OPENING SHOT

Where's the Bubble?
by James K. Glassman

The blazing-hot topic at suburban cocktail parties this spring is whether there's a bubble in the residential housing market. No wonder. In 2004, existing home prices rose faster than in any year since the 1970s. Some markets are going bonkers. Alexandria, Va., is up 31% in 12 months; San Bruno, Cal., 25%; and parts of Manhattan, more than 50%. A front-page New York Times story featured a Florida couple who had bought and sold four properties -- two condos and two houses -- in the space of six months, clearing $500,000. And none of the homes had yet been built! "It is much better than the stock market," says Carlos Lidsky, who, with his ebullient wife, flipped the houses much as investors in the late 1990s jumped in and out of high-tech IPOs.

Uh-oh.

The power of fear. But while such signs of speculation are troubling, there is little solid evidence that a real estate bubble is puffing up. One reason for optimism is that so many people are worried. Fear puts a lid on prices.

Another reason is history. Since 1950, according to data gathered by Freddie Mac, which provides financing for mortgage lenders, U.S. home prices overall have never declined over the course of any year. By contrast, even the broadly diversified Standard & Poor's 500-stock index dropped in 12 years since 1950, and Treasury bonds fell in 17 years.

Certainly, individual housing markets can suffer boom-and-bust cycles. (Look at Houston during the 1970s and California during the 1980s.) But real estate prices as a whole have been remarkably stable. The housing market has characteristics, such as sales commissions and transfer taxes, that tend to dampen volatility. Skipping in and out of a house in a day or two isn't particularly feasible, and the vast majority of home buyers, unlike stock buyers, are in for the long haul.

As a result, though existing-home prices rose faster in 2004 than in any year in a quarter-century, they were up just 8.3%, according to the National Association of Realtors. Since 1950, residential real estate prices have increased an annual average of 5%, says Freddie Mac. That's only a little more than 1% per year after inflation.

n other words, if you buy a house expecting to get rich, you're a fool. Real estate is very different from stocks. With stocks, you get a high reward as a payoff for high short-term volatility. With real estate, you get a lower reward but a smoother ride -- a good thing because most people own just one home at a time, so they don't get the risk-dampening benefits of diversification.

No free shelter. But let's be clear: The house you live in is not an investment. It's an asset that produces nontaxable personal income, in the form of comfort and joy. When you sell your home, you have to buy another one. By contrast, if you sell your General Electric stock, you can do anything you want with the cash. And selling a home when prices are relatively high inevitably means buying a home when prices are relatively high.

Of course, you could sell your house and rent, which The Economist prescribed, only slightly tongue-in-cheek, in a recent editorial. Yes, rentals are cheap these days compared with home values. Owning your own house, however, provides not only extra security (the landlord can't boot you out when the lease is up) but also tax breaks.

And don't forget the consumer's best friend: the glorious 30-year fixed-rate mortgage. You can get a loan that's only slightly above the rate at which the U.S. government borrows. (As I write, the average 30-year fixed-rate mortgage costs 5.5%; the 30-year T-bond, 4.8%.) Unlike the Treasury, you have the option of refinancing your loan to take advantage of a decline in rates.

Getting back to bubbles: In his book Bubbleology: The New Science of Stock Market Winners and Losers (Crown Business, 2002), economist Kevin Hassett defines a bubble as "a period when the price of an asset (stocks, real estate, tulips, etc.) suddenly soars for irrational reasons and then collapses." The key word is irrational. Prices often rise for good reason. For example, the price of a share of eBay rose from $8 in 2001 to $32 in 2003. A bubble? Not at all. The increased value was rooted in fundamentals. Revenues nearly tripled over that period, and profits quintupled. In fact, eBay kept rising and now trades at $38.

What can you afford? In a bubble, prices get divorced from reality -- though reality, in financial terms, is often in the eye of the beholder. One measure is affordability. "If people are paying a realistic portion of their income for housing," Marc Louargand of Babson Capital writes in a letter to clients, "it is hard to see conditions as a bubble."

