Sept. 22 (Bloomberg) -- Is ``irrational exuberance'' inflating U.S. residential real estate markets?
Robert Shiller, a Yale economist, says the current frenzy in real-estate prices is remarkably similar to previous market bubbles. Shiller critiqued the 1990s stock-market debacle with a book of the same title, referring to Federal Reserve Chairman Alan Greenspan's quip about the stock market of the late 1990s.
``Most people do not perceive themselves in 2003 as in the midst of a bubble, despite all the media attention to the possibility of a bubble, but they didn't either in 1988, after which real prices fell sharply in many cities,'' Shiller and fellow researcher Karl Case of Wellesley College said.
Shiller and Case's observations were detailed in a report prepared for a panel earlier this month at the Brookings Institution, the Washington research organization.
The report is unique because it surveyed homeowners through the third quarter of 2002 and compared results with a similar study they conducted in 1988 rather than relying only on recent economic data. It was in 1988 that the last peak in real estate prices occurred before a major decline on the East and West coasts (mostly concentrated in Boston and southern California).
It was Shiller who debunked the idea that the Dow Jones Industrial Average would hit 36,000 in coming years when his book came out in March 2000, the beginning of the three-year bear market. He drew attention for making a rational appraisal of basic economics at a time when a bubble was bursting and millions of investors were still buying stocks.
Is there a mania pushing real-estate prices into 1999 Nasdaq- like territory? His research on this is compelling.
The Psychology
The arguments against the housing market being in a bubble now are that reduced housing supply is creating demand and real- estate illiquidity would prevent rapid selling if prices fall. Yet there's still the persistent disconnect between personal- income growth and home prices.
When home prices outpace personal income, it's often a sign that there's a run-up in housing prices not supported by the underlying economy.
In California, Shiller and Case found, home prices rose 7.7 percent annually from 1995 through the third quarter of 2002 while personal income gained 4.5 percent per year. In Massachusetts, home prices were up 9.1 percent during that period while income increased only 5.1 percent.
It's a given that falling mortgage rates explain part of the housing boom, ``but they can't explain cross-state variations in appreciation,'' Shiller and Case state.
New Bubble Evidence
The economists found new evidence of a bubble by comparing home price and income data over 71 quarters.
They also polled homeowners who bought in 2002 in Los Angeles, San Francisco, Boston and Milwaukee. Their comparison with the 1988 survey is revealing. The psychological profile of the 1988 market sounds familiar: ``Buyers were influenced by an investment motive, that they had strong expectations about future price changes in their housing markets, that they perceived little risk.''
While Shiller says he's uncertain when prices will fall, he said ``cities such as New York, Boston and Los Angeles are eventually likely to show drops.'' To date, he has seen evidence of prices heading south, although not on either coast.
``Real home prices are already flat in Denver and Detroit, following periods of rapid growth. More declines in real home prices will probably come in cities that have been frothy, notably cities on both coasts of the U.S., and especially those cities that have had weakening economies.''
The Study Summary
Here's what Shiller and Case found in markets that they deemed to be most prone to the bubble:
-- ``A tendency to view housing as investment -- that is what a bubble is all about, buying for future price increases rather than just the pleasure of occupying the house.''
-- The ``meat'' of the bubble centers on expectations that prices will only rise. ``Roughly 90 percent or more expected an increase in home prices over the next several years, and the expected increase over the next 12 months was very high, even surpassing 15 percent in San Francisco in 2003.''
-- The denial factor is powerful. ``Most homeowners do not perceive themselves to be in a bubble even in the height of a bubble.''
While his research is cautionary, Shiller says his data ``doesn't prove there is a bubble.'' There's always the possibility the economy will rebound soundly and job growth will improve, which may derail the bubble scenario. Yet, using the past as a reference, he concedes that ``30 percent declines are not out of the question,'' as was the case in Southern California in the early 1990s.
Protecting Yourself
You can avoid getting burned in a real-estate decline. Avoid adjustable-rate mortgages unless you plan to stay in your property for less than three years and forget about interest-only loans.
Those most sensitive to housing costs are spending more than 50 percent of their yearly income on housing or have more than 60 percent of their net worth tied up in real estate, according to most financial planners. Losing one income per household -- where two are needed to pay the bills -- or getting slammed by higher mortgage rates, taxes or other expenses could endanger your home affordability.
If you are buying a new property, consider downsizing your expectations and buy a smaller house. Those with high loan-to- value ratios, that is, owning less than 10 percent home equity or in deep non-mortgage debt are also highly vulnerable if prices decline.
So paying down credit cards and your mortgage may be good insulation against any declines in housing prices. In fact, they're rational moves that make sense in any market. Last Updated: September 22, 2003 00:08 EDT