Is the Housing Boom Over? Home prices have gone up for so long that people think they'll never come down. But the fundamentals tell a different story--a scary one.
By Shawn Tully Reporter Associate Oliver Ryan

(FORTUNE Magazine) – Maybe this is the most ominous sign of trouble ahead in the real estate market: The Kiwanians have gotten into condos.

When real estate investor Warren Hickernell became head of fundraising at the South Sarasota Kiwanis Club, he wanted to try something different. He told his brethren right from the start: "I don't want to sell candy. I don't want to sell little trinkets. Here's what I do ..." What he did was buy modest houses, fix them up, and sell them. The club agreed to put money into his deals. But a couple of years ago Hickernell stopped buying houses for the club. The problem? It was getting harder to find bargains. "Amateurs are running up the prices here," he says. "People are asking too much." So Hickernell came up with a new strategy. He found an old mom-and-pop motel and converted it to condos. It sold out before the renovation was done, and now Hickernell and the Kiwanians are on their second motel.

For years the debate has been raging: Is it a bubble or isn't it? Two years ago FORTUNE looked at the housing market and saw reasons to be concerned (see "Is Real Estate Next?" on While home prices nationally were only 5% to 10% overvalued, we said, some frothy markets, mainly on the coasts, were more than 20% above historical norms. Our conclusion: While the trends were worrisome, "for the nation as a whole, no housing bubble exists ... we're not there yet."

Two years later it looks like "there" is finally here. The housing market is rapidly losing touch with reality. Fueled by interest rates that have remained near record lows, prices have continued to soar, and the gap between home values and the underlying fundamentals such as personal income and job growth is greater than ever. The most alarming development, though, is the change in psychology. "The market isn't acting rationally," says Christopher Thornberg, an economist at UCLA. "It's now an emotion-driven market where people are buying on the expectation of future appreciation." Increasingly Americans view houses not primarily as places to live but as foolproof, can't-lose investments. The passionate faith that money poured into real estate will magically multiply is creating a self-fulfilling speculative frenzy that's bound to end badly.

Of course, the picture varies widely around the country. In hundreds of inland cities, from Charlotte to Cleveland and Dayton to Dallas, price increases are in the low-single-digit percentages, and there is no bubble. The huge gains--and biggest risks--are concentrated in about 30 predominantly coastal markets that encompass 100 million people. Since 2000, home prices in New York, Washington, and Boston have surged 56% to 61%. Prices have jumped 58% in Miami and L.A., and a scorching 76% in San Diego, where the median home price in San Diego County is a staggering $582,000. The breakneck pace is actually accelerating in some of the craziest markets. "The rule of thumb here in Northern Virginia is that if you don't buy now, prices will be 1% higher next month--that's $6,000 on a $600,000 house," says Carl Cecil, a realtor in Fairfax, Va. "People are afraid of getting left behind, so they keep rushing to buy."

Another sign of fever: the unprecedented volume of deals. Home sales keep shattering records at a rate that's totally out of proportion with demographics, incomes, and every other metric. Last year Americans bought 7.2 million new and existing homes, almost 10% more than in 2002, and sales are running at a rate of 7.9 million this year. That pace of 660,000 homes turning over a month is probably unsustainable. It's 50% higher than the average home-sale rate of the mid-to late 1990s. Again, it's the speculative fervor that's to blame. "It's momentum investing, not that suddenly far more people are entering the workforce or moving across the country to higher-paying jobs," cautions Edward Leamer, an economist at UCLA.

When will the day of reckoning arrive? That's impossible to know. As we've seen in the past, bubbles can keep expanding far beyond what sensible observers see as the breaking point. But recent history has taught us something else as well: A market driven by irrational exuberance will eventually come back to earth. The most likely trigger would be a sustained rise in interest rates, coupled with continued increases in a burden on housing that the experts mostly ignore: soaring property taxes. That would help to deflate the rampant euphoria that's driving the market. After years of being ignored, the fundamentals will reassert their control.

The end of the boom won't look like a stock market crash, but it could still get pretty ugly. At best you'd have several years of flat or slightly falling prices in the hot markets. But if the economy slowed as well, the damage could be much worse. In the early '90s slump, for example, prices in Los Angeles county dropped 21%. And this time around there's a real danger that a downturn in prices, or even a stall, could slam the economy, especially all-important consumer spending. Americans have used their homes like ATMs, taking out $662 billion in home-equity loans and refinancings since 2001 --a cash infusion that helped support the economy at a time when the job market was tough and the stock market made investors feel ever poorer. And rising home prices conveyed a sense of well-being that encouraged more spending even by homeowners who didn't refinance. According to Mark Zandi of, home-price gains and refinancing added seven-tenths of a percentage point to GDP growth in each of the past three years.