Louargand cites the housing-affordability index calculated by Economy.com. If the median family income in a market is exactly the amount needed to qualify for a loan to buy a house at the median resale price, then the index is 100. If the median income is more than sufficient, then the index rises above 100. Louargand found that of the 318 metropolitan areas tracked, only 29 had affordability indexes less than 100. "In fact," he writes, "the average index value as of year-end 2004 was 180, which indicates that the median family income can qualify for nearly twice the median home value."

How can so many Americans afford houses at a time of rising prices? High incomes and low interest rates. Rates may rise, but they won't necessarily cause prices to tank. As Louargand points out, "The last time we had high interest rates [in the 1970s], home prices were soaring." High interest rates indicate inflation, which tends to be good for hard assets like real estate. And even if rates jump a full percentage point, the number of sub-100 markets would rise from 29 to 43 -- still a small number.

Even in places where prices are soaring, worries of a bubble could be overblown because higher prices appear grounded in good old fundamentals. Garrett Thornburg, who heads Thornburg Mortgage, pointed out to me that in hot markets, such as San Francisco and Aspen, Colo., "it is difficult to bring new product online." Environmental regulations, zoning restrictions and a shortage of land create limited supply, he says, "so if you want to be there, you have to pay up." Freddie Mac's data also show lean inventories of both new and existing homes.

On the demand side, purchases of second homes are rising as baby-boomers get close to retirement, and "the rapid influx of new immigrants has enlarged the home-buyer pool," writes Value Line Investment Survey's William Ferguson.

Investing alternatives. I am, however, annoyed and concerned when I hear my friends, who have made big, unrealized profits on their condos, talk about putting together pools to buy and sell real estate. As if it's so easy! Sure, consider buying a few rental properties for income and holding them for 20 years. But making money in real estate is no cinch. You're up against some very smart competitors who do it for a living. If you're convinced that prices will continue to climb, it's better to join the experts than to try to outsmart them.

You can, for example, buy stock in homebuilders, a course I've advocated for several years now. Ferguson notes that many of these builders "have strong balance sheets" and own "a large supply of land in a relatively land-constrained business." The home-building sector ranked number one in early March among the 98 industries Value Line covers.

Among the stocks rated 1 for timeliness by Value Line are Beazer Homes USA (symbol BZH), which concentrates on entry-level and first-move-up buyers; KB Home (KBH), because its PEG ratio (the price-earnings ratio divided by the rate of earnings growth) is just 0.6, and anything below 1.0 is generally considered a bargain; and Ryland Group (RYL), which has seen its share price triple in two years but still trades at a P/E of 10.

The REIT alternative. One warning, however: Although homebuilder P/Es are low compared with the market as a whole (the S&P 500 has a P/E of 20), they've escalated significantly in the past few years, from about 8 to about 11. As a hedge, it may be time to look at the sector that ranks 96th on Value Line's list: real estate investment trusts. If housing prices start to weaken with rising interest rates, then rentals will come back into fashion, and apartment REITs should benefit. Among them: Archstone-Smith (ASN), AvalonBay Communities (AVB), Equity Residential (EQR) and United Dominion Realty Trust (UDR). Each of these REITs currently carries a dividend yield of 4% to 5%.

But the main question about a real estate bubble is, why should you care? If you own a house for the right reason -- to live in it -- then short-term fluctuations are meaningless. If you are thinking about a first purchase or a trade-up, then the main issues are whether you can afford what you want on your income and whether you want to spend the dough on a house or on something else. If you do buy, don't expect the value of your house to rise much faster than inflation. Remember, it's not an investment. It's something better.

Weak dollar, low interest rates attract investors

By MIKE SCHNEIDER
Associated Press

ORLANDO, FLA. - There's a new group of buyers in the U.S. real estate market: foreigners.

A weak dollar and relatively low mortgage rates have turned houses and other real property into the investment of choice for a growing number of people from other countries. Some see real estate as a better way to earn money than stocks or other securities, while others are interested in using the properties themselves.

Ana McColgan, of Donegal, Ireland, is in the market for a three-bedroom home in the metro Orlando area.

