It looks an awful lot like a movie you’ve seen before, and not so long ago.
Prices are in the stratosphere. Everyone’s making money—on paper. Sellers are asking for the moon. Buyers are ponying up and then flipping for more. Investment clubs are proliferating. Amateurs are quitting their day jobs. Professionals are dreaming up new financial instruments to increase their leverage. A somber chorus of experts is issuing warnings about risks, bubbles, and insanity, but the market is ignoring them. For no apparent reason, prices have risen some 30 percent since the beginning of the year.
If you think you’ve seen this movie before, then you think you know how it ends: with catastrophic drops in prices; assets that are suddenly, irrevocably illiquid; and a long, painful morning after. At least, that’s what happened when the tech bubble burst.
But wait. Maybe New York real estate is different, with a happy ending, except for those unlucky few who walked out or never got in. Houses aren’t like stocks—they’re real assets. Even if prices drop, you can live in your house—something you can’t do with shares of Cisco Systems. Real estate is a great long-term investment, especially in New York: They aren’t making any more land.
And more important, those who’ve waited for the crash have gotten priced out. That two-bedroom you refused to consider at $750,000 three years ago? It just sold for $1.3 million. The crappy one-bedroom-plus-den you got outbid on a year later at $900,000? It’s on again for $1.2 million. Your idiot friends who bought last year “at the top” are now $500,000 richer. You, meanwhile, are still paying rent. Rent! When you own your house, you’re building equity. When you pay rent, you’re just hosing money away.
Most of New York is currently debating these questions—just about everyone except the brokers, of course, who tend to say that things are going up, up, up (and, so far, have been right). The fact is, there is much we don’t know about this real-estate bubble, if bubble it is. Does it end with a bang, with prices plummeting and wreckage on the pavement? Or a slow leak over a number of years? Or do prices simply stay where they are—the proverbial soft landing—making speculators unhappy but bothering no one else very much? Which script should we follow, and how does it end? There are lessons to be learned from the recent past, even if we aren’t condemned to repeat it.
The scariest aspect of today’s real-estate market is the conviction that houses are always a good investment. In the nineties, the mantra was “stocks are the best investment for the long haul.” This had the benefit of being true, then and now; for 200 years, stocks have outperformed every other asset class, including real estate. But the “long haul” is long. For vast stretches of time—1901 to 1920, for example, or 1966 to 1982—stocks have performed terribly. And, in New York, the same goes for real estate.
In the past ten years, New York real estate has been a superb investment. According to the appraisal firm Miller Samuel, the median price of a Manhattan co-op has tripled since 1995, vastly exceeding the performance of, say, the S&P 500, which has merely doubled. If one takes a longer view, however, the picture changes. Miller Samuel says that the median Manhattan co-op cost the same in 1999 as it did in 1981, eighteen years earlier. Over this period, meanwhile, the S&P 500 rose tenfold (before dividends!).
Nor is it true that “real-estate prices never go down.” On the contrary, from 1986 to 1995, after the stock market crashed and the government eliminated some real-estate tax shelters, the price of the median co-op dropped by nearly half, from about $360,000 to about $200,000. Those who bought new pads in the mid-eighties were underwater for more than a decade (and weren’t talking about what a great investment real estate was).
In other words, as Warren Buffett has observed, we tend to base expectations for the future on the experience of the recent past, on what we see in the “rearview mirror.” The trouble is, the recent past is often too short to provide a meaningful picture of long-term price behavior. Real estate and stocks do tend to vacillate around long-term trends, but the vacillations often take the form of ten-to-twenty-year moves, so they are easy to mistake for permanent realities. Thus, we tend to be most bullish at the end of bull markets (when we should be most bearish) and most bearish at the end of bear markets (when we should be most bullish). Over the true “long term”—30 years or more—real estate has indeed been an excellent investment, although nowhere near as good as stocks. Over shorter periods, however, both have occasionally been disasters.
So are we living in a bubble? Well, the average New York apartment has more than doubled in price since 1996, and in some areas, prices have quintupled. New York real estate certainly looks like a lot of the bubbles we’ve seen in the past. Still, many of the commonly cited “signs of the top”—bidding wars, vertiginous prices, lines outside new condo projects, everyone and their brother becoming “real-estate developers”—can be deceptive. When Netscape went public in 1995, it, too, was dismissed as a “sign of the top,” but it was only the beginning (and the Internet is anything but a hallucination).
Those who argue that real-estate prices can only go up have bogus arguments, too, of course: immigration pressure, restrictions on development, the advantages of owning versus renting, declining interest rates. These factors may explain the recent past, but they don’t offer insight into the future, and the only one that has really changed in the last decade is interest rates. A sharp rise in interest rates would almost certainly end the boom, but a basketful of Chicken Little warnings over the past few years has illustrated how hard it is to predict when this will occur.
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.”
On a macro level, what all this boils down to is that despite record-low interest rates and surging house prices, we are spending more of our incomes on mortgage payments and owning less equity in our houses than ever before. We are richer than ever, but most of our wealth is the result of stock and real-estate appreciation, not savings, and, therefore, is exposed to declines in these assets. And for the first time since the forties, we are also spending more than we earn.
What’s more, our financial system is now highly dependent on us making good on our debts. According to Paul Kasriel of Northern Trust, mortgage-related assets now make up nearly 60 percent of all commercial-bank assets, versus about 15 percent in the sixties and 40 percent in the late eighties. As long as we can keep making our payments, we’ll be okay. If we can’t, we may take the banking system down with us.
