Skip to content, or skip to search.

Skip to content, or skip to search.

Is Your Apartment Like a Dot-Com Stock?

ShareThis

The most compelling evidence that house prices are, if not a bubble, at least way ahead of themselves is the diverging relationship between prices and rents and incomes. Most people prefer to own rather than rent, but when prices get too far out of line, renting becomes irresistibly attractive. Similarly, bigger salaries allow you to afford more house, but if prices grow faster than incomes, eventually people get priced out.

Nationally, over the last few decades, house prices have grown slightly faster than the rate of inflation and in line with the growth of rents and incomes. In the past ten years, however, real-estate prices have shot way ahead of all three. Smaller divergences in the seventies and eighties were followed by corrections, in which home prices fell in real terms. So, nationally we’re probably headed for trouble.

New Yorkers have a response for those who worry about national problems: New York is different. For example, the city is nicer than it used to be, foreigners are frantically exchanging cheap dollars for pieds-à-terre, there are too few apartments, suburbanites are realizing en masse that commuting sucks, etc. As with the “low interest rates” argument, these factors may explain some of the recent price moves, but they don’t provide insight into what will happen next. They also don’t offset New York’s unique risk; namely, that any self-respecting terrorist won’t be plying his trade in Topeka.

New York does appear to be different in one key way. According to Wellesley professor Karl Case and Yale professor Robert Shiller, in most parts of the U.S., the correlation between income growth and house prices is tight. In New York, however, along with California, Connecticut, Massachusetts, and a few other “glamour” states, prices are much more volatile. Specifically, here, instead of rising slowly and steadily, real estate booms and busts.

So is it a bubble? As with the rest of the country, the divergence between New York real-estate prices and incomes and rents over the last decade suggests that it is. Prices have risen at more than twice the rate of either rents or incomes since 1996, a trend that even the mayor’s office believes is unsustainable. The ratio of prices to rents is also higher than at any time in the past two decades, including the late eighties. On the other hand, in the longer term, the conclusion is not so clear. Business360, an economic-research firm, points out that if you go back to 1981, wage growth in Manhattan has significantly outpaced real-estate price growth.

On the supply side, too, the recent news raises concern. Market forces are working the way they are supposed to, and after bumping along flat for most of the early nineties, the number of annual building permits issued by the city has quintupled since 1995. Someday, supply will exceed demand. If this happens when hundreds of new buildings are still being constructed, look out below.

And then there is the final ingredient of most price bubbles: leverage. Leverage is an element in the system that helps boost prices but is itself dependent on prices, such as debt. At the extremes, leverage can create a house of cards.

In the Japanese stock market of the late eighties, for example, leverage came from equity cross-holdings, as companies bought each other’s stocks and reported the gains as earnings. This made earnings growth increasingly dependent on stock-price appreciation. When stocks stopped rising, so did earnings. With the tech bubble, leverage came from red-hot debt and equity markets: Every company that raised cheap cash spent it on software, advertising, technology, and financial and accounting services. When the markets shut down, this put the squeeze on not only the companies themselves but all of their suppliers.

The leverage in Japan and the Internet is painfully obvious now, but few spotted it ahead of time. The good news with real estate (sort of) is that the source of the leverage is blindingly clear. The bad news is that there is a boatload of it. As interest rates have dropped and money has become cheaper, American mortgage consumers have reacted not by paying less for what they borrow but by paying the same and borrowing more. In the past few years, moreover, America’s mortgage lenders have devised ever-more-creative ways to shovel money out the door.

Today, we can graze from a buffet of debt options, including interest-only, adjustable-rate, negative-amortization, “silent seconds,” and home-equity loans. Our American dreams, furthermore, needn’t be stymied by puritanical lenders who insist on our scrounging together a down payment. Today, we can sometimes borrow as much as 125 percent of the value of our houses, and we can buy them with no money down.

Such exotic financing used to be available only to the superrich, but it has recently been extended to nearly everyone. These loans allow you to borrow more money—and, therefore, spend more on your house—for the same initial monthly payment. The catch is that your initial payment may change at some future date, potentially blowing your financial security to smithereens.

One of the most popular loans in New York these days, for example, is an interest-only five-year ARM. According to Melissa Cohn, CEO of Manhattan Mortgage Company, borrowing $1 million with one of these today results in initial monthly payments of $4,166, a savings of more than 25 percent over the $5,915 payment on a standard 30-year loan. Of course, the savings evaporate when you have to begin paying back principal. At today’s interest rate, your payment jumps to $5,845 (costing you more than $100,000 versus a 30-year fixed loan). If rates rise to, say, 7 percent, it will be $7,067. Of course, no interest-only ARM buyers expect to have to deal with such “payment shock,” because they intend to have sold or refinanced long before the end of the fixed-rate period (which, if prices rise and rates don’t, they can). In a rising market, the power of such leverage is magical. The ability to pay less and borrow more enables even the most cash-strapped buyers not only to get into the real-estate game but also to make money hand over fist. If prices rise just 10 percent a year, an 80 percent loan amounts to just 50 percent of a house’s value in five years—allowing the owner to take more cash out—and a 20 percent down payment reaps a staggering 300 percent return (pre-transaction costs).

If the consumer understands what he is buying—and, most important, makes a smart buying decision—the choice of mortgage products is good (only after a crash will we blame mortgage brokers and lenders for suckering us into taking on too much debt). The trouble is that leverage is just as powerful in the other direction. If interest rates rise, there will be a payment shock even if the owner refinances with another interest-only loan. If prices fall, even modestly, an owner’s down payment may be wiped out.

Ten years ago, in the wake of the late eighties real-estate crash, we were terrified of overleveraging ourselves. After a decade of price appreciation, however, we aren’t. “Kids buying today have no fear,” says Frank Gooden of Park Slope mortgage broker First Merchants, Inc. The average buyer these days assumes not only that prices will continue to rise but that he will soon make a lot more money, turning payments that are painful today into a no-never-mind.

Exacerbating our tendency to take on increasing risk is our lenders’ tendency to do the same thing. According to Melissa Cohn, in the eighties, lenders capped monthly mortgage payments at about 28 percent of a borrower’s gross monthly income. Now they occasionally allow payments up to 50 percent. In other words, a $100,000-a-year buyer who in 1985 would have been able to qualify for payments of $2,300 a month can now qualify for payments of $4,200. As Cohn says, “You can get approved for way more than you can handle.”


Advertising
Current Issue
Subscribe to New York
Subscribe

Give a Gift

Advertising