June 2003

Planning

Copyright by American Planning Association

When the Bubble Bursts

Good news: Housing doesn't necessarily behave like the stock market.

By Corey Cox, AICP

In 1987, economist Kenicihi Ohmae stood on a Tokyo street corner with an American television reporter. Ohme placed a white handkerchief on the sidewalk. "Right here, we're standing over the most expensive residential area in Tokyo," Ohmae said. A square foot of property smaller than his hankie was worth $22,000.

Fifteen years later, the same square foot had dropped in value by nearly 60 percent. Now the Tokyo real estate market of the late 1980s seems like a classic real estate bubble. Will the same thing occur in the U.S.? And will communities have strategies in place to cope? After all, housing is one of the few props holding up the nation's economy during the current recession.

A bubble by any other name

A housing bubble takes place when housing prices are pushed higher than an area's economy can adequately sustain. At such a time, incomes are rising and jobs are increasing. Later, when the economy is disrupted, jobs are lost and incomes fall. The number of prospective buyers who can pay inflated housing prices drops — and so does home value.

This drop can be a major financial setback to homeowners expecting to cash out on the value of their homes. It can cause an economic blip regionally if great numbers of people have borrowed the maximum amount against their homes and spent the money on consumer goods under the assumption that housing values will rise forever.

Home prices have been rising faster than personal income. In the past seven years, nationwide home prices have risen 30 percent more than the rate of inflation, increasing housing wealth by an extra $2.6 trillion. This is about $35,000 for each of the nation's 73.3 million homeowner households. The implications of this rise are not entirely clear, because in past downturns, housing has slowed down along with the overall economy.

Some experts think there is a disconnect between the overall economy and housing prices. They worry that another bubble, like the one in the technology sector, is in the offing. The tech bubble preceded the stock market downturn that wiped out $7 trillion in investor wealth.

"At present market values, the collapse of the housing market will lead to a loss of between $1.3 trillion and $2.6 trillion in housing wealth. This collapse will slow the economy both by derailing housing construction and by its impact on consumption through the wealth effect," wrote Dean Baker, co-director of the Center for Economic and Policy Research in Washington, D.C., in 2002 . However, Baker is the only prominent economist I found who is predicting a nationwide collapse in housing prices.

Many other prominent economists, including Alan Greenspan, are less concerned. Frank Nothaft and David Berson, chief economists at Freddie Mac and Fannie Mae, say there is no nationwide bubble right now. One of the preconditions of a bubble is an inelastic supply, they add, whereas in most regions the housing supply is still growing. Also, the housing market is not like the stock market because homes are generally purchased for consumption, and stocks are not.

Further, according to the optimists, many baby boomers are still nesting and will likely stay in their homes for some time. Homeowners typically stay put for between 12 and 14 years, long enough to withstand a down market. The most likely scenario will be a correction in regions that have inflated housing values — but even those regions are likely to recover, according to these experts.

Steady as she goes

Although reliable data have been kept only since the mid-1960s, most economists agree there has not been a protracted period of falling housing prices nationwide since the depression of the 1930s. There are examples of "bubblettes," such as those in Boston and Los Angeles in the early 1990s. But these markets did recover over time, and homeowners who toughed it out generally found that their homes had appreciated substantially. Most walked away with a profit when they sold.

During the last half of the 1980s, Boston home prices rose by 73 percent while incomes rose only 42 percent. A recession and attendant correction resulted in an 11 percent drop in home prices that did not recover fully for seven years. During the late 1980s and early 1990s, Los Angeles saw an 89 percent increase in home prices and a 37 percent increase in income. Soon afterward, defense-industry cutbacks precipitated a correction that reduced house values by 24 percent in L.A. over a five-year period. It took another four years to recover.

These bubbles were regional. During the same period, Minneapolis, Chicago, and other cities continued to experience uninterrupted increases in housing values.

In the last 12 months, the average prices of new homes nationwide have soared by 10.3 percent, and those of existing homes by 7.2 percent. During that period, incomes rose only 2.3 percent. According to the economists, housing markets are most vulnerable in regions that have a lot of over-development, inflated home prices, and high consumer debt. It seems likely that places with more stable economies will experience no change or even continue to see rising house values.

The mortgage picture

Low mortgage interest rates have kept the housing market strong nationwide during the recent recession. That is largely because lower interest rates have enabled the average homeowner to buy a more expensive home without having to make a higher monthly mortgage payment. Coupled with huge changes in the mortgage business over the past decade, low interest rates have also made home ownership possible for a record number of households. Home ownership reached 68.1 of all households last year, up from 64 percent in 1994.

Changes to the mortgage industry include the growth of Fannie Mae, a giant government chartered company that improves the flow of capital through the home loan market by buying loans from other lenders. Also, new software has automated some aspects of loan approval systems to make it cheaper to process loans and easier to identify creditworthy borrowers. Lenders recently have been requiring down payments from first time home-buyers as low as six percent (compared with 10 percent in 1989).

