How high can it go?

The best worst-case scenarios for how the b-word could play out

Unless you’ve been living in your own bubble for the past year or so, you’ve probably heard and read more than enough about whether there is a real estate bubble.

Instead of asking whether there is a bubble, The Real Deal spent last month exploring the likeliest scenarios for how a bust to the current housing boom could play out, step-by-step.

Looking at a variety of factors which have arisen before to help send real estate prices spiraling down, we examined whether interest rates, new construction, jobs and Wall Street, or tax changes would be the death knell of the current boom, and whether New York is a protected market.

We also looked at why some are asking “Bubble B.S.?” (see separate story, “Bubble, we hardly knew ye,” in this issue)

You’ll also find a compendium of all the major cover stories written about the bubble in the past year, representing the best efforts of top journalists to decipher the market, as well as the views of economists like Paul Krugman, Robert Shiller and some guy named Alan talking about “froth.”

Interest Rates
By Philana Patterson

“You aren’t going to stick a pin and see it disappear,” said Robert Knakal, chairman of Massey Knakal Realty Services as he discussed the possibility of a housing bubble. “It’s like lava. It [would go] where gravity is going to take it slowly and methodically.”

Economists, real estate professionals, real estate investors, and would-be home buyers and sellers fear that a sharp change in interest rates would carry with it a seismic shift that could burst a housing bubble and send prices on a downhill slide.

What would otherwise be something of an economic abstraction is now viewed with potential alarm, as the Federal Reserve Board hews to a course of gradual increases to the federal funds rate, while market reactions remain hard to read. Short- and long-term mortgage rates remain near historic lows, but as those market responses remain hard to read, worries about the severity of a market correction continue to mount.

As the Fed increases, which affect short-term mortgage rates through the yield of the 10-year Treasury bond, continue, long-term bond yields typically rise. Long-term rates serve as the benchmark for 30-year fixed-rate mortgages, and typically rise in this interest rate environment. This time around, long-term rates haven’t risen in tandem with short-term rates, creating what Federal Reserve Chairman Alan Greenspan has described as a “conundrum,” and what other market watchers fear could eventually be an inversion of the yield curve, a phenomenon in which short-term bond yields surpass long-term yields. The last time that affected the economy was the lengthy recession of the early 1980s.

But the continuation of nearly historically low short-term rates has fostered a proliferation of adjustable rate mortgage products that allow real estate investors and home buyers to purchase property that may have been too expensive for them at higher interest rates. Recent figures from the Mortgage Bankers Association show a continued boom: Adjustable rate mortgages made up 29.7 percent of mortgage applications in the first week of August, down from 34.2 percent in the same week a year earlier. Cheap financing led to an extended housing and refinancing boom, and housing prices have risen more than 45 percent since 1996, adjusting for inflation, according to the Center for Economic and Policy Research in Washington.

Economists explain the disconnect between short- and long-term rates by pointing to Chinese, Japanese and, to some extent, European purchases of 10-year U.S. treasury notes in an effort to keep the U.S. economy robust and its purchase of foreign goods strong.

Dean Baker, co-director of the Center for Economic and Policy Research, says foreign buyers may decide they can’t keep funding U.S. debt at a premium. “They know they are paying more than what [U.S. treasuries] are worth because their goal is to keep the U.S. housing market going,” he said, “which helps the U.S. economy and keeps demand for exports high.”

Market watchers say it’s unlikely that foreign investors and governments will eschew U.S. debt unless there is a major political or catastrophic event that makes investing in the U.S. unattractive, which would hit the housing market hard.

“We could see a bursting if rates get to 6.5 to 7 percent. You have people so stretched already,” Baker said. Baker believes the U.S. is already in the midst of a housing bubble, fueled in part by the many buyers who are using adjustable rate mortgages, zero-principal loans and mortgages with balloon payments that will have to be refinanced at higher interest rates later. “My guess is that you’ll have a lot of people who can’t make payments and in many cases their homes will be worth less than the payments,” he said, “so there will be no incentive to stay and they’ll walk away.”

If mortgage rates rise and pop a housing bubble, new rates would make real estate payments higher than many buyers could afford. Selling activity would lag and prices would get shaved, said Richard Sylla, the Henry Kaufmann Professor of the history of financial institutions and markets at New York University’s Stern School of Business. None of this should happen overnight.

“The speculators will go away, the builders will cut back it will probably slow the economy down some,” Sylla said. “It’s not unprecedented for prices to fall 20 percent.”

As in the real estate downturn in the early 1990s, the market for studios and one-bedroom apartments in New York will probably suffer the most, while larger apartments may fare better. “Part of the fall is the speculators disappear and that restores a normal market,” Sylla said. “You go from a hyper market to a normal market and prices stabilize.”

A bubble burst could have farther reaching consequences. Nationwide, a housing bubble burst could have dire outcomes, says the Center for Economic and Policy Research’s Baker.

“It’s going to be devastating,” he said. “You are talking about a recession and probably a very bad recession. Housing represents 6 percent of GDP [gross domestic product]. Right there, that could easily be cut in half with 3.5 million jobs being lost.”

