Geared up: a new gold rush in property threatens the engine of American growth

Author: Christopher Swann

Published: March 28, 2005

Tom Kunz, head of Century 21, the largest chain of property agents in the US, recently entered a lottery. The prize on offer is not a cheque the length of a bookcase but rather the chance to bid for an apartment in Hawaii. Even if he wins he may have to camp outside the property to ensure that he beats the crowd of other aspiring homeowners.

Many buyers in California, Hawaii, Nevada and Washington DC have been forced to endure similar indignities. Figures this month showed that surging demand pushed up prices in each of these states by more than 20 per cent in 2004, with Nevada topping the league with a 32 per cent rise.

In Las Vegas - the hottest property market in the US last year with prices rising by 36 per cent - the result has been little short of a buying frenzy, says David Brownell, a local property agent. "It was not so much a matter of how many days a property was on the market but how many hours," he says. "You would often see makeshift camps outside newly completed buildings, with people sleeping in tents for days in order to be among the first bidders."

In the end, he says, some housebuilders had to hire security guards to stop people camping outside their properties. Others barred speculators or second-home buyers from bidding.

Although most policymakers and property agents have been at pains to reassure the American public that there is no bubble to burst in the national property market, many economists are increasingly concerned by these mini-bubbles. There is mounting evidence that many homeowners are cutting financial corners to buy in some of these pricier areas. The practice of buying properties only to flip them on for a profit has also been on the rise. Both trends increase the risk of outright declines in property values in some of the wealthy US states where prices have become most overstretched.

Even if prices hold up in Middle America, a dip in values in the country's richest areas could deprive the US economy of one of its primary sources of growth. Americans have come to see their homes much like cash machines, withdrawing Dollars 223bn (Pounds 119bn, Euros 171bn) last year from the equity in them. According to a recent speech by Alan Greenspan, chairman of the US Federal Reserve, approximately half of this money shows up in increased spending by consumers. If so, about 40 per cent of the 2004 increase in consumption rested on withdrawals from the housing market.

The worry is not simply that consumers will stop taking money out of their houses if appreciation stops or prices fall. They may also feel the need to bolster their savings accounts - again to the detriment of consumption.

Many people draw comfort from the fact that there has been no nationwide fall in house prices over a calendar year since the Great Depression. There have, however, been steep and almost simultaneous declines in America's wealthiest states. Between 1990 and 1995, prices in California fell 13.4 per cent, while property values in Massachusetts and New York slid 11.4 per cent and 5 per cent respectively. "Taking into account inflation and rising earnings, these were chunky falls and such declines in economically pivotal states did appear to take its toll on consumer spending," says Ian Morris, US economist at HSBC.

Valuations in these states are again starting to look stretched. House prices have been racing ahead of earnings in many economic centres of the US. In Boston, for example, prices rose 50 per cent faster than earnings in both 2004 and 2003. In Miami, property climbed 87 per cent faster than earnings last year and 60 per cent faster in 2003.

Even though low interest rates are making larger loans affordable, prices in many areas appear increasingly out of kilter with earnings. In most of the Republican heartland of America there is no problem. In Nebraska the median home is worth just 2.6 times the median household income. But in California the median price of a home stands at around eight times the annual median family income of its residents. The situation is not much better in Massachusetts, Washington DC and Nevada. In Massachusetts a typical middle-income family with two earners making Dollars 50,000 each now owns a house worth Dollars 663,000, according to Economy.com, the consultancy.

Unsurprisingly, many buyers in such areas have been taking greater financial risks in order to get into their new properties. The more people who have put themselves out on a limb, the greater the likelihood of a serious economic fallout if interest rates rise faster than expected - which, after last week's surprise acceleration in consumer price inflation, now seems a less remote possibility.

The 30-year fixed-rate mortgage has been going out of vogue in the most expensive states as banks have become prepared to lend higher multiples of earnings for adjustable-rate deals. According to the Mortgage Bankers Association, at the end of last year close to half of recent home loans in value terms were at adjustable rates, up from 20-30 per cent between 2000 and 2002. In California, they estimate this has been closer to 60 per cent.

"This is a sign of desperation," says Stephen Roach, chief economist at Morgan Stanley. "To expose yourself to floating-rate obligations at the bottom of an interest-rate cycle is a huge risk."