Some 11.2 million mortgages were refinanced in 2001, setting a new record. All but one-fifth of these resulted in some cash-out of equity. This has helped keep U.S. consumption buoyant during the economic downturn. Surveys indicate that the money was spent on repayment of other debts, home improvements, consumer expenditures, taxes, and business investments.

Despite the recent cash outs, today's consumer debt burden is higher than ever before. And there is less money for homeowners to tap into. Some analysts predict that cash outs this year will average $10,000, compared to $30,000 last year. Despite the steady escalation of home values, the ratio of homeowner equity to market value has steadily declined, from 77.1 percent in 1950 to 52.2 percent in 2001.

Silicon Valley: high-tech market

Silicon Valley has the highest median home price in the country, and some of the highest incomes. Both jobs and incomes have declined there lately.

About 127,000 jobs were lost in Silicon Valley between the first quarter of 2001 and the second quarter of 2002. Average incomes declined from $79,800 in 2000 to $62,000 in mid 2002. Yet average home values remain around $500,000. Is a housing bubble about to burst?

Surprisingly, the answer may be no.

In a paper called "The New Economy and Housing Market Outcomes," written for the Fannie Mae Foundation, three authors from the Institute of Urban and Regional Development at the University of California at Berkeley explained why the housing market in Silicon Valley may be holding steady. According to John Landis, Vicki Elmer, and Matt Zook, "Housing prices in new economy markets are found to be higher, peakier, and more volatile than in old economy markets. Home ownership rates are lower and crowding is higher."

When asked to comment on these findings, executive Rick Zipf of V Commerce Corporation, a software firm that provides Internet hosting and related services for the retail and consumer electronics industries, said in an interview, "I would add that the lower home ownership rates and overcrowding fluctuate with changes in the tech economy. There are times when a great number of workers are needed to work on a specific short-term project. There was a flurry of activity to prepare for Y2K. Many of the programmers who worked on this came from India and China and went back when the work was done."

Interim workers typically rent apartments and, at the peak of a demand, those apartments are sometimes crowded. (As in other many other cities, the Silicon Valley apartment market is currently soft. San Jose rental amounts in large apartment complexes have declined from $2,200 at the end of 2000, to $1,430 for the first quarter of 2003.)

"Generally, high-value homes are occupied by the same people who were there before the downturn and they continue to work for established, more stable companies," Zipf says. In his opinion, the Internet economy is likely to take until 2005 or later to reach its previous level.

In San Jose, the epicenter of Silicon Valley, home values reflect not only an increase in demand by high-tech workers, but 30 years of constraint in land supply. Growth boundaries were put in place in San Jose's general plan in the 1970s; one goal was to keep housing density modest. Three decades later, with most of the land within the boundary developed, the city has amended its general plan to add some high-density development opportunities around existing and planned transit corridors, says Mike Mena, a planner with the city.

However, workforce housing has become a major concern in San Jose. Average incomes are relatively high, with the average for a moderate-income family of four defined as $96,000, low-income as $74,000, and very low-income as $48,000. A moderate-income family could afford only one-fifth of the homes in San Jose. With the current median home value just shy of $500,000, this will not match the definitions of affordability of many teachers, nurses, firefighters, police officers, or janitors who are needed in San Jose.

The Housing Trust Fund of Santa Clara County is trying to address this mismatch. Contributors include corporations like Hewlett-Packard, Adobe, and Intel, which recognize the workforce housing problem and have a vested interest in attracting workers to San Jose. The fund provides gap financing for affordable housing projects and has raised $20 million since 1999.

Phoenix: the boom engine

Metropolitan Phoenix has experienced explosive growth for three decades. Construction and growth-related industries (from sand and gravel extraction to banking) account for more than one-fifth of the Phoenix economy. What would happen to metro Phoenix if this housing growth stopped?

"We would dry up and blow away," says Jay Butler of the Arizona Real Estate Research Center at Arizona State University. "Of course, this possibility is extremely remote. The housing boom in Phoenix is fueled by immigration supported by a continuous influx of jobs. Employers continue to come to Phoenix

because the costs of housing and labor are relatively low compared to other places. People continue to come because, even though many of these jobs are not at the high end of the pay and benefits spectrum, they are jobs."

Butler adds: "Some of the market may be artificially inflated as a result of flipping. Flipping Properties, a guide to making money in real estate, recently made it into Amazon's top 100 sellers."

Phoenix is surrounded by a vast amount of undeveloped flat land, allowing outward expansion of the metro area and relatively low housing prices. Government and fiscal structures contribute to outward expansion as well. There are 26 local governments in and adjacent to metro Phoenix. These range from mature and completely developed (Tempe) to poised for development (Buckeye) to combinations of everything in between (Phoenix).

Property taxes are low in Arizona, and it is typical for half of a city's operating budget to be financed by sales tax revenues. This situation causes expansion at the periphery because local governments vie for the next auto dealership or regional mall. In recent years, some Phoenix-area communities have adopted adequate public facilities ordinances (Queen Creek), or drafted innovative development agreements (Goodyear), to make sure that adequate city services are in place as well.

