would be able to trade up to bigger, better houses find themselves stuck in what were supposed to be starter homes. That means they don't sell, further tightening the supply of houses available.

There are signs that things could be getting out of whack, prompting some economists to warn that the real estate market in at least some parts of the country is in a condition much like the stock market bubble of the late 1990s.

Other economists, however, say rising house values in many metropolitan areas, including Washington, are supported by changing demographics, job creation and still-attractive mortgage rates. Federal Reserve Chairman Alan Greenspan has said the central bank does not think there's a national problem.

Among the symptoms that some say point to a bubble: a widening gap between rental and ownership costs, a spike in the number of investors rather than occupants buying, and a ever-tighter affordability squeeze. Much of the boom in recent years has been sustained by low interest rates, which kept monthly payments down even as purchase prices rose. But the consensus among economists is that interest rates will rise at least a little this year.

"We're in a bubble, and prices could fall substantially," said Robert J. Shiller, a professor of economics at Yale University and author of the 2000 book, "Irrational Exuberance," which appeared just months before the stock market began its slide. A second edition of Shiller's book recently hit stores, with a new section on real estate. In it, Shiller presents figures that show that American house prices have gone up only an average of 0.4 percent a year since 1880, when adjusted for inflation, with most of the gain in the past eight years. "It's just not the investment people think it is," he said. "It's only been a good investment for the past few years."

David A. Lereah disagrees. "There is no national housing bubble," said Lereah, chief economist for the National Association of Realtors and author of the recent book, "Are You Missing the Real Estate Boom?"

"Any talk about the housing market crashing is ludicrous," he said.

Lereah said the national real estate market is an amalgam of local real estate markets and that for a local bubble to burst, there would have to be "rising housing inventories, double-digit price appreciation for several years consecutively and then a local negative economic effect, like big job losses. Right now, most local areas have a lean supply of homes. And the Washington area is creating tens of thousands of jobs rather than losing any."

The Census Bureau reported last week that the Washington area added 75,000 residents last year, making it the fastest-growing metropolitan region outside the Sun Belt.

Lereah pointed out that housing prices nationally, when not adjusted for inflation, have never decreased since his association began collecting data 40 years ago. And he said inflation adjustment is irrelevant, because most people buy homes with relatively small down payments and any increase in price is leveraged into larger returns on those investments.

While the economists debate, the tight market is changing lives. Sharon McKee just bought a one-bedroom, one-bath condominium, without parking, in the Logan Circle neighborhood of the District. It was listed at $375,000, but McKee raised her offer to $412,000 to beat out several other bidders.

"There was very little to look at," McKee said, "maybe one or two new places a week." Previously, she rented a much larger apartment for about $300 less than her new mortgage payments.

And that's one of the disturbing new signs: Renting suddenly looks like a bargain.

The gap between the cost of renting and the cost of buying, which historically move in tandem, has widened considerably in the Washington area, especially over the past year. It is now the widest it has been since 1989, just before the last real estate crash, according to a study by Torto Wheaton Research in Boston.

The monthly cost of renting an apartment in the Washington area in 2004 was just 59 percent of the cost of buying a home, according to the study. That's down from 82 percent in 2001.

"The fundamental relationship between renting and owning has gone astray, which suggests there's an overheating in home prices in Washington," said Gleb Nechayev, senior economist at Torto Wheaton. "There are two ways that the ratio could be restored to a historic norm. Either home prices could decline, rents could rise, or both could happen. The biggest contribution to this balance will come from home prices, we believe."

But Thomas S. Bozzuto, chief executive of the Bozzuto Group, a Greenbelt company that both manages apartments and builds homes for sale, said the gap between renting and owning is more worrisome in other cities and will probably tighten here because rents are starting to go up after a period of stagnancy.

"Rents are not as deeply discounted in Washington as they have been in other parts of the country, like Atlanta," said Bozzuto. "The cost of owning a home is going up here, but rents are rising as well. The apartment market is sufficiently tight here and the demand for apartments sufficiently strong so that you haven't seen rents drop like they have in other markets."

Another worrisome sign to some economists is the high number of investors purchasing real estate these days. A recent study by the National Association of Realtors showed that one-quarter of all homes bought last year were purchased as investments, a high proportion by historical standards. Investors are considered more likely than owner-occupants to try to sell if prices fall.

"One of the signals to watch out for with a bubble is the percentage of homes being sold to investors," said Susan M. Wachter, professor of real estate at the Wharton School of Business at the University of Pennsylvania. "The only problem is that once you notice some of these signs, it's usually too late."

Investors count on a mix of rents and price appreciation for profit. If rents are soft while prices are rising, success isn't a sure thing -- but some are still willing to make a bet.

"The numbers are much more difficult to work now," said Steve Rudin, a former local television weatherman who left the forecasting business a few years ago to become a real estate investor and developer. "It's a much more dangerous game than it was even two years ago. Prices are so high that it's harder to make a profit." Still, Rudin said, he plans to continue investing.

Another alarm bell this spring is that salaries aren't keeping pace with rising home prices, so the affordability created by low interest rates is eroding.

"Home prices have gotten out of whack with any respect to personal income and ability to pay," said William Wheaton, a professor of economics at the Massachusetts Institute of Technology, research director of MIT's Center for Real Estate and a partner in Torto Wheaton Research. "Some of that is due to interest rates. There's a considerable risk of rising interest rates that could blow it all up."

A report released Friday by investment bank Goldman, Sachs & Co. pointed out that affordability -- measured as a ratio of home prices to income -- remains "decent" nationally, but has become problematic in some markets on the East and West coasts, including Washington. In these markets, according to the reports, it is becoming as difficult to afford a house as it was 1981 and 1989, the last two times prices peaked before crashing.

Low mortgage rates have played a huge role in the sizzling real estate market. And most economists predict that mortgage rates, which have been at or below 6 percent for months, will remain low for the rest of this year, rising only gradually to somewhere around 7 percent for a 30-year fixed-rate mortgage by year-end. But factors such as the high price of oil and the weak value of the dollar could kick rates up, economists warn.

To afford ever-pricier homes while keeping monthly payments under control, buyers are routinely taking out interest-only loans, adjustable-rate mortgages or even negative-amortization mortgages, where a buyer borrows more than the purchase price of the home, something that worries even the most bullish of housing economists and builders.

"We're bringing a lot of people with marginal credit into homeownership," Wheaton warned.

If interest rates rise, some of these new borrowers could be caught with mortgages they can no longer afford. And banking on a mortgage payment that will almost certainly rise means betting that home prices will continue rising, too. However, historically real estate markets have been cyclical, with high points followed by troughs.

Nonetheless, Jennifer Tyler isn't worried. She just took out a 10-year, interest-only loan to keep the monthly payments affordable on her new Capitol Hill house.

"Anything can happen in 10 years," she said. "I can move, I can re-finance." She said that her interest-only mortgage, where no principal is paid for the entire 10 years -- and thus she builds no equity unless the house value increases -- saved her about $200 a month and made the difference between buying and not buying.

"Anyway," she said, "the house will almost certainly appreciate, too."

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