The alarming-sound-bite crowd has itself in a tizzy over the possibility of a bubble in residential real estate prices. The most lurid stories claim that the next itsy-bitsy increase in interest rates will cause a complete collapse of the U.S. housing market, leaving people unable to make their home payments but unable to sell because the property will not be worth as much as the mortgages. Widespread economic devastation, they say, will inevitably follow.

Accompanied, perhaps, by male pattern baldness, the heartbreak of psoriasis and the return of the Black Plague.

I disagree. Interest rates rise and fall over the decades. These scenarios surface every time rates start to rise. But beneath the hysteria, there is some truth. Some individuals do get hurt, especially in the short term. And some changes in lending terms since the last period of generally rising interest rates could amplify the effects.

Mommy, What’s a Bubble?

“Bubble” is meant to evoke the image of chewing gum. Eventually, the material on the surface of the bubble becomes too thin to hold, a tear develops at the weakest spot, air rushes out, and the whole thing collapses. Unlike more technical economic terms, it is a readily-understood metaphor of what can happen in the market for any particular product.

Classic supply-and-demand economics teaches that any potential seller has a price below which he will not sell, and any potential buyer has a price above which he will not buy. Not all sellers will have the same minimum and not all buyers the same maximum; each sets his own value for his own reasons. In the aggregate, there is a price acceptable to an equal number of buyers and sellers. This equilibrium point changes over time as the underlying value judgments change.

Any individual’s valuation of any particular asset is a blend of many factors, mostly subjective and rarely analyzed mathematically. Typical factors include utility (how useful is the asset to you or someone else?); scarcity or, more precisely, the perception of scarcity; ability to substitute other, similar assets; urgency (must the seller or buyer act quickly, or can he wait?); and speculation (a belief that the asset will increase in value).

Bubbles occur when speculation becomes the dominant, or even exclusive, factor. Normal economic laws are replaced by Barnum’s “There’s a sucker born every minute.”* Economic history is full of bubbles, including Dutch tulip mania in the 1630s, Florida land development in the 1920s and technology stocks in the 1990s.

A recent article in The New York Times cited statistics that the average price of a home in the United States has increased an average of 7.7 percent each year for the last five years. The Chicago area posted a bigger increase, 9.0 percent. Is this a bubble?

Taking the Long View

I don’t think so, at least not locally, though speculation is certainly present. Real estate is a long-term investment, if for no other reason than because it takes time to buy, time to sell and the transaction costs are relatively high. Long-term investments do not make money at a steady pace. Prices may stagnate for long periods, they may go down, they may go up. In the long run, I think well-located real estate will just about always improve in value. (By “well-located,” I mean in a city with a reasonably healthy, diverse economy. Property in one-industry towns, or dusty, dying farm villages may be simultaneously cheap and overpriced.)

Living for Now

In the short term, housing prices can fall. What do you do then? Probably nothing. Just keep living in your home, be patient and keep paying the mortgage—if you can.

Sometimes, one must sell a house when prices are down, due perhaps to a death, job transfer, or divorce. Perhaps you just give up some of the gain previously accumulated, or the sale may be at a loss. The danger lies in being “under water,” where the sale proceeds will not be enough to pay off the mortgage. This is among the reasons mortgage lenders traditionally required a 20 percent down payment. Only a truly serious crash in housing prices (Manhattan in the late 1980s, the San Francisco Bay area in the dot.com bust) would put those loans under water. The 10 and even 5 percent down payments that used to be rare, however, have become common in the last decade. Even a small dip in prices could cause problems for those homeowners if it occurs at the wrong time.

What I find more dangerous is the inappropriate use of interest-only mortgages. A traditional mortgage is an amortizing loan: part of each payment goes to interest, part to principal. The interest amount drops a bit each month (since you have paid down the principal) and the principal portion therefore increases. The payment on an interest-only loan is much smaller because there is no principal portion. A $200,000 loan, for example, at 5.5 percent would have a $1,136 payment with a 30-year amortization, and a $917 payment if interest-only.

Interest-only loans are all adjustable-rate loans, as are some amortizing mortgages. Because there is no principal portion, the monthly payment can increase rapidly on an interest-only loan. The monthly payment on my own interest-only mortgage has increased 74 percent since the interest rate bottom in 2002. Had it been an amortizing loan, the increase would have been only 37 percent, but from a higher base. I was prepared for the increase, but I’m a financial sort of guy.

Interest-only loans were unheard of 10 years ago. They came on the scene as a way to keep payments down in the face of rising costs. There lies the problem.

Too many home buyers are choosing interest-only loans based solely on the size of the initial monthly payment. That is what they can afford, not the much higher payment they could face in a few years. If their income goes up, great. Otherwise, they wouldn’t be able to meet the mortgage payments and would have to sell. And if that happens when housing prices have dropped... well, if you hold someone under water long enough, he drowns. And if a lot of people are drowning, home prices will drop because more will be for sale.

These individual disasters are sad, and will deepen and prolong any overall slump in home prices. But that is a long way from a bubble bursting.

*P. T. Barnum did actually not say this; a competitor, David Hannum, apparently did while suing Barnum.

Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.

Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He has also been known to produce theatre.

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