In light of current conditions, homeowners should be bracing for several years of flat or even falling prices in the hot real estate markets. What does that mean for people planning to buy houses? If you're hoping to stay put for ten years or more, go ahead--you have time to ride out the cycle. But it doesn't make sense to stretch for the biggest, most lavish house you can afford. If you're going to live in the place for just a couple of years, you may be better off going where the true bargains are, into a rental. And if you're looking to invest in houses for a quick killing, forget it: This is no time to gamble on the real estate market.

The boom started innocently enough. During the late 1990s a robust economy and job growth, combined with moderate interest rates, led to steady appreciation in real estate values. But instead of cooling when the stock market crashed and the economy stalled, the housing market, in a history-defying surge, steamed right through the last recession--and hasn't looked back. The average nationwide rise of 47% in median home prices since 1995 (after adjusting for inflation) is like nothing America has ever seen. In the boom from 1982 to 1989, median prices jumped by 14%, and even that was enough to trigger a substantial decline; from 1989 to 1994 they fell by 5% in real terms.

But that's not what most people are prepared for. The level of optimism is incredible, and contagious. A recent UBS/Gallup poll found that real estate is the most popular vehicle for investment in America, and that a majority of Americans surveyed think that it's even more attractive than six months ago, when home prices were far lower. "The expectations of future home prices are spectacularly and unrealistically high," warns Ian Morris, an economist with HSBC. A recent survey by economics professors Robert Shiller and Karl Case found that 28% of homebuyers in Boston, Los Angeles, and San Francisco expect home prices to rise 20% a year for the next ten years.

That widespread euphoria has touched off a wave of speculation by amateur investors. From half-built condos in Miami to sprawling subdivisions carving a checkerboard in the Las Vegas desert, increasing numbers of Americans are buying homes and condos to flip for a quick profit. In California, for example, 3.1% of buyers are reselling houses within six months, up from about 2% a year ago. It's not just the investor-speculators who are feeding the frenzy. It's a host of normally rational Americans. The idea is spreading that because real estate is composed of solid, tangible stuff like land and beams, rising values are somehow grounded in something equally sturdy.

Unfortunately the homeowners who believe that are joining the ranks of speculators at precisely the wrong time. "There's not much distinction between people flipping houses and people who keep trading up to more and more expensive homes because they think they'll make a lot of money," says Leamer. "They're making big, risky bets on housing. Then they buy into new-era theories to justify it."

Sound familiar? The parallels to the tech-stock bubble in early 2000 are unmistakable and scary. In fact, it looks as if America's speculative fervor didn't die when the Nasdaq crashed; it just leapt to houses. Two guys who cleaned up in the Internet boom are trying to work their magic on real estate now. Jim Clark of Netscape, Silicon Graphics, and Healtheon fame was overseeing the renovation of his palatial 47,600-square-foot mansion in Palm Beach when a friend pitched him on condo development in Miami. Clark dispatched his longtime collaborator T.J. Jermoluk to check it out.

Now the two are building a giant, curved-glass condo tower called Blue in a once-rundown industrial district near downtown Miami. Jermoluk thinks Blue will be a big success because it will beat competing towers to the market. But he takes a dim view of the horde of developers planning to flood the area with condos over the next few years. "It's like the dot-com craze," says Jermoluk. "The first IPO did well, so ten more entrepreneurs thought it was a great idea to start the same kind of company. How many dot-com pet-food companies do you really need?" As Jermoluk points out, investors learned the answer the hard way. And he says the same lemming-like rush will drive down prices in Miami real estate. (He, of course, expects to stay one step ahead of the crowd.)

In hot markets like Miami, real estate is a world gone mad: Giant condo complexes with hundreds of units are selling out in days--and the juice is coming from speculators. "I estimate that between 40% and 70% of the units are selling to investors who will never live there," says Lew Goodkin, a leading real estate consultant, who adds that in a normal market the figure is about 10%. "This is the highest level of speculation we've ever seen in the Florida market. It scares the hell out of me."

