Haunted Houses

TOM NOON REMEMBERS LIKE it was yesterday when California's last housing boom stalled. After unheard-of sales and price growth throughout the 1980s, the state's housing bubble started leaking air in the spring of 1990 and deflated “pretty quickly,” says Noon, D.R. Horton's COO-California. The causes included usurious interest rates, severe job losses, and parity between supply and demand. The consequence was a six-year-long recession during which builders and unemployed homeowners evacuated the state in search of more-stable ground.

Those conditions don't exist today, in California or many other markets where prices and sales have exploded. The nation's housing market is on an unprecedented roll, propelled by favorable demographics and low interest rates. Horton, the nation's largest builder, reported a 26.9 percent revenue gain on a 15 percent increase in unit sales for the nine months ending June 30. But this boom has also produced exorbitant price increases—“froth,” to use Alan Green-span's buzzword—driven by inventory shortages and mutated by speculative buying.

The housing market attracts attention because it is one of the country's few reliable job producers, because so much of the banking industry's assets are tied up in mortgage lending, and, of course, because everyone needs a place to live. But everyone and his brother seem to be weighing in on whether the latest boom will end with a bang or a whimper and what either result might mean for the country's economic health.

One authoritative source, the National Association of Realtors' (NAR) chief economist David Lereah, says that homeowners' net worth has swelled by $3 trillion during the market's run-up. Barring an unlikely spike in interest rates or an unforeseen international “event,” Lereah expects demand to stay reasonably solid. (NAR projects that home sales in 2005 will rise 2.8 percent to 6.97 million units.) But he told The Wall Street Journal in July, “You can't sustain double-digit price appreciation and keep homes affordable.”

That Journal article cites first-quarter data from Economy.com showing that median-income households in 41 of 325 metro areas couldn't afford their markets' median-priced homes. The FDIC stated that, during the 12 months through March, price appreciation outpaced income growth in 38 of 50 states. Bears such as Morgan Stanley's chief economist Stephen Roach disparage the current boom as a house of cards whose day of reckoning has been delayed only by “a mountain of debt” taken on by buyers through interest-only and negative amortization mortgages and propped up by foreign investment capital.

On the other hand, a sizable contingent of economists and builders appears to agree with Credit Suisse First Boston's analyst Ivy Zelman, who sees a “bubblish” housing sector with some markets more vulnerable than others to imploding. In its report “U.S. Home Prices: Does Bust Always Follow Boom?”, the FDIC estimates that 55 markets had inflation-adjusted price appreciation of at least 30 percent over the past three years. But history is instructive here: The FDIC also notes that between 1978 and 1998, there were 54 booms and 21 busts (when nominal prices fell at least 15 percent over a five-year period). This suggests that most booms settle into periods of regional price stagnation rather than spiral into national disasters.

Some economists insist that today's boom simply conforms to prevailing market fundamentals. Mark Vitner, senior economist for Wachovia's Economics Group, explains that over the past two decades, the U.S. population has increased by 57 million people, three quarters of whom reside in the 15 states under the greatest price appreciation pressure. Vitner also notes that “there's absolutely no supply out there,” and U.S. Census Bureau data show that of the 439,000 homes on the market nationwide in May 2005, 20.5 percent hadn't been started and 57.2 percent hadn't been completed.

Two Federal Reserve Bank of New York economists, Jonathan McCarthy and Richard Peach, wrote last December that between 1990 and 2003, American families gained 130 percent in purchasing power due to steep interest-rate cuts and a 50 percent gain in median household incomes. During those 13 years, by comparison, the Home Price Index calculated by the Office of Federal Housing Enterprise Oversight rose 72 percent.

BUILDER looked back at three regions with tumultuous housing-sector histories —Texas, New England, and California—and found that sales typically declined more precipitously than did prices. But when bubbles burst, recovery took years and, by winnowing smaller companies, often strengthened the competitive positions of deep-pocketed large public builders.

David Weekley's worst memory of Texas' economic descent in the mid-1980s was “buying down” mortgages, by as much as 10 percent of the selling price, to entice buyers when interest rates were 18 percent. “It was bizarre,” recalls Weekley, chairman of Houston-based David Weekley Homes.

Today, he and other local builders don't need sales gimmicks because demand is robust. But with few land-use constraints, there's been no price boom in Texas. Houston and Dallas, which rank third and fourth in the nation for single-family permits, saw prices increase last year by 4.4 percent and 3.0 percent, respectively. Most Texas builders would rather live with that than revisit the nightmare they endured two decades ago.

Back then, a gushing oil economy made Texas the nation's go-go market. Houston added 250,000 people and 100,000 jobs per year from 1970 through 1981. During that decade “there wasn't anything you could build you couldn't sell or lease,” says Jim Gaines, research economist for Texas A&M's Real Estate Center. “Everything was based on expectations that oil prices would rise to $30, then $50, and then $80 [per barrel]. There were a few contrarians, but no one listened.”

