Soaring home prices dazzle investors

Many Americans appear to believe there's no place like home - no place better to invest their money, according to Smith Barney's Consulting Group.

Today, I will discuss CG's thoughts on how investors are being lured by low mortgage rates, easy terms and double-digit price gains in some U.S. cities. They're rushing to buy bigger homes, second homes and rental properties in hopes of cashing in on the boom.

More adventurous buyers are stretching - some might say overstretching - their finances in an effort to maximize their potential gains. No-money-down loans and interest-only mortgages (which allow borrowers to avoid repaying principal for the first few years of the loan) are becoming popular.

Some would-be tycoons are even borrowing from their 401(k) and IRA accounts to finance downpayments on their real estate deals - on the assumption that their properties can be quickly sold, or "flipped" for a profit which will more than pay back the loan.

Helping drive the boom: The relatively tepid performance of the U.S. stock market over the past few years. With long-term bond yields also still relatively low, many investors have been looking for higher returns outside the financial arena. As is often the case, increased demand has pushed home prices higher in many markets - attracting still more buyers.

There's no question a house or condo unit can be a smart investment, especially considering the tax breaks and other benefits associated with home ownership. But, like any other investment, residential real estate carries risks. Investors who ignore those risks could suffer the consequences.

The outsized gains of the past few years may have left many home buyers with unrealistic expectations. Indeed, some financial experts warn that overeager investors have fueled speculative bubbles in some markets - especially on the East and West coasts and in several fast-growing sunbelt regions.

When those bubbles burst, these experts warn, reckless investors could see dreams of wealth turned to ashes. Some may end up owning properties that are worth far less than the mortgages on them. Costs - such as taxes, insurance premiums and maintenance fees - that seemed trivial when prices were soaring could become a substantial burden.

It's easy to see why many homebuyers have thrown caution to the wind. U.S. home prices have been rising at the fastest rate since the late 1970s. A national index of home prices maintained by the Office of Federal Housing Enterprise Oversight, a regulatory agency, jumped more than 12 percent in the year ending in March. Some metro areas saw price gains of 20 percent or more.

To some experts, this suggests home prices in some hot markets are now fundamentally out of kilter with economic fundamentals. Price increases have greatly outstripped income gains in many areas- pricing some potential buyers out of the market. Prices also have risen faster than rents, making renting an increasingly attractive alternative. Yet prices have continued to rise.

One driving factor is a widespread perception that some areas are so desirable, or so prosperous, that prices can only continue to rise, thanks to the limited supply of homes available. Or, as the old saying goes: Buy land, they've stopped making it.

However, as financial behaviorist Robert Shiller notes, such confidence can be misplaced. "It is easy for residents there to imagine that more and more people are thinking similarly, and that they will continue to bid up real estate prices in their city," he writes. "This is irrational exuberance in the context of real estate."

Shiller points out that many metro areas still have plenty of raw land within easy commuting distance that can be developed, adding to the supply of houses. And as prices continue to rise in high-cost markets, companies and people may be inclined to move elsewhere. "Prices rise while people are optimistic, but forces are set in motion for them to crash when they get too high," Shiller warns.

When - and how - this cycle will end isn't clear. Federal Reserve officials, including Chairman Alan Greenspan, generally have taken a relaxed view of the housing boom. They argue that while certain markets may have turned bubbly, the risk of a sharp national downturn in home prices is fairly remote.

On the other hand, there have been some extremely painful regional declines. From the third quarter of 1990 through the first quarter of 1995, for example, home prices in the Los Angeles metro area fell an average 21 percent, according to the OFHEO. Prices didn't regain their peak value until the second quarter of 2000, nearly 10 years after the bubble burst.

Owning a home has long been considered an important piece of the American dream. It also has been a financially rewarding experience for millions of Americans. But investing in residential properties carries many of the same risks as investing in financial assets - plus some additional ones.

The boom of the past few years apparently has convinced some homebuyers that prices can go only one way - up - and that fundamental values no longer matter. In the late 1990s, many investors felt the same way about Internet stocks, only to find out the hard way how wrong they were when the bubble burst.

Real estate may have a place in your total wealth portfolio. But speculating on home prices is a poor substitute for having a diversified, long-term investment strategy, one that covers a broad range of asset classes. For more information, call 689-8704 or e-mail William.a.creekbaum@smithbarney.com.

- William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.