"We keep coming over there anyway, so I'd rather have it than pay for hotel rooms," said McColgan, who's married with two children. "Maybe we could rent it out to offset the cost of having it."

Lowerys USA, which specializes in helping British buyers find properties in central Florida, saw sales increase threefold last year to $15 million.

"There has been a tremendous sales binge going on here for about 15 months now," co-owner Roy Young said.

Going beyond coasts
Historically, coastal areas have gotten the most attention from foreign investors; the East Coast was attractive to Europeans, while the West Coast appealed to investors from Asia. But the recent boom in foreign investment has included areas such as Atlanta, Chicago and Las Vegas, said Mark Levine, director of the Burns School of Real Estate and Construction Management at the University of Denver.

"We have seen this grow from coastal areas to major cities across the U.S," Levine said.

A favorable exchange rate has been a big factor in the increase. The dollar has fallen significantly over the past three years against the 12-nation euro and the British pound. Last week, a euro was worth about $1.30, and a pound about $1.90.

"There is a sense that the falling dollar does make U.S. real estate more attractive because, relatively speaking, homes are more affordable than they are in other countries," said Walter Molony, a spokesman for the National Association of Realtors.

The weak dollar played a role in Howard Gould's decision to purchase a four-bedroom, three-bathroom home in Kissimmee, near Walt Disney World, for $260,000 in September as a rental-home investment. The Briton wasn't deterred by three hurricanes that had passed recently through the region.

"We bought at what we thought to be a good exchange rate," said Gould, a director of a turnaround and management company in Leeds, England. "We chose Florida because we like it there. We thought property, at least in that particular area, would appreciate at a fast rate."

Attractive mortgage rates
Mortgage rates are also a draw. While 30-year fixed rate mortgages hit an eight-month high of 6.04 percent at the end of March, they have retreated since then and are still quite low by historical standards.

And the Internet makes it easier for foreign investors to look for properties in the United States and then market them to potential renters. Gould, for instance, offers images of each room of his Florida home on a Web site, along with a calendar of which days the property is available.

In 2002, the last year figure were compiled, the leading countries of origin for foreign investors of U.S. property were Japan, Canada, Britain, Germany and the Netherlands.

An upbeat Canadian
Canadian Brian Krausert's family owns a condominium in Hawaii, but they plan to sell it and purchase another one in cash this year. They tend to visit for several weeks during Christmas and Easter.

"I believe the Canadian dollar will grow against the U.S. dollar," said Krausert, president of Beaver Drilling in Calgary.

"If the Canadian dollar becomes stronger against the U.S. dollar, the asset becomes cheaper for us to buy. The prudent thing to do would be to sell now."

Some German clients are looking at golf communities in Atlanta since "everybody is in love with golf now in Germany," said Sebastian Haase, an Atlanta real estate agent with Coldwell Banker.

Other German clients are thinking about purchasing homes in north Georgia's Blue Ridge Mountains.

"It looks a little bit like the Black Forest. There's a homey feeling," Haase said. "Prices are excellent up there."

While Las Vegas real estate has always been popular with international investors, particularly those from Asia, the new focus of foreigners has been on high-rise condominiums springing up around the area.

"They're looking at what good investments they can get, and of course a weaker dollar will enhance that aspect," real estate agent Crete Carey said.

The current conditions have made property in Phoenix more desirable for foreign investors, especially Canadians who for years have been major land investors in the area, said R.L. Brown, publisher of the Phoenix Housing Market Letter.

"In many cases they have been in effect the land bankers for the Phoenix home building community," Brown said. "They have bought and held farmland or desert land to ultimately resell to home builders."

Downward trend seen
After four record years, U.S. home sales are expected to cool off in 2005 as the mortgage rate creeps up. The National Association of Realtors is predicting a 3.2 percent decline in the sales of existing homes and a 5.9 percent decline in new-home sales. But real estate experts said foreign investment in U.S. real estate should continue to grow because of the market's stability and the diversity of properties available.

McColgan plans to go to an expo in Belfast on buying homes overseas next month and has contacted a real estate agent in Florida to help her find a home.

"We hope in years to come to spend a couple months of the year in Orlando," she said.