If high mortgage rates burst a housing bubble, Baker says home values could fall 25 percent to 30 percent nationwide, though it probably wouldn’t happen right away. “Bubbles go out not with a bang, but with a whimper,” Sylla said.

New Construction
By Tom Acitelli

A surplus of new construction would not cause a New York housing bubble to burst, but experts say that might happen if it’s accompanied by a steady increase in mortgage rates.

More than 9,000 new condo units are expected to be constructed in Manhattan alone by the end of 2005, according to The Real Deal’s analysis of data from the state Attorney General’s office. Also, outer-borough areas like Long Island City and the Williamsburg waterfront even the South Bronx are seeing some of their briskest residential development ever.

The debate centers on the question of whether the New York market could absorb any amount of construction, because new condos are in such demand that only a spike in mortgage rates could slow the market.

“I don’t think the market is showing anything but vibrancy, and I don’t expect it to change,” said Neil Binder, principal of Bellmarc Realty. “The level of building now, it’s reducing the increases in prices somewhat, but I don’t think it’s going to change the overall vibrancy of the market.”

But if mortgage rates rise from their historic lows, developers could suddenly find themselves changing plans. Condo conversions and construction could be supplanted by rental construction, which has slowed in the record housing market, where more money can be made building condos than rentals.

One potential scenario goes like this: With demand slowed by higher rates, construction would level off; and that leveling off would lead to more rentals to lease and less condos to sell. That, in turn, would help drastically slow the for-sale housing market.

“If you see mortgage rates increasing, that’s going to drive buyers, particularly first-time buyers, back to rentals,” said Jonathan Miller, president and CEO of Miller Samuel, a Manhattan real estate appraisal firm.

A possible upside to new construction helping slow the housing market is that its effects could probably be predicted. Miller compared construction forecasts to turning a supertanker because of the years involved in seeing a building to completion. Developers, then, may have leeway to convert to rentals before building condos that will be hard to sell. Another factor to consider is land prices. In many parts of Manhattan, it currently only makes sense to build condos, not rentals, because of high land prices. That would have to change to spur developers to build more rentals.

Today, new construction is spread out across areas like western Queens and Harlem that traditionally haven’t seen substantial condo construction. Prices in these areas are generally less expensive than in places like the Upper East Side and Lower Manhattan, where busy condo construction is nothing new. With that price range, then, according to brokers, developers could still expect to sell well, even when inventories are high.

“We’ve all heard about the stuff that’s coming onto the market, stuff in the pipeline,” said Greg Heym, chief economist at Halstead Property and Brown Harris Stevens. “I just don’t see that as being what causes any kind of substantial decline [in the market]. There’s just not enough product coming on the market that can do that.”

Jobs and Wall Street
By Philana Patterson

Manhattanites boast some of the country’s highest incomes, largely thanks to Wall Street and the financial services industry. But if high finance lands on hard times, it could have a profoundly negative impact on the area’s housing market.

Kent Swig, commercial landlord and co-chairman of Terra Holdings, said real estate prices were not severely affected by the most recent recession because big earners were left largely unscathed.

“We’re now coming out of a recession [since Sept. 11] where we lost 250,000 jobs,” Swig said. “It represented almost 10 percent of the entire layoffs in the United States, but still, it was more of the introductory workers.”

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Swig compared that scenario to the last major round of layoffs in New York City, when some 350,000 people lost their jobs from 1989 to 1991.

“That additional 100,000 people that were laid off then directly impacted the sales market because those people were earning a half a million and $1 million a year,” he said. “It cut deep into the buying power of the marketplace. Even those who had jobs remaining felt so insecure they wouldn’t buy, either. And the market went down one of the few times recently it did.”

Jonathan Miller, president and CEO of real estate appraisal firm Miller Samuel, agreed with Swig’s assessment. “The core for me as to whether or not there is going to be a bubble lies with personal income and inflation,” he said.

What sort of scenario could lead to those kinds of job losses and how directly would they be connected to real estate price decreases?

The answer is elusive, and complicated because it’s hard to measure how many more people can afford $1 million apartments and the mortgage payments over $100,000 a year, said Robert Knakal of Massey Knakal Realty Services.

“How many people can afford to pay this much for units?” Knakal said. “There’s no way to predict that.”

Around 9.4 percent of Manhattan households have median incomes of more than $200,000 annually, compared with 2.2 percent of households nationwide, according to the most recent Census. Nearly 324,000 New Yorkers are employed in the lucrative finance and insurance industries, according to a city report issued this summer.

In a downturn, Wall Street bonuses, which fuel the Manhattan market in the early part of each year, would be hit hard. It’s happened before. In the shadow of the Sept. 11 terrorist attacks and the dot-com bust, bonuses fell more than 34 percent, from $19.5 billion in 2000 to $12.8 billion in 2001. Wall Street bonuses were up an estimated 10 to 15 percent this year compared to 2004, but that doesn’t mean some aren’t uneasy.

