By Robert Irwin
Question: My wife and I are considering renting out our home and buying another primary residence. I have run the numbers and determined that we could probably achieve positive cash flow with the rental. My concern is with buying a primary residence at the market peak. There has been plenty of talk of a real-estate bubble recently (especially here in San Diego). If the bubble pops, waiting will allow us to buy a property during the down part of the real-estate cycle. But I am afraid that if we wait a year or two, interest rates will climb (where else can they go from 40-year lows?) and home prices will become out of reach. What is the best strategy in today's housing market?
-- Jean-Pierre, San Diego
Jean-Pierre: I understand your concerns about the so-called real-estate bubble popping, leaving you high and dry. However, you must understand that the real-estate bubble is largely a construct of the media.
The current real-estate boom, coming so closely after the boom and bust of the dot-com stock market, makes it ever so easy and tempting for reporters to make the comparison. Internet stocks went straight up, then straight down. Why not real estate? Media analysts find that this topic resonates with the public, so they repeat it. However, as with so many things in life, saying that a bubble exists doesn't necessarily make it so.
Real estate has always had up and down cycles, often lasting around seven years. The last down cycle was from roughly 1992-98 in many parts of the country. Prices dropped as much as 30% in the hardest-hit areas. Since that time, we have been in an up phase. However, there was a lot of lost value to recoup and in some areas only recently have prices topped what they were back in the early 1990s.
The strong growth of families and family incomes over the past decade is influencing the current surge in prices. As a result, some areas are now experiencing housing shortages. Add historically low mortgage interest rates to the equation and it is easy to see why prices are moving up.
But are they really that high? A recent report from the National Association of Realtors indicates that its housing affordability index rose 4.8 percentage points in the fourth quarter of last year to 140.7. (An index of 100 suggests that the median-income family can afford the median-priced house. When the index is above 100, it indicates far more families can do this.) According to the NAR, the median-priced house in the U.S. cost $161,600 in the fourth quarter of 2002 while the median family income was $52,950. This means the "average" family could actually afford a house priced at $227,400. All of this suggests that the current uptick in the real-estate cycle may still have a lot of steam left.
This isn't to say, however, that the market won't turn down. It will; we just don't know when. One indicator to watch is mortgage interest rates. If interest rates turn around and move higher, fewer people will find housing affordable, sales will slip and so will prices. With the government posting huge deficits and competing in the money market for funds, this is an increasing possibility. Other factors could also influence the market -- in either direction.
Even if the real-estate market turns down, however, it is unlikely to "crash." If past downticks are any indication, what usually happens is that as sales slow, homeowners tend to pull their houses off the market, rent out their homes or make some other adjustment. As a result, prices seldom plummet, but usually slowly drift downward. As noted, during the last real-estate recession in the mid-1990s -- the worst since the Great Depression -- the most that prices dropped (in some of the worst-hit areas) was around 30%. Compare this to dot-com companies whose values in some cases have dropped more than 99%.
All of this indicates that, as always, if you enter the market, you take your chances. No one has a crystal ball and no one can call any market with certainty. Yes, prices will eventually go down. But they may go up more before they begin swinging lower again.
