With home prices generally glowing brighter than holiday window displays, does it make sense to buy in the hottest residential markets?
The bull market in home prices continues unabated, sporting the best gains in a quarter century. U.S. home prices rose almost 13 percent from last year's third quarter through Sept. 30, reports the Office of Federal Housing Enterprise and Oversight (OFHEO), a mortgage enterprise agency.
The dicey ``to buy or not to buy'' question need not involve timing the market, though. It's important to focus on building equity and achieving investment goals while exercising caution in choosing financing.
The news on the home front is still cheery for most of the U.S., where prices gained an average 4.6 percent in the third quarter. Of the top-20 metropolitan areas tracked by OFHEO, 11 were in California, four in Florida and two in Nevada. Hawaii showed the highest appreciation of any state with a 28 percent annual gain, followed by California with a 27 percent increase. Atlantic City, New Jersey, rounded out the list of top metropolitan areas with a 24 percent jump.
Soft Landing?
Are home prices headed for a soft landing or a crash? That's certainly on the minds of property buyers in Las Vegas, the fastest-growing U.S. area, where prices climbed 42 percent annually for a nearly 80 percent gain in five years.
In California, areas like Los Angeles, Riverside-San Bernardino, San Diego, Ventura (including Oxnard and Thousand Oaks), have seen home prices more than double during the last half-decade.
Even less-frothy markets like New Jersey and New York have experienced five-year gains of 74 percent and 68 percent, respectively.
How long will the gains continue? There are convincing points on both sides of the question of whether a bubble exists on the East and West coasts. One of the strongest economic indicators supporting bubble conditions is that home prices are dramatically outpacing income growth.
Ingo Winzer of Wellesley, Massachusetts, publishes a ``Local Market Monitor'' ( http://www.localmarketmonitor.com ) research report for several U.S. markets. He says that comparing per- capita income growth to residential price increases shows several major coastal markets are at risk for price declines.
Highest-Risk Areas
Some of the highest-risk areas in Winzer's top-25 list of overpriced markets include Orange County, Ventura and San Diego, California; Atlantic/Cape May, Bergen-Passaic, Monmouth-Ocean and Newark, New Jersey; New York City; Boston; and Miami, Ft. Lauderdale and West Palm Beach, Florida.
``For prices to come down in those (overpriced) markets, you'd have to have some pretty stiff local recessions,'' says Winzer. ``Prices wouldn't come down rapidly but decline about 20 percent over the next several years.''
Most residential property observers from Federal Reserve Chairman Alan Greenspan to the real estate trade group National Association of Realtors deny the existence of a bubble.
The confluence of mortgage rates less than 6 percent, buyers eschewing mediocre returns in stocks and bonds, and baby boomers surging into housing may be pivotal factors.
What to Avoid
In Orange County, California, for example, where Winzer calculates that home prices are almost 60 percent overvalued (leading his list of overpriced markets), demand has exceeded supply for almost four years.
Anil Puri, dean of the California State University-Fullerton Business School, sees moderation on the horizon for that county, yet denies that a bubble is present.
``Home prices could drop 20 percent over the next two years,'' Puri says. ``But it would be gradual. I don't see a collapse.''
The conventional wisdom is that consumer price inflation will eventually boost mortgage rates another point or so in a year's time. That may slow demand and trigger a decline in home prices.
Keeping that likelihood in mind, buyers banking on automatic appreciation should avoid adjustable, interest-only loans and no- money-down loans.
The Right Financing
``Some recent buyers of starter homes borrow with no-to-low equity down with adjustable terms at basement-level interest rates,'' reports ``Emerging Trends in Real Estate,'' a new study by the Urban Land Institute and PricewaterhouseCoopers LLP.
``These folks -- stretched to the limit on car payments and family bills -- count on property values to keep escalating. But higher interest rates and rising mortgage payments make them particularly vulnerable to default,'' the report states.
The simplest rule of thumb when buying in this market is to choose the financing that suits your ability to pay and still build up funds for retirement, college and emergencies.
Don't worry about market movements if you plan to stay in a house, co-operative or condominium for five years or more.
If you need to buy in an overpriced market, consider renting, particularly if you plan to stay in a home less than three years. You may get a better deal on monthly payments.
No-money-down and interest-only loans sound great if you are cash challenged, but they may give you no equity upfront. If appreciation doesn't materialize, you don't have much equity to show for your investment. Building equity is an often-neglected part of wealth-building plans.
Build Equity
Remember that if you eventually move to a less expensive house, the net proceeds are yours to keep tax-free. Generally, you need to stay in your principal home at least two out of the last five years to qualify for this break, although some exceptions apply.
Home equity also can be employed in college financing (for loans or cash outs) and is exempted from most financial aid formulae.
``I think that building equity is really important,'' says Randy Johnson, a mortgage broker with Independence Mortgage Company in Newport Beach, California, and author of ``How to Save Thousands of Dollars on Your Home Mortgage.''
``Assuming you want to sell the house in the future, it will cost you 7 percent (of the purchase price) to do so,'' Johnson says. ``That means if you only have 7 percent for equity, you have zip for down payment for the next home.''
To contact the writer of this column: John F. Wasik in Chicago at jwasik@bloomberg.net .
