Make Democracy Work

Published October 14, 2005 in East Valley Opinions of the Arizona Republic as “Real Estate boom a house of cards.”

This summer it was hard to tell which was hotter the real estate market or the pavement.

One might imagine the following future: “3 bedroom/1 bath. Separate 2 car garage. Featuring hardwood floors, high coved ceilings, custom window coverings. $839,000.”

In fact, that future has arrived. That modest home was offered for sale in Redwood City near San Francisco in July. Here prices remain significantly lower, but prices have doubled over the last three years.

Prices go up when demand outstrips supply, and, sure enough, as prices have risen we’ve seen some moderating of the real estate market this fall. But, as Federal Reserve chair Alan Greenspan has noted, markets also suffer from “irrational exuberance.” In 1999 I had students who skipped class to day trade in the stock market. After some easy money, they likely lost their shirts. Today my students want to get into real estate. No wonder. Since January 2000, the S&P 500 index has lost 1 percent annually on average, while Real Estate Investment Trusts have returned 23 percent a year. It won’t last.

Especially on the coasts and to a lesser extent here in the Valley, our real estate boom will soon resemble a house of cards. Yes, we’ve stacked those cards to unprecedented heights, but someone opened the door and the dog just came rushing in. The net result won’t likely be pretty.

When we moved to Arizona in 1998 we rented a 3-bedroom 1600 square foot home in Ahwatukee for $1,000 a month. Homes like it in Ahwatukee sold at the time close to the price of the home we bought a year later in Tempe. As homebuyers we paid $817 a month for principle and interest (at 6.875 percent). In this basic calculation, which ignores insurance, property taxes and appreciation, buying with 10 percent down was 82 percent of what it cost to rent.

If we fast forward to 2005, the picture has changed dramatically. Fixed rates have dropped to 6 percent, but home prices have escalated while rents remained flat. Using August data from the Multiple Listing Service to compare homes in the 1400-1600 square foot range in four neighborhoods in Chandler and Tempe, average mortgage payments were now $1500 regardless of whether one paid 10 percent down with a fixed rate or paid nothing down and used an adjustable rate mortgage with initial an interest rate of 4.6 percent for 80 percent of the home’s cost and a “piggy back” home equity loan to cover the remainder. By contrast renting similar homes in these neighborhoods cost only $1,080.

To bridge this affordability gap, the mortgage industry has developed interest-only mortgages which with a one-year adjustable rate of 4.6 percent dramatically drop mortgage payments to $960. The catch is after five years, payments will likely jump at least 75 percent due to higher interest rates and paying back principal. For households squeezing into homes through the interest-only route, it’s a financial impact that will hit many hard. In June the Republic reported that nearly 40 percent of Phoenix area homebuyers were choosing the interest-only route, the third highest rate of any metropolitan region outside California.

Which is why news of rising inflation may be a lot like the dog coming in through the open door.

Dramatically higher energy prices impacting producers will soon be passed on to consumers. Construction already stressed from rising raw material costs will face added price pressures as the Southeast rebuilds after Hurricane Katrina. The Federal Reserve may face a lose-lose situation, where raising short-term rates to halt inflation triggers a recession and not acting leads to an inflation-inspired surge in mortgage rates. Either way, house prices could plummet along the coasts sending homebuyers scrambling.

Recent events may not yet be enough to tip us in that direction, but the question isn’t if, it’s when.

Dave Wells of Tempe holds a doctorate in Political Economy and Public Policy and teaches at Arizona State University. Reach him at Dave@MakeDemocracyWork.org.Sources: