The trend shows no signs of slowing down. ‘For Sale’ signs go up in front of homes in many U.S. cities and within days, sometimes hours, offers come in that meet or exceed the exorbitant asking price.


Is this too good to be true? Are home prices a bubble that is soon to burst?


Following several years of rapid home price appreciation, real estate experts at Wharton and in the private sector say current housing prices in the U.S. are based on solid foundations and are not purely a speculative bubble. However, they also say that certain regional markets are vulnerable to a downturn related to local economic conditions, and they note that today’s national rate of appreciation is not likely to continue.


Joseph Gyourko, chair of Wharton’s real estate department and director of the Samuel Zell and Robert Lurie Real Estate Center, points to the San Francisco housing market as a potential regional bubble. “There are clearly markets, the Bay Area being the most prominent, where the pricing implies pretty high appreciation going forward. It’s hard to see how you are going to get that with the collapse in technology. I would consider that a bubble,” says Gyourko. “But in a typical market, no, I don’t think we’re in a bubble. I think prices, while up, are not unreasonable in most markets.”


According to Susan Wachter, professor of real estate finance at Wharton, housing prices have exceeded the rate of inflation for five of the last six years. Prices rose 6.3% last year, reports the National Association of Realtors, and in May they climbed 6.6% over the same month a year ago. From 1996 through 2001 the annual rate of inflation fell in a range from a low of 1.51% in 1998 to 3.38% in 2000. “This increase in housing prices is exceptional, that much we do know,” Wachter notes. “If we look at historical data going back in time, this recent trend is unprecedented.”


Wachter believes it is difficult to proclaim a national housing bubble because she does not believe homebuyers are speculating in the housing market in order to turn a quick profit on their investment. “That may be happening in selected markets but it’s not a bubble that’s going to take down our entire mortgage sector.” She adds, however, that the housing market historically lags other markets in reflecting economic conditions. While home prices may not be building into a full-scale bubble, the recent economic downturn may be reflected in prices that increase less than inflation next year.


Low Interest Rates, for Now

A key factor driving home price appreciation in hot housing markets is today’s historically low cost of borrowing, says Todd Sinai, Wharton real estate professor. But, he warns, “We are at a point in the housing market where homebuyers have got to be very sensitive to interest rates. If interest rates climb, we will see a commensurate drop in home prices in some markets.”


In the 30 years that Freddie Mac has been keeping mortgage rate statistics, the rate for a standard 30-year fixed loan has fallen below 7% in only the years 1998, 2001 and again this year. For most of the 1980s and 1990s they were in the double-digits, says Lawrence Yun, senior economist for the National Association of Realtors.


Sinai says people should think of housing costs as being the annual cost of financing, including the mortgage interest payment, as well as maintenance costs, price appreciation and the return the homeowner foregoes by not investing the down payment in another type of asset. “Right now housing looks relatively attractive because stocks and bonds are not returning much and mortgage interest rates are low,” he says .

For example the after-tax annual cost of financing today is about 5% of the house price, or about $20,000 for a $400,000 home. If interest rates were to increase to 7% after taxes, that would raise the costs to around $28,000 a year for the same $400,000 home. A family who could just afford a $400,000 house at $20,000 a year, he says , may not be able to afford it at $28,000. “It means that prices will weaken if interest rates go up and people should be aware of that.”


The National Association of Realtors’ current forecast indicates mortgage rates will increase to 7.5% next year, up from 6.8% now. If interest rates go up sharply, Sinai says, it would not necessarily create widespread economic fallout because many people would simply not move. They would continue to pay their current low-interest mortgages. But, he says , housing sales volume will decrease, driving prices down as the few buyers in the market command more bargaining power.


“If you’re never going to move, then you don’t really care whether your house goes up or down,” says Sinai. “If you have bought a million dollar house and you have locked in, you can afford it because you locked into an interest rate of 6% for 30 years. You can afford it even if the value drops to $500,000. “But,” he says , “it will be miserable if you decide to move.”


Land’s End?


The increase in housing prices might also be based on a major market change, according to Wachter. Real estate historically has tracked construction costs, with increases in prices balanced by new technology that lowers costs. But there appears to be an important change in the other key component in home costs: land.


While there are still millions of acres of open land across the United States, it is becoming harder to build in the most desirable metropolitan areas where people have access to employment, says Wachter, adding that these controls on development may be limiting the supply of new homes and driving up prices.


