In Bay Area, fears about a bursting real estate bubble persist as prices keep rising Article by Rick Jurgens A steep, five-year climb in Bay Area house prices may have ended, and prices are likely to remain flat or even decline over the next couple of years, economic forecasters say. But please don't call it a bubble, they say -- even though the downturn already taking shape in the housing market follows a run-up that for a while seemed to defy the economic laws of gravity. Three years ago, it seemed there was no downside to owning a home in the Bay Area. Home prices had risen briskly on the strength of a roaring regional economy driven by technology and Internet companies with skyrocketing stock prices. The technology bubble -- these days, with the benefit of hindsight, almost everybody calls that a bubble -- burst in 2000. Stock prices plummeted. In the Bay Area, more than 200,000 jobs vanished, and the energy crisis drained billions of dollars from the economy. Gaping deficits appeared in state and local government budgets. That should have been bad news for the housing market. Instead, after a brief pause in 2001, housing prices resumed their hike into the stratosphere. In the East Bay, home prices doubled between 1997 and 2002, according to an index compiled by Fiserv CSW, a Boston home price survey firm. Continued strength in the local housing market should be music to the ears of long-time homeowners, especially those looking for growing real estate wealth to salvage Nasdaq-ravaged nest eggs. It also should please recent buyers, with the promise that their high-priced houses -- over half the 9,000 Bay Area home sales in December were priced at more than $416,000 -- will prove to be sound investments. "Everyone shakes their head but laughs with glee at the value of their home," said Tom Jones, executive director of the California Futures Network. They may not be laughing for long. Some economists see signs that house prices may be poised for a plunge. The pessimists say prices have reached unsustainable levels, due to demand fueled by low-interest rates, an irrational faith that prices will always go up, and buyers scrambling to find a home before prices go even higher. "I don't think a 20 percent drop is out of the question," said Cynthia Kroll, an economist at UC Berkeley's Fisher Center for Real Estate and Urban Economics. Those currently considering home purchases should be aware that a year from now "they might not be able to sell that house for what they paid for it," she warned. Joe Mattey, vice president for portfolio management at PMI Group, a Walnut Creek mortgage insurer, doesn't see a bubble in the housing market, either nationally or regionally. "Actual decreases in home prices are very rare events," he said. Still, the nationwide economic downturn has hit hard locally. "The Bay Area is at ground zero of the current contraction, especially in San Jose," Mattey said. And that has put pressure on home prices in some areas. Mattey, in a November survey, saw a 60 percent chance that Silicon Valley home prices would fall over the next two years. In the East Bay, Mattey saw a one-in-three chance of a decline in average home prices over the next two years, and a one-in-13 chance of a decline of 10 percent or more. Nervous Bay Area homeowners may already hear footsteps. In the region's commercial real estate market, office vacancy rates reached 20 percent at the end of 2002, and rents fell 20 percent from their peak in 2000, according to Grubb & Ellis, a commercial real estate broker. Ned Spieker, a prominent Bay Area real estate investor, recently predicted that the commercial property slump would continue until 2005. Apartment rents have also fallen sharply. At large apartment complexes in the East Bay, the average rent of a two-bedroom, two-bath apartment fell 15 percent, to $1,408, in the fourth quarter of 2002 from $1,653 in the first quarter of 2001, according to RealFacts, a Novato real estate firm. Vacancy rates for units of all sizes soared from 2.7 percent to 6.1 percent during the same period. Home prices have also fallen sharply in some tony Silicon Valley communities. Michael Sklarz, an analyst for Fidelity National Information Systems, said the average home price in Palo Alto fell 33 percent, from $1.2 million in the fourth quarter of 2000 to $809,000 in the fourth quarter of 2001. Nearby, in Saratoga, the average price plummeted 40 percent, from $1.8 million in the second quarter of 2000 to $1.1 million in the fourth quarter of 2001. Prices in those cities have recovered somewhat since then. Which raises the question: What is a bubble? Economists believe that bubbles can occur in markets where investors' emotions swell into a mania and sweep aside concerns about economic fundamentals. At a recent conference to discuss whether a nationwide housing market bubble exists, Robert Shiller, a Yale economist, noted that housing price changes in a region normally track changes in employment and income. Recent increases in Bay Area home prices, despite declines in employment and income, could be "evidence of speculative psychology" taking hold in the market, he added. Others are skeptical of this application of a theory that explains price explosions and collapses in markets for stocks and, in 17th-century