But so far the speculators are prospering, and their success is luring hordes of new amateur gamblers. "Electricians are flipping condos for $100,000 profits after a year," says Jack McCabe, who heads a Florida market research firm. "They're becoming millionaires." Both Goodkin and McCabe fear that investors who put down just 10% or so to reserve a condo that will be built in 18 months will simply walk from contracts, swamping the developers with unsold units. Jermoluk shares his concerns. "These flippers remind me of the dot-com day traders who had no idea what the company they were investing in actually did," he says. The gold rush isn't confined to condos. "Many of my clients are investors who buy in new developments with no interest in living there," says Rene Bianchi, an agent with Century 21 in West Palm Beach, Fla. "They often don't even come to see the houses they're buying. I just send them digital pictures."

The rub is that the speculators and other investors could vanish just as fast as they appeared. Chris Brown, a developer in Sarasota, sold out his planned 134-unit condo complex in May in a morning. "A year from now we won't be selling out in a morning," he says. "People could be buying bonds instead of real estate, so developers will have to work for a living again."

We already have a sobering example of what happens when hot money alights in a market, then departs like a desert storm. The California speculators who drove up prices in Las Vegas 45% from November to May have moved on. The reason they exited offers a lesson. While they were bidding up the prices of two-bedroom houses from $190,000 to $275,000, the investors, who often never even saw the houses they were buying, tried to rent them to cover their carrying costs. But the fundamentals caught up with them. "Rents not only didn't rise, they actually dropped," says Linda Rheinberger, a Las Vegas broker. Stuck with rents that weren't high enough to cover taxes and interest, many investors bailed. Since May, the number of homes for sale in Las Vegas has soared from 4,000 to 14,000. It now takes several months to sell a $300,000 home, vs. a few days at the height of the fever. "It was like a disease," says Rheinberger. Selling prices of new homes actually dropped 1.2% in July as buyers lobbed in lowball offers and many builders accepted them.

While home prices are often driven by emotion, over long periods they are tethered to two fundamentals: local rents and household incomes. Rents are to houses what earnings are to stocks. They represent the income your house or condo would generate if you decided to lease it out, or what you'd have to pay to live in a townhouse rental or large apartment, say, that's worth about as much as your home. In areas like Las Vegas and Orange County, Calif., which boast an active market for single-family rentals, homeowners can compare the value of their houses to what their neighbor is getting in rent. In areas where few people let their houses, the best proxy is apartment rents. If home prices are immense in Miami or the New Jersey suburbs and apartments are a screaming deal, more people will rent, lowering demand for houses and clamping a lid on prices.

Today something unusual is happening. Even in this modest recovery, the rental market is extremely weak. The explanation is simple: The excitement around mining money from lots and shingles, coupled with the lure of low rates, is persuading people to buy houses even though rentals are, in many cases, a far better deal. The frenzy has driven the ratio of house prices to rents up to levels that are simply unsustainable. According to data from Fidelity National Financial, the ratio now stands at 15.2, the highest level in at least 20 years (see the chart on page 106).

Since the mid-1990s, prices nationwide have risen an astounding 25% faster than rents. As usual, the gap is most glaring in hot markets. Michael Sklarz, a real estate analyst with Fidelity National Financial, calculated the ratios of median home prices to annual rents in a number of U.S. cities. Since 1995 the ratio has jumped to 18 times rents in San Francisco (up from 13); to 22 times in San Diego (up from 13); and to 18 times in New York (up from 11). In Orange County, a house selling for $800,000 two years ago now fetches $1.2 million. But rents haven't budged; tenants are still paying the same amount to enjoy that sumptuously priced home as in 2002--around $4,000 a month.

Those numbers are much like inflated P/E ratios. In time, rents exercise a gravitational pull on housing prices. "House prices are just the present value of future rents, so when the prices decouple, the fundamentals aren't supporting the rise," says Andrew Clark, an analyst with Lipper, a financial research firm. "Prices must eventually fall back into line." Morris of HSBC reckons that if rents rise with inflation, at around 2.5% [a year], for the next six years, housing prices would have to stay totally flat to bring the ratio back into balance, showing no gain at all through 2010.