So what might Chicken Little expect to see in the near future? Barring a terrorist attack, you’re not likely to wake up tomorrow to find your apartment worth half of what it is today. Real-estate markets don’t tend to crash as violently as stock markets. Instead, one day, prices just stop going up and properties sit on the market. Low offers come in, but sellers hold out or wait to sell until prices recover, which they don’t. Eventually, those who have to sell—because of payment shock, relocation, or job loss—take what they can get and prices recalibrate.
One of today’s optimistic arguments is that hordes of buyers will jump in when prices dip—an argument common in the 1999 stock market, as well. What this ignores is how quickly psychology changes when prices begin to fall. People are desperate to buy today, in part, because they fear that prices will be higher tomorrow. In a declining market, the reverse is true: Buyers have an incentive to wait. Furthermore, when guaranteed gains disappear, Johnny-come-lately speculators rush off to the next hot market, further dampening demand. Owners whose equity has been depleted feel poorer and start saving instead of spending, weakening the local economy. Real-estate brokers, mortgage brokers, appraisers, inspectors, architects, engineers, movers, contractors, appliance vendors, and other industry participants make less, and their reduced incomes and buying power further lessen demand. And so on. In the stock market, the saying goes, you don’t want to try to “catch a falling knife.”
For homeowners who haven’t taken on high payments or exposed themselves to rate shocks, a real-estate crash should be tolerable: You can just live in your bad investment and avoid taking a loss. However, if you have banked on further price appreciation to offset a lack of savings, or rapid salary growth to take the sting out of payments, then you may get screwed.
If so, in your misery, you’ll have company. American homeowners have grown so accustomed to raiding their home-equity piggy banks that many have already factored gains and cash-outs into their spending and retirement plans. This, combined with negligible savings and huge debts, could lead to a truly nasty scenario. If home-equity wealth and income drop, the financial squeeze might curtail other spending. This, in turn, would slow the economy, kneecapping the other American wealth repository—the stock market. Although stock performance has stunk for five years, the market is still expensive: It could fall by half and not reach the level at which other bear markets have bottomed. If real estate and stocks collapse, rising unemployment could trigger more defaults and, ultimately, another S&L-style bailout.
Even if a change in the price trend doesn’t result in disaster, it will likely reverberate through the local and national economies. In New York, real-estate taxes represent about a quarter of the city’s revenue. A decline in prices would not dent revenue immediately, but it would slow future growth. And with the city’s budget forecast already in deficit, this might force spending cuts, increased taxes, or both.
One thing we know from the stock bubble: If the real-estate boom ends badly, there will be hell to pay, and it won’t be directed at buyers who overstretched. As in the stock market, such folks will be portrayed as innocent victims duped by a constellation of professional shysters: brokers, appraisers, lenders, et al. One can already imagine the outraged sound bites emanating from televised congressional hearings: “You knew rates would rise, didn’t you? And you knew what would happen when they did.”
Regulatory backlashes are as much a part of market cycles as booms, and in the midst of them, practices once viewed as business-as-usual are suddenly deemed sleazy or criminal. Conflicts of interest in the real-estate industry can make Wall Street look saintly. The entire real-estate-brokerage complex—from agents to mortgage brokers to appraisers to lenders to tax collectors—is wired to benefit not just from homeownership but transaction volume, so even when it is in a buyer’s or seller’s interest to do nothing (often), the pressure is to transact. In a rising market, no one sees this as a problem. But in a declining market, established practices can seem evidence of an industry rotten to the core.
One New York–specific “dirty little secret,” for example, is the “negative pledge” co-op loan. Co-op boards often restrict the amount of mortgage debt a resident can carry, usually to between zero and 50 percent of the purchase price. As the Website of one mortgage broker makes clear, however, with help, these rules can be ignored: “Negative Pledge financing is offered by a select group of lenders that understand the New York marketplace. They don’t advertise their services, but we know who they are.”
How does a negative-pledge loan work? The lender gets in on the game. The borrower gets two commitment letters—one for the permitted financing, the other for the rest—and the co-op gets a resident secretly leveraged to the hilt. New York co-op boards are the last organizations most people have sympathy for, but this may not be a defense for misleading them.
Bear markets for assets are bull markets for politicians and lawyers. In the wake of a real-estate bust, many enterprising regulators will no doubt seek to follow in Eliot Spitzer’s footsteps.
For practical purposes, the bubble debate is academic: You can afford what you can afford, and no one knows what the market is going to do. As Keynes observed, prices can stay irrational longer than you can stay solvent.
The great error made in the nineties was not the failure to recognize that the stock boom might be a bubble: By 1999, in fact, most professionals thought that it might be a bubble but kept buying anyway, because they didn’t know when it would end. The great error was the belief that before the bubble burst, something would change that would tell everyone to get out—that somewhere, a light would turn from green to red.
Having lived through that bubble, and looked hard for the signal, I would respectfully suggest that this is wishful thinking. Lights were flashing yellow, of course—and had been for years—but conditions just kept getting better. Eventually, by the end of the decade, life had been so good for so long that almost no analyst or strategist on Wall Street saw anything that would bring the party to a halt. And in New York real estate, life has been good for quite a while.