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Study: Housing bubble likely to deflate slowly

Despite fears of  rising interest rates and falling demand, researchers at Harvard predict that jobs growth and increased demand for homes will let the market down gently.
/ Source: BusinessWeek Online

Researchers at Harvard predict that jobs growth and increased demand for homes will let the market down gently.

Gloom has spread like a storm through the housing market in recent months. With rising interest rates and fears of falling demand, housing stocks have slid sharply. D.R.Horton, Pulte Homes, Lennar, KB Homes, and Toll Brothers have lost between one-third and one-half of their market values since their peaks last summer. The research firm A.G.Edwards & Sons declared in a note to clients that "the soft-landing thesis for the homebuilding industry is dead."

But are fears of a housing market meltdown exaggerated? That's the conclusion of a new study by Harvard University's influential Joint Center for Housing Studies. In its annual State of the Nation's Housing report released June 13, researchers took a more sanguine view of the outlook for the real estate market than the growing number of bears predicting that overheated markets like New York, Washington, and South Florida could see a 20 percent to 30 percent price decline in coming years.

Make no mistake, researchers at Harvard are expecting a slowdown from the torrid pace of recent years, given the rise in interest rates and the surge in energy prices pinching many household budgets. But Harvard's housing scholars believe that those economic headwinds will be offset by continued employment growth, and, thanks to steady flows of immigration, an increase in the number of households that will buttress demand.

As a result, they subscribe to the "soft landing" scenario in which price appreciation cools and the nation's housing stock holds its value. And if the bubble does deflate, the study's researchers believe it will "deflate slowly rather than burst suddenly." "We don't see any reason for a panic," says Rachel Drew, a research analyst at Harvard who co-authored the study.

Which isn't to say that housing prices couldn't go down in some markets. Researchers note that in the past 30 years, nominal house prices have fallen by 5 percent or more at least once in about half of the nation's 75 largest metro areas. But, notes Drew, every time a local market has suffered a crash—as happened with Texas in the 1980s and California in the early 1990s—the cause wasn't an overheated market. Two other factors mattered more: Years of overbuilding by developers that left those areas saddled with massive inventory overhangs and major losses of employment (caused by the oil bust in Texas in the 1980s and cutbacks by the aerospace and defense industry in California in the 1990s).

Now, Drew expects demand to remain relatively strong. Thanks to immigration and continued employment growth, the Harvard team projects growth in the number of U.S. households to accelerate from about 12.6 million over the past 10 years to 14.6 million over the next decade (although one concern the Harvard researchers note is that too much recent job creation is in lower-paying jobs). They expect the supply side of the equation to remain in balance as well. In past housing busts, developers were guilty of failing to anticipate the economic downturn and were left with a huge glut of unsold homes that only exacerbated the downturn.

Drew notes that developers have been prudent in anticipating the cooling of the housing market and last year began sharply curtailing the construction of homes built on spec. As a result, the nation currently has a six-month supply of unsold homes (counting sales of new properties and resales of existing homes), which is roughly in line with past housing cycles where a boom was followed by a soft landing.

"In no markets are we seeing major employment losses and overbuilding right now," says Drew. "If that pattern were to hold, we wouldn't expect to see major declines."

Strong equity
Nor are Drew and her colleagues worried about the rise in interest rates, which given the popularity of adjustable-rate mortgages—often taken out by home buyers who needed the low "teaser" rates that are a feature of most ARMs just to qualify for a home—would suggest that many recent purchasers are going to see a sharp increase in their monthly mortgage. Drew notes that the majority of Americans either have fixed-rate mortgages or own their homes outright (mostly retirees).

Most ARMs are structured with a fixed rate for the first five or 10 years, so most of those adjustable rate notes won't begin resetting until sometime later this decade. Indeed, Harvard researchers concluded that only about 6 percent of homeowners have a mortgage that will reset at a higher rate sometime in 2006.

And even if housing prices fall, the bulk of homeowners will be above water with their mortgage. Drew & Co. notes that as of 2004, the most recent year for which data is available, roughly 3 percent of all homeowners have less than 5 percent equity in their house, and a whopping 87 percent of owners have 20 percent of more equity in their home. So fears that a small downturn could turn into a wave of panic selling by homeowners who are suddenly upside-down are overblown, says Drew.

Plenty of skeptics
There are plenty of economists who are more skittish about the housing outlook. Jan Hatzius, an economist at Goldman Sachs & Co. said in an interview that he's concerned about the growing number of unsold homes on the market, which he fears could eventually trigger a downturn in prices that could crimp spending by consumers. Hatzius notes that the National Association of Realtors' measure of existing home inventories was up 33 percent year-over-year through late April.

His analysis of real-time indicators, such as the number of homes for sale on the NAR's Multiple Listing Service, show that inventories have risen another 10 percent just in the past six weeks. "The increase in home inventories shows no signs of abating," he says. "We would be very careful before concluding that the housing market is in a soft landing." If the trend continues into next year, which Hatzius thinks is conceivable, that could result in a 6 percent decline in real home prices, he notes.

To be sure, Drew notes that the Harvard study was based on the state of the market at the end of 2005 and admits her optimism has been tempered a bit by the slowdown that's occurred so far this year. "The first-quarter numbers showed the housing market slowing a little faster than we expected," she readily admits. But for the most part, she stands by the conclusions of the report.