Prices are also way out of line when stacked against another important yardstick: personal income. From 1975 to 2000, home prices always stayed in the range of 2.7 to 2.9 times median annual income; in fact, 2.9 was once considered a huge number. It's where the ratio stood before housing prices sank in the early 1990s. But starting in 2000, this crucial figure entered uncharted territory. Today the ratio stands at 3.4, 17% higher than just five years ago. And get this: The ratio is now 6.4 in California and five in Massachusetts. Just to return to the once-lofty level of 2.9 would require roughly five years of flat prices--about the same kind of market correction that would be necessary to bring prices back in line with rents.

It is possible, of course, to offer another, more optimistic assessment of the housing market. For instance, what if those towering ratios aren't signs of excess, but rather are reflections of a fundamental change in the supply-demand equation? Indeed, a lot of prominent people are making that argument. "Prices will keep rising," says Bob Toll, CEO of Toll Brothers, one of the nation's biggest homebuilders, because restriction on building will limit the number of new homes coming to market. How will buyers afford ever-rising prices? "People will spend a bigger and bigger percentage of their incomes on housing," he says. "We could become more like Europe, where people will live with their parents for years until they can afford a house."

But on close inspection, the bull case isn't convincing. First, let's analyze the demand side of the equation. Job growth remains tepid, and personal income is rising at a modest 4.2% rate. So the economy is not putting lots of extra money in people's pockets. America is adding 1.3 million households a year through immigration and normal population growth, but that's nothing special. The figure was almost as high in the early 1990s, when real estate prices dropped.

Meanwhile, several powerful forces are working to curb demand. Most obviously, thanks to the dramatic split between prices and incomes, even robust earners can't afford many of the houses now for sale. In California, the median home price is $464,000, vs. $382,000 a year ago. To qualify for a mortgage to purchase that nearly half-a-million-dollar property, a husband and wife would have to earn a combined $112,000 a year; 12 months ago the income threshold was $85,000. Today fewer than one in five California households can afford to buy the median-priced house.

And just as low interest rates fueled the boom, higher rates could end it. Federal Reserve chairman Alan Greenspan has already raised short-term rates twice and has indicated that more hikes are coming. The average rate on a 30-year mortgage is now 5.8%, up from 5.2% a year ago. While the recent economic sluggishness may mean that rates won't rise as fast as once feared, the long-term direction seems clear. "With budget deficits, a chance the dollar will fall, and the risk of an era of high oil prices, long-term rates are bound to rise," says Dean Baker of the Center for Economic and Policy Research, a Washington think tank.

For now, homebuyers are coping with higher rates by taking out adjustable-rate loans. Early last year, about 16% of all new mortgages were ARMs. By this summer that figure had jumped to 36%, and in California--with its glaring affordability problem--60% of new buyers are armed with ARMs. The catch is that in the future those ARMs convert to what are almost certain to be far higher rates after periods that range from six months to five or seven years. Interest-only loans, where homeowners can build equity only through appreciation, are also gaining popularity. (See "The Money Manager" for advice on borrowing strategies.)

When rates do jump, some people who stretched to buy their houses with the shorter-term ARMs won't be able to afford the monthly payments. It doesn't have to be a huge number; a relatively small shift in the ranks of sellers puts heavy pressure on prices. But people holding 30-year fixed-rate mortgages aren't totally protected either. The market value of their house isn't affected by their own carrying charges but by the monthly payments a new buyer must make. Say 30-year rates rise by next year to 7.25% (which is still below the 35-year average of more than 9%). To keep mortgage payments at the same level homebuyers enjoy today, would-be borrowers will have to take out a 20% smaller loan.

There's another powerful threat to demand--one that has gotten surprisingly little attention: the burden of property taxes. Last year total property taxes on homes and condos reached about $235 billion--about 87% of what Americans spend annually in mortgage interest. For many of the elderly, property taxes are the biggest housing expense. And they're exploding, with little relief in sight. In a study of 12 suburban towns outside Los Angeles, Miami, New York, Washington, and other cities, Runzheimer International, a research firm in Rochester, Wis., found that taxes rose an average of 39% from 2000 to 2004. "With the increases in local budgets, property taxes will just keep rising," says Ken Cuccinelli, a Virginia state legislator who lives in Fairfax County. "My taxes have jumped 80% in five years."

To make matters worse, more and more Americans are getting trapped by the Alternative Minimum Tax, which denies most itemized deductions, including property taxes. If Congress doesn't change the rules, the AMT will snare 30 million taxpayers by 2009. So over the next few years, an increasing number of suburbanites will get hit with the full force of the increases in their levies, without the traditional break on their federal taxes. The impact of rising rates and property taxes is unmistakable: It will curb demand for the million-dollar homes.