Despite a recent employment report that showed that U.S. non-farm payrolls rose by 207,000 in July, Miller said he’s worried about some of the job cut headlines he’s read. Ford Motor Company said earlier this year it needs to cut 2,750 salaried jobs in 2005; in July, Honeywell International Inc. said it would cut 2,000 jobs from its aerospace business; and, also in July, Hewlett Packard Co. said it would cut its workforce by 14,500. No doubt a far-reaching national economic slowdown would in turn affect New York.

“What I am worried about is that we hit a point where we see the economy slip and we see more layoffs,” Miller said, “and then we lose the demand side of the equation.”

Tax Changes
By Tom Acitelli

Real estate tax laws could be the pin that pricks a housing bubble, and market watchers say the state of current legislation bears watching. “The single biggest reason why housing prices fell in the past were due to changes in the tax law,” said Neil Binder, a veteran New York broker and co-founder of Bellmarc Realty.

Binder said that in the late 1980s, the federal government started restricting the amount of investor deductions relating to real estate.

“That caused,” he said, “a segment of the market to withdraw from participation, and the market went south.”

Binder’s assessment of the aftershocks from the federal Tax Reform Act of 1986 is comparatively mild. The New York State Society of CPAs headlined an essay about the act, “Destroying real estate through the tax code.”

The act basically did three things to real estate: eliminated the capital gains tax differential; stopped the passive loss limitation rules; and lengthened the tax write-off period for real property. Eventually, some investors realized real estate could be too costly with higher taxes and less deductions, and they left the market, driving down prices in the absence of demand.

Today, tax law changes could be just as immediate, but will probably not come from tweaking either capital gains taxes or write-off periods. In fact, the 1986 changes have largely been absorbed into the daily reality of real estate investment. It’s the changes that could come in the form of a national sales tax, a flat tax, or a value-added tax that could stymie real estate, though these options all face considerable political challenges before they would become reality.

Any one of these changes would, brokers say, be followed by an exodus of real estate investors and buyers, especially at the higher-end of the market.

A national sales tax, for one, would wipe out the 1031 exchange benefit, which basically allows a seller to sell a building and not pay taxes on the profit if the seller invests it in another building right away.

This exchange is “fueling our market right now,” said Adelaide Polsinelli, a broker with Besen & Associates. It’s used by, she estimated, “about 50 percent of the buyers today.”

A flat tax would wipe out a lot of the deduction benefits owners get, Polsinelli said, such as when they make improvement to property. And a value-added tax would mean sales taxes on units in new buildings.

“If [the federal government] eliminates this current tax system,” Polsinelli said, “it’s not as if a 1 percent sales tax is going to bring in what the current system is bringing in. They’re going to have to go out and tax more stuff.”

Any changes and none are immediately expected from Congress would have to be phased in or could risk toppling the real estate market in New York and elsewhere. “Any proposed change needs to have a long transitional change-in. You need to give us five, 10 years,” Polsinelli said. “You can’t do it overnight.”

Is NY a Protected Market?
By Philana Patterson

Some economists and real estate market watchers contend that New York is different than the rest of the country and could withstand a possible real estate downturn that could hurt other parts of the U.S.

While he believes that real estate prices are too high in Miami, San Jose and San Francisco, John Marchant, an economist at research and consulting firm Business360, says Manhattan’s status as a financial and cultural capital and the fact that it has a local real estate market that differs so much from the rest of the country provides some protection for the New York market even if interest rates spike.

“Typically if you buy a co-op you have to put down at least 20 percent those people usually have lots of assets and typically have lots of income,” Marchant said, noting that co-ops make up 85 percent of the for-sale housing inventory in Manhattan. “Co-ops sometimes require 50 percent in cash. Is that person really going to care if interest rates go up or down a bit?”

New York has also attracted a lot of Europeans, particularly buyers from the United Kingdom, where Marchant himself is from. “If you are a Londoner, New York is cheap,” he said. “If you are a banker in London you can buy a weekend place.”

Unlike many cities, New York is what Kenneth Holley of Atlanta Life Investment Advisors considers a “captive market.”

“If you want to live in and around New York City, there’s a point when you can’t say you live in New York City,” Holley said. “If you are going to be a part of the mix in New York there is a certain distance you can’t go farther than.”

Like Marchant, Holley says he thinks there is more risk in other parts of the country.

“Atlanta worries me because people can go outside the perimeter with their firms,” Holley said. “You need to be in Manhattan to be a Wall Street firm. Lots of firms have tinkered and toyed with the idea of leaving Manhattan, but most of them have wound up staying.”

Dean Baker, co-director of the Center for Economic and Policy Research, doesn’t buy those arguments.

“These are people who probably bought big into the dot-com bubble,” Baker said.

He says real estate values may be even more vulnerable in cities such as New York and Boston where prices could drop by as much as 35 percent. Living in New York to take advantage of the amenities the city has to offer as opposed to a city in the Midwest is a kind of tax, Baker says.

“The question is: ‘How much of a premium would you pay?'”