Then the oil and banking industries teetered precariously. In February 1991, BUILDER reported that from 1983 through mid-1984, Houston lost 140,000 jobs, and its housing starts fell from 30,000 to 6,000 per year. The Web site HoustonHistory.com chronicles the gory details after oil prices plummeted to $8 per barrel in 1986, a year when Houston's building permits fell in value to $64 million, from $251 million in 1982. That year, 25,602 properties were foreclosed upon. Eleven banks failed in the first nine months of 1987, the most since the Great Depression. BUILDER reported that building companies in Texas shriveled to fewer than 200 in 1988, from 900 in 1983.

“What saved me was my remodeling - work,” recalls Mike Kirlin, who owns Plano, Texas–based Kirlin Custom Homes, which started in 1985. His and other builders' sales . didn't start rebounding until 1992 and didn't fully recover until after 1996. Texas builders suffered another setback after the terrorist - attacks of September 2001, but business since has been brisk. Single-family starts in the Houston-Galveston-Brazoria area hit record levels in 2004. Starts in North Texas have risen seven consecutive years, according to Metrostudy, a housing analysis firm. “What's unique about the latest boom is its longevity,” says San Antonio–based consultant Paul Montelongo.

But cheap and available land and labor - keep prices stuck in neutral. Robert Pavlis, . who owns Dallas-based Pavlis Custom Homes, says the house he purchased in 1979 for $240,000, and renovated for another $70,000, sold last year for $365,000, “and all that appreciated was the land.” Plentiful real estate has been catnip to production builders that have invaded Texas in droves and have leveled prices, too. “Large builders may make their margins in other markets, but they're making their volumes in Texas,” claims Weekley.

New England was a home builder's paradise in the early to mid-1980s. “The pace of buying and reselling was astounding,” recalls Barry Rosa, vice president with Prudential Connecticut Realty. Prices were unbridled: Wellesley College economics professor Karl Case, who has analyzed New England's housing market extensively, found that Boston's prices jumped 158.8 percent between the first quarter of 1983 and the third quarter of 1988. Not surprisingly, builders and developers became avid speculators.

The American Housing Survey estimated that Boston gained 73,800 housing units between 1985 and 1989, 52,100 of which were condominiums; many of them were shoddily constructed, which led to greatly diminished resale value. But the region's growth couldn't match the frenzy of building. Boston's population increased only 5 percent in the 1980s, and employment inched up 2.8 percent annually between 1985 and 1988, according to Case's research.

Four body blows finally knocked New England down: the 1987 stock market crash, slashes in federal defense spending (which hit Connecticut's defense-dependent economy hard), the high-tech bust (which crippled Massachusetts), and a reeling banking sector. “I personally paid Fleet Bank $2 million in interest [on loans], and they were ready to flush me,” recalls Bill Ferrigno, who owns Sunlight Construction in Avon, Conn. “I would have been out of business except for my trade partners.” New England lost 116,000 jobs between June 1989 and June 1990, and Boston's housing supply ballooned to 16 months in 1990, recalls Lereah.

A “very long recession” followed, says Bill Ethier, director of Connecticut's HBA. To reduce what several sources say was a “huge overhang” in inventory, prices dropped significantly from 1990 through 1993, started leveling off again in 1994, and began to rebound in 1997. However, permits, a lagging indicator, hit bottom, at 7,671 units, in 1996. Connecticut now builds around 11,000 homes a year, 85 percent of them single-family.

The state's prices rose 15 percent in 2004, and Rosa says developers seem cured of their “anything goes” mania. That doesn't mean builders aren't aggressive, though: Torrington, Conn.–based T&M Building offers buyers a “shared appreciation” deal, which gives them a 10 percent discount if they agree to split the difference with the builder if the home is eventually sold for more than 25 percent of the purchase price, according to T&M's co-owner Greg Ugalde.

New England's zoning laws, among the toughest nationwide, also keep lots in short supply and prices high. Gary Ruping, who owns Billerica, Mass.–based Ruping Builders, recently purchased a house for $450,000 and planned to raze it and put up another because “the land alone is worth $450,000.” The presence of Toll Brothers and Pulte Homes drives up the cost of land, too, but Ruping says it's still easier for a local builder to navigate his state's “onerous” approval process.

But as prices keep rising, New England keeps losing people. Ferrigno fears an “orderly panic,” but Don Klepper-Smith, chief economist with New Haven–based Data-Core Partners, thinks an “orderly step-down” in prices is more likely, at least in Connecticut, where the median price-to-income ratio has risen moderately in recent years.