Let's shift to the other side of the housing equation: supply. The crux of the bulls' argument is that the supply of housing can't keep pace with demand. "This housing boom isn't mainly about demand, it's about supply," says David Lereah, chief economist for the National Association of Realtors. "The problem with supply is that in the coastal cities there practically isn't any."

It's true that towns in the New York and Virginia suburbs, where it used to take 18 months to subdivide land, now require three years or more, and that environmental restrictions are taking more and more land off the market. The homebuilders say that supply constraints are a major reason for their success. "The money and manpower it takes to take land through the zoning process so we can build on it is so great," says builder Bob Toll, "that the towns have practically handed the big builders an oligopoly."

The supply argument makes sense--especially in tony suburbs favored by baby-boomers seeking good schools for their kids and in other areas with unique appeal. But as prices rise, more potential buyers will consider other options, including rentals. Last year's two million housing starts far exceeded the growth in U.S. households, which averages 1.3 million a year. So what's happening to those extra units? Many are built as rental housing, much of which remains empty. The national vacancy rate now stands at a record 10.5%. In places like New York and Boston, while home prices soar, landlords are luring tenants with a month or two of free rent.

And in many strong markets supply isn't constrained at all. Take condos in Miami. Today the high prices are doing just what they should, stoking a rampage in construction. Instead of shunning developers, Miami and many other cities are encouraging them to rebuild their ravaged business districts into gleaming clusters of residential and office towers. In southeast Florida no fewer than 25,000 new condo units are planned for construction or conversion in the next 18 months. "Since about 5,000 new condos sell a year, that's about five years' supply," says real estate consultant McCabe. "Miami will have an enormous oversupply of condos in a couple of years."

When prices get high enough in the hottest markets, buyers simply commute from areas where homebuilding is plentiful and prices are low. That's what's driving growth in the Inland Empire, which comprises Riverside and San Bernadino counties east of Los Angeles and north of San Diego. Houses here cost less than $300,000 on average. So thousands of people who work in Los Angeles are moving in--and spending up to two hours a day on the highway. "If you could save $10,000, it wouldn't be worth it," says Bruce Norris, an investor who has bought many houses in the area. "But when you can save $200,000, suddenly the commute doesn't hurt so much." But even relative bargain spots are not immune to competition. As prices climb in the Inland Empire, says Nick Manfredi, a local real estate investor, more commuters are choosing to rent homes in Orange County and other places closer to their jobs.

Another wellspring for supply: At these prices, retirees are starting to cash out--and moving to up-and-coming locales where it's still cheap. A case in point is Jack Cushing, 74, a veteran of the auto-leasing business in Chicago who's lived the past seven years in Las Vegas. This summer, Cushing decided to take the money and run. "This was a one-shot opportunity to make a lot of money," says Cushing. "My wife and I really liked Las Vegas. I would never have sold if the market hadn't been so strong." Cushing sold his home for $485,000, banked a tidy profit, and spent $400,000 for a home in Phoenix that's bigger--and, he says, even nicer. Look for a lot more arbitrage as the first wave of baby-boomers starts retiring in a few years.

Put all these elements together, and it's hard not to be alarmed. In the worst-case scenario, interest rates would spike, bringing the boom to a sudden end. House prices in the overheated markets would fall steeply. And the pace of sales would tumble: Owners who couldn't afford their mortgages or had to relocate would be forced to sell at a loss, but others would simply pull their homes from the market. That would have an immediate impact on the real estate sector, which accounts for about 25% of the entire economy. New construction would slow dramatically, thousands of real estate brokers would lose their jobs, and the furniture and appliance industries would go into the tank. There'd be the risk of a downward spiral, as consumers started to rein in spending, further slowing the economy--and driving home prices even lower.

Fortunately, that's still a long shot. The most likely outcome is far less dire. If job growth accelerates and mortgage rates don't climb above 8%, real estate will muddle through. Prices in places like New York, Boston, and San Francisco will simply slide sideways for three to five years, not even rising with inflation. Eventually, rents and incomes will catch up. In the rest of the country, prices will still inch upwards, giving the economy a modest lift by supporting a healthy construction market, at least in certain regions. And houses will go back to being homes and nothing more. What would be so bad about that?