In addition, recent interest rates and mortgage lending practices have improved housing affordability in metro Phoenix, despite rising home values. Dean Brennan, AICP, a principal planner with the city of Phoenix, expressed his surprise at recent housing trends.

"After seeing a prolonged period of mid- to upper-end housing growth, the housing boom market has recently shifted; for the first time, a lot of affordable units are being built, especially in the Laveen area of southwest Phoenix," he says. "This also seems like a good time for renters, as the apartment market is soft with many complexes offering months of free rent and other incentives to attract tenants."

Whose ox is gored?

Writing in a 1991 issue of APA's PAS Memo, Dwight Merriam, a partner in the Hartford law office of Robinson & Cole, noted that there are four perspectives to consider in planning to mitigate the potential damage of a land-use market recession: the local government; the developer; the lender; and environmental, neighborhood, and citizens advocacy groups.

Merriam said there are opportunities for all four interest groups in a down market. Developers may find approvals easier to obtain, local governments may find it easier to adopt new regulations, lenders can strike deals and form relationships for the future, and citizens groups can get more cooperation from developers who are pressed to complete their projects quickly.

In recessionary times, local governments may need to be more flexible when requiring upfront expenditures from developers, Merriam wrote. Also, he suggested there be a phasing plan so that only a minimal amount of land is vulnerable as development occurs, and he stressed the need for adequate performance bonds for closing up the site should construction be halted. Finally, he said local governments should have some oversight during construction, should a project run into trouble.

Current trends, future markets

Several factors could affect future housing markets — whether a housing bubble occurs in particular regions or not. Baby boomer buying patterns, immigration rates, and the Internet are among those factors.

There are currently 77 million baby boomers living in the U.S.; they make up 31 percent of the entire U.S. population. Will they behave like their parents when making housing decisions?

The answer is probably not. Early indications are that boomers are more likely to stay in their homes after the nest is empty. Also, U.S. tax law now allows married homeowners who have lived in their homes for at least two years to exclude up to $500,000 in capital gains taxes when they sell.

Market research by Del Webb Corporation, the developer of retirement communities, indicates that there will be more demand for home offices, and business and educational centers. Many boomers will work past the age of 60, Webb also found. Age-restricted communities will not be as popular with boomers as with previous retirees, because boomers want to be near their children and grandchildren.

The echo boom generation will create a second wave in housing demand because they number 72.7 million, almost as many as the boomers themselves.

Meanwhile, some speculate that cities, regions, and even nations will become less important as the Internet allows information workers to live anywhere they want. For planners that means the Internet will make some baseline data and projections less reliable — and make decisions about housing and job location even harder.

Income disparities, affordable housing

Although many major U.S. cities are thriving, as employment and high-end housing continue to shift to suburban and non-metropolitan areas, families who cannot afford nearby housing will increasingly lack access to the social and economic opportunities that are key to family stability and the growth of wealth. The number of families being squeezed out of affordable suburban housing is increasing, according to a 2001 study for the National Housing Conference, a nonprofit based in Washington, D.C.

That study, From Paycheck to Paycheck: Working Families and the Cost of Housing in America, found that police officers, nurses, teachers, janitors, and clerks in 60 major metropolitan areas may not be able to afford to buy homes on their salaries alone. The study attributed the lack of affordability to the strong economy and rising housing costs between 1997 and 1999.

"The federal government withdrew support for regional affordable housing programs nearly a quarter of a century ago," says Stuart Meck, FAICP, a senior research fellow at APA. "States and local governments had to step in to fill a considerable void. Around the country there are a number of notable voluntary programs, but most are only scratching the surface. Some state governments have assumed a more substantive role by enforcing or overseeing regional approaches, with results turning on the degree of state commitment and financial resources."

Reading. Accessory Dwelling Units: Model State Act and Local Ordinance, by Rodney Cobb and Scott Dvorak, was commissioned by the Public Policy Institute of AARP. It explains how local governments can assure the independence and security of older residents with a minimum of public investment.

Paycheck to Paycheck: Working Families and the Cost of Housing in America, a 2001 study prepared for the National Housing Conference, documents the affordable housing crisis in the U.S.

In Incentive Zoning: Meeting Urban Design and Affordable Housing Objectives (Planning Advisory Service Report 494), APA Researcher Marya Morris profiles communities that have used innovative methods.

On the web. In Regional Approaches to Affordable Housing (Planning Advisory Service Report 513/514), APA researchers Stuart Meck, FAICP, Rebecca Retzlaff, and James Schwab, AICP, evaluated 23 programs across the nation. The U.S. Department of Housing and Urban Development and the Fannie Mae Foundation helped fund the study.

The State of The Nation's Housing, 2001. This report from the Harvard Center for Housing Studies contains a comprehensive analysis of the current housing market.

Town of Cary Affordable Housing Toolkit. This 1999 work was conducted as a part of the town's housing plan.