San Diego It's not a question of if there is a real estate bubble. It's a question of whether it bursts or slowly leaks air. It may expand for more than a year, if interest rates only rise moderately and the local economy stays strong. But one way or another, prices will peak, buyers evaporate, and prices soften, drop, or plunge. Overvaluation never goes on forever. And the longer it lasts, the more traumatic will be the end.
The real estate bubble, which has swelled more in coastal California than in almost every other part of the nation, has been part of the Federal Reserve's unspoken strategy. To stave off the possibility of a 1930s-like deflation, our central bank in 2001 began dropping short-term interest rates to their lowest level in four decades. The objective was to entice consumers to buy homes and refinance their mortgages as rates continued receding, thus supplying more moolah to buy goods and -- ugh -- pay off credit card debt. It worked. Reckless consumer buying and borrowing boosted the economy. But now, to deter inflation, interest rates must go back up.
That's bad news for sizzling San Diego. Signs of excess are ubiquitous. Home prices have moved up more than 40 percent in the past year. The median price (half of home prices are higher, half lower) is now more than $500,000. Prices are rising fastest in lower-income areas. You can offer $450,000 for a 1200-square-foot fixer-upper and get outbid.
More than two-thirds of new mortgages are of the variable-rate or interest-only variety -- ergo, buyers are giddily dancing up to the cliff. Many people bidding for downtown condos are real estate speculators. A whopping 90 percent of Southern California condo conversions are in San Diego County. The number of real estate agents soared 20 percent in just two years. At cocktail parties, San Diegans boast of their paper real estate profits, just as they bragged of their tech-stock profits before the 2000 crash.
As in prior bubbles, homes are becoming poker chips: too many people buy them to sell them, not live in them. Only a decade ago, San Diego was in a real estate depression. People found themselves owing money on a home worth $30,000 less than they paid for it. So they turned their houses over to the bank and skedaddled. Foreclosures jumped almost 40 percent to 3116 in 1993 and by 1996 had climbed to 4077, according to La Jolla's DataQuick Information Systems.
But today, people have forgotten the early 1990s because interest rates remain low, and the stock and bond markets are overpriced. A decade ago, about half of San Diegans owned homes. Now it's approaching 65 percent. People are seduced by the fact that mortgage interest payments are tax-deductible.
But over the past year in San Diego, apartment rents have gone up 4 percent, while home prices have zoomed at ten times that rate. That tax write-off is not so enticing, considering what's being paid for houses and condos.
Bubbles are hard to quantify, but Edward Leamer of the University of California at Los Angeles compares the price of a home with the annual rent it could command. By this reckoning, San Diego was in the nation's second worst bubble three years ago. Leamer says there is still a "clear bubble" throughout Southern California, and San Diego remains one of the nation's bubblier markets.
Economists generally concede that there is a difference between today and the early 1990s housing depression. In the 1980s, construction had zoomed. By contrast, recent construction has been "about a half to a third what it was in the 1980s," says Alan Gin, University of San Diego economist. Also, says Gin, the San Diego economy collapsed in the early 1990s as the aerospace industry crashed. Jobs disappeared, as did homebuyers.
Nonetheless, says Gin, "I haven't been on the bubble train, but I am thinking of buying a ticket." The value of his own home is up 60 percent in two years. "A lot of speculators are moving into downtown condo investments," and there are other signs of speculation. The era of exceedingly low interest rates is ending.
"The residential real estate boom in California is over," says Ross Starr, economist at the University of California, San Diego. But, like any prudent economist, he won't say when the boom will end. (Remember, fear of rising interest rates usually stimulates homebuying for a while. That's inflating the bubble now.) The Federal Reserve "has made it very clear that short-term rates are going up." A conservative forecast is for short rates to rise 1.25 percentage points in a year. Wall Street is looking for an increase of two full percentage points by the end of next year.
Such interest-rate increases will wallop people with adjustable-rate mortgages, says Starr. Some households will go from shelling out one-third of their income to service their mortgage to one-half, he says. "It's going to make it harder for people to hold on to houses. When people go to resell, potential buyers won't have access to anywhere near as attractive loans. Large inventories of owner-occupied real estate will be staying on the market."
It's possible that interest rates will go up more slowly than now anticipated. That would happen if there is stagnating economic growth, which would likely hit San Diego. If you have an interest-only loan, you might have to sell your house to make your balloon payment -- and sell it into a weak market. At this point in the bubble, both rising interest rates or a weakening economy would be bad.
You do not want to get caught when the music stops. Keep in mind that many of the self-professed experts quoted in mainstream media are whores who are well paid by the real estate industry. These perennial bulls insist that real estate is mainly a matter of supply and demand and that there is a dearth of supply, along with steady demand. These streetwalkers ignore the role of rising interest rates and conveniently forget that housing prices often get so high that mortgages are difficult for families to handle. Demand is not constant.