Even more striking has been the rise in interest-only mortgages, which permit borrowers to take out larger loans. Interest-only loans have been particularly prevalent at the upper end of the housing market - the "jumbo" loans above Dollars 333,700 in 2004, as defined by Fannie Mae and Freddie Mac, the mortgage finance groups - where many Americans are straining to get the keys to their ideal property. According to LoanPerformance, the mortgage data analyst, 58 per cent of jumbo loans for homes nationwide last year were interest-only - up from 38 per cent in 2003, 20 per cent in 2002 and 5 per cent in 2001.

In high-value areas the prevalence of these mortgages has been considerably above the national average. In Las Vegas they have accounted for 70 per cent of purchases last year, in Oakland, California, 58 per cent and in San Diego 67 per cent.

"There has been an explosion of interest-only mortgages," says Paul Calem, head of product research at LoanPerformance, and a former Federal Reserve economist. "It is a sign that many people are really struggling to afford the homes they want."

There has also been much more speculation in recent years, with people extending their borrowing and renting out properties with an eye to selling them as house values rise. Speculators can be the first to sell when market conditions deteriorate. According to LoanPerformance, 8.5 per cent of mortgages taken out in the first 11 months of last year were by people who did not plan to live in the property, up from 5.8 per cent in 2000. Again, the national trend conceals even more worrying local bubbles. In Las Vegas, 16 per cent of homes were bought solely as investments.

Bidding wars have become a standard part of the home-buying experience in many markets. The escalation clause - whereby rival bidders offer to top the next highest offer by a certain margin - is now common. Rob Bergman, a property agent in Washington DC, says that in many bidding battles buyers are giving up their right to lower their offers if investigations later show structural damage. "In order to win, people are often giving up a range of safeguards," he says. "This has become a fact of life in a market where you can sometimes offer 25 per cent over the asking price and still not win the bidding."

Mark Zandi, head of research at Economy.com, says: "It is hard to dismiss such frothy conditions in so many key US states as merely a local problem." He estimates that around 50 per cent of the US's Dollars 17,000bn housing stock is now overvalued.

The central question for economists is whether these local bubbles are likely to burst or deflate gently. The consensus is that values even in such overheated areas will either stagnate for several years until earnings catch up or edge down only slightly. This would take some of the steam out of the economy without dealing a hammer blow to consumer confidence. The main reasons for this optimism are improvements in the job market and the expectation that interest rates will rise only modestly.

But recent research by Ian Morris, US economist at HSBC, has challenged these assumptions. According to Mr Morris, declines in real house prices have tended to set in before interest rates or unemployment really start to rise. "Assets tend to be leading indicators while unemployment tends to lag behind other economic trends," he says. "We don't necessarily need a sharp rise in interest rates to undermine the housing market and economic growth."

The precedent of the Netherlands is particularly worrying for the US. There, after years of steep increases, house-price inflation tumbled back to zero in 2003 when interest rates and unemployment were coming down. This slowdown contributed to a consumer slump, with spending declining through most of 2003. The discomforting message from the Netherlands is that even the flattening of house-price inflation may have a more dramatic effect on consumers than expected. n the US there are enough overheated areas to raise fears of serious economic consequences as these markets cool down. An estimate by Economy.com suggests that house-price appreciation has been responsible for one-quarter of the economic growth in the US since 2000 - taking into account equity withdrawal and the faster pace of home building. The sense of rising wealth provided by the property market has also encouraged Americans to consume more and save less of their incomes.

Figures from the Federal Reserve this month underlined just how dependent Americans have been on housing market appreciation for rising levels of wealth. Since the start of 2000 net household wealth has risen by Dollars 5,020bn to Dollars 48,525bn - despite a Dollars 341bn decline in holdings of equities. Of this increase in wealth, 70 per cent came from the increase in owners' equity in property.

Largely as a result of this surge in wealth, Americans have neglected to save. In January, consumers put aside just Dollars 1 for every Dollars 100 of disposable income - close to the lowest level since the second world war. Even in the high-spending late 1990s, Americans saved an average of Dollars 3.80 for every Dollars 100.

"Americans have been putting too many of their eggs in one basket," says Bill Gale, an economist at the Brookings Institution. "As a result, their spending may have become too sensitive to the moves in the housing market."