Between May 2004 and May 2005, San Diego's prices increased 7.5 percent to $488,000, the first time in six years that growth rate was single digits. New-home prices declined that month by 2.3 percent, according to DataQuick Information Systems, a tracking firm. Those numbers prompted industry watchers to wonder if California's high-flying housing market was finally coming in for a landing.

Builders still shudder at thoughts of the early 1990s, when “someone switched the lights off, and they stayed off” for six years, says Bruce Giffin, owner of Giffin & Crane, a Santa Barbara–area builder that specializes in $5 million-plus homes. But even then, California's home prices were resilient. Professor Case found that, following five years when prices in Los Angeles rose 102 percent, prices there declined only 19 percent between the second quarters of 1990 and 1993.

California never was the economic basket case that New England or Texas became; its ailment was too much of a good thing. In the 1980s, its population grew 29 percent and the state generated 1,000 jobs per week. John Laing Homes' CEO Larry Webb recalls builders and developers putting up houses as fast as they could, creating “tremendous oversupply.” Capital flowing into the industry from savings and loan banks and Japan “made builders think California was recession-proof,” says housing analyst and consultant John Burns.

The savings and loan money evaporated after Washington passed the Financial Institutions Reform Recovery and Enforcement Act, which imposed more-stringent standards on any lending institution that was engaged in real estate transactions. And California's employment machine broke down when its aerospace industry sputtered from defense spending cuts. “Job losses in the 1990s were critical to California's bubble bursting,” says Jim Wilson, housing analyst for JMP Securities. Twenty percent mortgage rates didn't help either, and prices finally tumbled, by 25 percent or more in some markets, says Raphael Bostic, a professor with the University of Southern California's Lusk Center for Real Estate.

A period of stagnation ensued, but prices eventually bounced back “with a vengeance,” says California Building Industry Association executive director Robert Rivinius, aided by a 1997 federal law that allowed married owners to keep up to $500,000 in profits, tax-free, from selling a home. Sales in the 1990s dropped 24.7 percent, but prices dipped only 11.7 percent, according to Union Bank's senior economist Keitaro Matsura.

Now, low interest rates and lenient mortgage financing keep demand surging, despite roaring prices that, according to California Association of Realtors' estimates in May, left 84 percent of the state's households unable to afford a median-priced house. Other market forces—especially demographic trends and environmental and zoning laws that restrain development—buoy optimists' predictions that any price falloff should be mild. What worries Giffin, though, is the “psychology of fear” he claims the media incite when they hint at a housing bubble, and steeper price erosion if it pops. “Aversion is a motivating factor, and if people read this often enough, it affects their thinking.”

Giffin voiced his concerns as the housing market in several areas of the country was sending out mixed signals about where it's headed. Newsday reported that the median price for a home on Long Island, N.Y., rose 13 percent to $429,000 in June, compared with the same month a year earlier, while the island's inventory of unsold houses increased 22 percent. Re/Max International's CEO, Daryl Jesperson, notes that listings nationwide through June were nearly 10 percent higher than a year ago. “Demand is still strong, but it's going from white hot to red hot,” he says.

There are myriad reasons for concern about how this boom is playing out. Zelman questions builders' lofty assumptions about sales velocity and thinks their willingness to bid high on land jeopardizes their long-range profitability. Case, Bostic, and Michael Carliner, an NAHB economist, ask what happens if China sours on purchasing U.S. mortgage-backed securities. And NAR's Lereah derides lenders he says are “spoiling the party” by offering low down-payment mortgages that enable buyers “who might not qualify otherwise.”

Some builders who have been through booms and busts say their companies' safest cushion might be a business model that dotes on customers and keeps in check the arrogance and complacency that led to past excesses. “We all thought we were infallible, but for 15 years I've managed my business with the mind-set that a recession could be around the corner,” says Webb of John Laing Homes, which expects to close 2,850 homes and generate $1.5 billion in revenue in 2005. Case in point: The company got into land development to have more control and to assume more of the entitlement risk, Webb says. “I'm more cautious today because I don't want to make the same mistakes.”

John Caulfield is a freelance writer based in Old Bridge, N.J.

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SOURCE: OFHEO

BOUNCE BACK: The Office of Federal Housing Enterprise Oversight's House Price Index measures changes in the average price in repeat sales or refinancings. The index shows that California's prices dipped more than 12 percent between the fourth quarters of 1991 and 1994 and then stagnated for several more years before moving upward. It took Texas—whose economy in the mid-1980s fell into near depression—more than seven years before home prices returned to 1986 levels. Connecticut slogged through a six-year economic downturn from 1988 to 1994 during which prices tumbled nearly 18 percent. California and Connecticut have experienced robust appreciation during the latest price run-up, but Texas prices have risen only modestly, primarily because developable land there is still plentiful.