“This may be a structural shift. This doesn’t mean we’re not continuing to sprawl. We have a lot of population growth and we’re continuing to increase our demand for spacious living in the suburbs. But there’s a push back on that with local controls and policies to slow growth which inevitably will increase the price of developable land.”


While only a small portion of the housing stock is new construction – about 1-2% – the constraints inevitably are felt in the market for existing homes if fewer people are able to buy new ones. “New housing will be built,” she says , “but with a lag, so in those markets with growth controls it doesn’t mean there will never be new housing. It may mean it will take longer.”


According to the National Association of Realtors there is currently a 4.5 month supply of housing on the market. “From an historical point of view this is very low,” says Yun. “In the early 1990s it was about six or seven months supply so there is definitely no oversupply.”


Despite demand, homebuilders have not overreached, adds Michael Carliner, staff vice president for economics at the National Association of Home Builders. “Whether they are more cautious or lenders are more cautious or because they can’t find labor or land, inventories have been very lean. In previous cycles builders got excited about higher prices and went out and overbuilt. There’s not much indication that has occurred this time,” says Carliner. Homebuilders, he adds, cut back on building plans last fall in anticipation that the terror attacks in September would cut demand. “If anything, now they’re saying they might have been too cautious.”


Housing Market Vs. Stock Market


According to Chris Mayer, Wharton professor of real estate, the housing market tends to lag other more efficient markets in responding to economic change, which may explain why the market continues to boom despite the recent economic downturn. “Roughly speaking, if there is a change in the economy, the housing market changes half as fast as the overall economy,” he says. “If unemployment goes up one year, it can take a couple of years for the housing market to fully reflect the change in the overall economy.”


One reason is that homes are not as actively traded as other types of assets, such as stock. There are no arbitragers to adjust the prices quickly, and there is no way to short the market if investors believe home prices are due to fall.


Also, housing prices are different than stocks because they do not appear to incorporate many predictable changes in future returns. “The industry is very focused on the past,” says Mayer, noting that asking prices for homes typically are based on comparable sales data, which often reflect agreements made six to eight months earlier.


Finally, he say , homeowners are extremely reluctant to take a hit on their house. “There’s a lot of evidence that people don’t like to realize losses in the housing market. Even if they become unemployed they may put their house on the market but not bring the price down until they, and others, have a hard time finding a new job.”


Indeed, since 1968 there has never been a year when home prices fell on a national basis, though there have been years with less than 1% increase, says Yun.


According to Mayer, there is anecdotal evidence that some people are moving money from the stock market into housing, thereby driving up prices. But he says studies do not show much of a link except for Silicon Valley.


Gyourko suggests that stock market transfers would not sustain current housing prices. “I don’t know how much is being shifted out of equities into housing, but to maintain the current level of prices there must be a continued flow,” he says. “It can’t go on forever and it won’t.”


As always, demographics play a part in home price appreciation as the baby boom generation passes through its peak home-buying years. At the same time, the children of the baby boom are beginning to enter the market. “The interesting question now is what kind of housing baby boomers choose in the future,” says Mayer. “If I were worried about one part of economy it is in the market for places with good schools where there may be fewer families buying houses because of demographics,” he adds. “This isn’t next year, but in the next five to 10 years.”


Yun suggests that there is another built-in check on home price escalation that prevents formation of a bubble. “Unlike stocks it is hard to overextend one’s self in buying a home,” he says. “The reason is when people buy a home, most take out a mortgage. When they take out a mortgage there’s a thorough financial background check. Even if the consumer wanted to overextend, the banks would not allow that.”


Mayer says lenders have increasingly linked consumer debt to housing, through home equity loans, for example, because consumers seem more willing to declare bankruptcy to clear up credit-card debt. However, they remain highly reluctant to lose their home and will do what it takes to make payments collateralized by their house.


But that could be tested in markets where lenders gave loans at more than the purchase price, he says . “I don’t think we know yet what will happen with the people who borrowed 125%. The economy hasn’t been bad enough. If we hit a double dip or no recovery in the next year we might reach that point, although that’s not something I’m looking for.”


As for the future, the National Association of Realtors forecasts price appreciation will be 5.3% this year, but slow next year to 4.2%, which Yun says is close to historic equilibrium.


Until then, however, the buzz over housing prices will continue. “I think people will always talk about houses. For most individuals their house is their single largest asset,” says Mayer. “There is some evidence that when house values are going up people think of their house as an investment. But when prices are flat or falling people think of it as a place to live.”