It may not even take a flat or falling housing market to damage consumer confidence. A market that merely fails to meet the expectations of many Americans may be enough to convince them to rein in their spending.

A recent survey by Yale University suggests that many people in property hotspots have bought in the expectation of wildly unrealistic gains. In Los Angeles, the survey suggested that on average homeowners in 2004 expected their property to appreciate by 22.5 per cent a year for the next 10 years. This was close to double their expectations in 2003. Even in the humbler property market of Milwaukee, consumers are expecting a rate of appreciation of 13.4 per cent a year over the coming decade. The dream of coasting to wealth on the back of housing appreciation seems even stronger than during the property boom of the late 1980s, when residents of LA were expecting a more modest appreciation of 14 per cent per year over the coming decade.

"Many people, particularly in frothy areas, seem to be assuming that the housing market will continue do their savings for them," says Mr. Zandi. "If prices start to slide in some of these states, it will be quite a blow and many may feel they need to increase their savings rate quite significantly at the expense of consumption."

Calculations by HSBC suggest that the US would need to create an additional 2m jobs to make up for an end to mortgage equity withdrawal. This is not a blow that the economy could easily take on the chin.

When George W. Bush, US president, convened a panel of experts to advise on overhauling the tax system, his first instruction was in effect to forbid them from tampering with the favourable tax treatment of home ownership. The goal of home ownership is as American as apple pie and for a US politician to challenge the wisdom of such tax breaks would be akin to criticising motherhood.

The US government encourages home ownership in two main ways. First, it provides backing for Fannie Mae and Freddie Mac, the home loan giants, providing an implicit financial guarantee that enables them to offer fixed loans at lower rates than would otherwise be available. Second, the government exempts a large chunk of housing activity from taxation. Interest payments on mortgages up to Dollars 1m can be deducted from tax and a married couple can make a capital gain of Dollars 500,000 from the sale of their primary residence every two years without being subject to capital gains tax.

The most compelling argument for this treatment is that home ownership produces a range of positive spin-offs for society. "When lower income areas have greater ownership, it seems that crime and vandalism is reduced and areas become better maintained," says Anthony Chan, a senior economist at JP Morgan Asset Management.

But others are less convinced of the merits of providing such favourable treatment for housing. This year, tax privileges on housing will cost the US Treasury Dollars 116bn - generosity that few governments can match. Critics of the system argue that it has pumped extra air into the US housing-market bubble, diverted resources away from US industry and even failed in its goal of promoting home ownership.

Len Burman, an economist at Washington's Urban Institute, argues that the mortgage interest tax deduction, which alone will cost the US government Dollars 73bn in 2005, actually makes it harder for lower-income families to get on the housing ladder.

"The main effect of the subsidy is to make ownership more attractive and thus raise the cost for everybody," he says. "Because it is a tax deduction, it is of greatest benefit to those who pay the highest marginal rates - precisely the kind of people who are likely to own homes anyway. Because it raises house prices it is bad news for low-income aspiring home owners - and higher prices more than offset the support provided to this group by other government home-ownership subsidies."

The US rate of home ownership is climbing and now 69.2 per cent of households are home owners. But this is in the same range as Canada or the UK, which are much less generous in their tax support of home ownership.

Critics of the housing subsidies also argue that they have encouraged overinvestment in housing. Although the US provides a host of tax breaks on savings, especially for those putting aside money for their retirement, these are less generous than the tax treatment of housing. "Americans are saving by overinvesting in tax-preferred housing," says John Makin, an economist at the American Enterprise Institute. "Unfortunately, housing does not add as much to labour productivity as more traditional capital does, and so the rush of American saving into housing raises questions about the durability of America's strong productivity growth."

Dallas Salisbury, the president of the Employee Benefit Research Institute, worries that Americans have been encouraged to put too much of their resources into one asset. "The US has just got carried away with promoting housing," he says. "In part because of the tax treatment, it is seen as a great way to save for retirement, yet only about 13 per cent of people we surveyed said they would be willing to sell their houses in order to (provide money to) live on during retirement."

But, like most critics, he believes that there is unlikely to be any reduction in the tax breaks for housing. "It has become like an addiction in the US," he says. "The more of the economy that is wrapped up in the housing sector the harder it is to contemplate doing without this government support."