Holland, for tulips. The nature of single-family housing markets prevents speculation from becoming the dominant driver of prices, said Mattey, the PMI economist. Still, residential real estate markets do crash. Home prices in Japan soared in the 1980s and early 1990s, then fell by 70 percent. Waves of foreclosures swept Boston and Houston in recent decades. Property values dropped 20 percent to 30 percent in Southern California after post-Cold War cuts in defense spending derailed that region's economy in the early 1990s. Bay Area values sagged more gently, about 10 percent in the East Bay. The crashes were precipitated by the retreat of speculators, skeptics say. "In a bubble, there's a speculative element," said John Karevoll, an analyst at DataQuick Information Systems Inc., a La Jolla real estate information firm. California markets have shown no significant increase in such indicators of speculative activity as absentee owners and flipping -- resale of acquired properties within nine months, Karevoll said. House markets are protected from manias because suppliers can usually respond quickly to sharp drops in demand, analysts say. Cautious lenders can put the brakes on new projects, especially in the Bay Area with its rigid building restrictions and scarce land. And past slumps have shown that owners are unlikely to flood the market in a rush of panic selling. "If house (prices) drop, people can just wait," said Raphael Bostic, an economist at the University of Southern California's Lusk Center for Real Estate. So far demand has remained surprisingly strong in the Bay Area and other housing markets around the nation. Economists and industry executives say low interest rates -- under 6 percent for 30-year, fixed-rate mortgages in late January, according to Freddie Mac, the Federal Home Loan Mortgage Corp. -- are a tonic that has sustained housing demand in an otherwise anemic economy. But a market that depends for survival on extremely low interest rates could be killed by a rate increase. "Interest rates are clearly propping up the residential market," Spieker, the real estate investor, said recently. "It's Katy bar the door if interest rates, for whatever reason, go up." "Even a slight rise in mortgage rates could ... slow the rate of appreciation in home values," economists for the Federal Deposit Insurance Corp. warned recently. But that won't happen, the bulls say. "The chance that interest rates are going to knock the legs out of this market isn't there," Ken Goldstein, economist for the Conference Board, said at the recent bubble conference. Still, another analyst at the bubble conference worried about other storm clouds on the horizon. Doug Duncan, chief economist for the Mortgage Bankers Association of America, said that a prolonged war with Iraq or a major terrorist attack could drive up oil prices or sap the confidence of consumers and investors. A double dip recession poses yet another threat, he said. Nicolas Retsinas, director of Harvard University's Joint Center for Housing Studies, said that ultimately the health of the housing market depends on an economy that produces jobs: "As long as people are still working, everything is going to work out, but that's the kryptonite." Mattey, the PMI economist, said the housing market could survive temporary job losses but could be hit hard by structural changes that result in permanent job losses. A downturn could be triggered by people moving out of the Bay Area, he said. Declines in home prices would hurt those who need to sell to take jobs in other regions and those who plan to retire soon and cash out their built-up home equity. Long-term owners would find the pain cushioned by the substantial rise in home prices in recent decades, which would likely leave many as net winners. Those who bought near the peak of the market or tapped their wealth by taking out home-equity loans might wish they had similar cushions. A housing price decline could have further repercussions in the regional economy, by reducing the wealth available to local consumers and by slowing building activity and construction jobs. Not everyone is dreading a downturn in prices. That could be good news for those seeking shelter in an overheated market, lowering the barriers to affordable housing development, advocates say. But most in the industry shun bubble talk. Some Realtors worry that it might become a self-fulfilling prophecy. "The tone of the conversation really defines the outcome," Patrick Stone, chief executive of Fidelity National Information Systems, warned the recent bubble conference. Economists are skeptical. Bubble talk won't produce economic changes that wouldn't otherwise occur, Kroll said. Besides, she added, "it's good that people are thinking that prices are high" as they consider making deals in the current market. Besides, said Thomas DiMercurio, president of Fidelity National Asset Management Solutions in Westminster, Colo., frothy optimism won't save a housing market that's about to fall over a cliff. DiMercurio, who makes his living disposing of foreclosed homes reclaimed by lenders from delinquent borrowers, recalled the upbeat mood that preceded market collapses in Boston and Houston: "Up until the precipice, you can be hearing really positive things."
February 2, 2003