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Market has borrowers stretching every which way.

As appreciation for residential real estate continues to track a path further and further upward, many buyers, sellers and market experts alike are asking just how high prices can go, how long the up-cycle can continue, and if a precipitous fall in value lurks somewhere in the wake of the current trend of rising interest rates.

Those belonging to the camp that believes there is a current national real estate bubble--a group that seems to grow in size the longer the dizzying appreciation continues--have no trouble in pointing to a number of worrisome factors in today's market to support their conviction that pricing is poised for a slide.

The proliferation of what Fed chairman Alan Greenspan dubbed exotic mortgage products such as adjustable rate loans, piggyback loans, interest only loans, and home equity loans, whose monthly payments can as much as double if interest rates rise to not unfathomable levels, as well as mixed economic signals such as choppy job growth, and the way real estate appreciation has exceeded salary increases have provided fuel for many an apocalyptic scenario.

For buyers using exotic mortgage packages to stretch themselves to the maximum financially in order to acquire a home, real estate bubble believers question what will happen if rates climb higher or quicker than expected. Interest only loans, which offer cheap payments for the first few years, convert to standard amortization mortgages after a set period of time, wherein the buyer has to take on both principal and interest payments. Saddled with fresh principal payments and perhaps higher interest rates because rates for such loans reset to correlate with the prime rate, buyers may be overwhelmed. Those who believe there is a bubble point out that such buyers likely won't have savings to bail them out; the Commerce Department's Bureau of Economic Analysis reported in recent weeks that the net average savings for Americans has hit zero.

The other exotic loans are only variations on the interest only theme bubble believers allege; they stimulate demand by temporarily improving affordability and play into the short-sightedness of buyers who in reality don't have the income to make such home purchases. Buyers doubtlessly count on further appreciation to bail them out if they run into a financial jam, but if rising rates trigger a sell off for those with exotic loans, many houses may come on the market at once and pricing could take a hit.

While the number and impact of exotic loans has been played down by some, they make up not an insignificant portion of the mortgages being signed in New York City and Long Island. According to data from the PMI Group, a mortgage insurance company, 19% of mortgages taken in Long Island are piggyback loans, loans in which nearly all of the purchase is financed, the portion that covers the down payment usually with an equity loan that resets monthly to the prime rate and is consequently very sensitive to interest rate increases. Data compiled for New York City, White Plains, and Wayne, New Jersey shows that 32% of mortgages in these areas are piggyback loans.

"People are stretching pretty much anyway they can," said Marco van Akkeren, an economist with PMI. "And that data doesn't even count the interest only and option ARMs that we've been seeing."

Because the gap between short and long-term rates has compressed so dramatically, those employing more creative mortgages are only saving a few percentage points at most on the interest rate for their loan, a fact that speaks to someone for whom every penny counts. And every penny counts for someone extending themselves to their financial maximum.

But there are those who believe housing prices will take a fall or that, at the very least, appreciation will taper significantly well before interest rates have the chance to rise high enough to crush those unprepared for the consequences of using risky loans. According to the PMI Group, the country's west and east coasts are rife with overvalued markets that are on the verge of a correction within the next two years. PMI data indicates that New York City has a 33% chance prices will drop in the next couple of year, while Long Island has an even higher 54% probability, a figure that makes it the second most prone market to a price correction behind only Boston's 55%.

PMI uses a market's rate of appreciation, current pricing levels and job climate to calculate its prediction. While New York City and Long Island have strong employment and high salaries relative to other parts of the country, the areas' rampant appreciation--prices have risen 77% in the New York metro area since 2000--combined with the fact that buyers' incomes have lagged well behind the rises in home prices, led PMI to score the area quite low in terms of its affordability and consequent continued ability to appreciate.

Beth Haiken, a spokesperson for the PMI Group, clarified that the firm visualizes the current residential real estate market as a balloon and not a bubble.

"We don't think that it's going to pop," Haiken said. "It's more likely to deflate slowly."

That phenomenon seems to already be happening in San Diego, where houses have been spending more time on the market before they're sold and pricing has begun to recede. San Diego was listed as the third most probable market for a price correction according to PMI data and is a city that has experienced some of the wildest appreciation. Prices there have risen 118% since 2000 and the chance for a price correction within the next two years is 53%.

Many critics of the real estate bubble theory consider San Diego's slowdown not a foreboding harbinger of residential real estate doom but a natural and healthy check on a rate of appreciation that is unsustainable.

"If appreciation was to continue at this rate and never slow down then you'd eventually have a bubble," said Lawrence Yun, an economist at the National Association of Realtors. "What you're seeing here is the market regulating itself and working, there's no real estate bubble."

John Lonski, chief economist at Moody's Investors Service, indicated that real estate will not fall in value but that, like in San Diego, appreciation will return to more normal levels, around 5% he predicts for next year down from roughly 15% this year.

Prominent Manhattan commercial and residential property owner Kent Swig doesn't agree that either a lag in appreciation or a price drop is in store for the city. According to him, the supply of housing here is simply too low and demand that has been created by a new wave of buyers eager to be city dwellers is far too high.

He also cited the fact that most buyers are users rather than investors--meaning they aren't buying houses just to make money but because they simply need a place to live--as another indicator of the strength of the market.

"The Upper West Side has approximately 53% fewer apartments to purchase than 22 months ago," Swig said. "And it's not the only place, we have a citywide decline in apartments and the city is adding small levels of inventory on a historical basis because land and development opportunities are so scarce. On top of that, for the first time in 50 years, the population is growing and can see that pricing can only go even farther up."

Swig further added that the Fed's so far measured pace of 25 basis point increases to the Federal Funds Rate only act to check inflation and therefore will continue to keep long term interest rates down.

"If I take a book on your desk and I move it an inch and a while later I move it another inch and another inch, you probably wouldn't even noticed it changed its position," Swig said."

Yuan offered optimistic data as well noting that the city added roughly 70K jobs over the past year.

Crumbling housing prices are usually contained to a specific area where there have been widespread layoffs or when the perception of job security is affected by adverse economic conditions. Two examples used prominently by real estate experts are Texas in the mid 1980s when the oil industry took a hit and in Southern California in the early 1990s when the tech and defense industries were downsized. Both areas experienced significant depreciation.

With continued signs of economic growth, commensurate damage to the job market doesn't seem likely here, although Lonski noted that the financial industry, the biggest industry in the city, is sensitive to periods of high interest rates.

Swig also rejected the concept that exotic mortgages were especially dangerous tools for homebuyers to temporarily attain the unaffordable.

"People buy things beyond their means all the time, that's the way it has always been," he said.

A particularly risky market in his eyes is the condo boom in South Florida and Las Vegas where a large portion of the demand has been driven by investors hoping to profit on appreciation.

A hiccup in either market could trigger a sell-off that in turn could result in a downward spike in prices, the kind that real estate bubble believers have been long predicting.
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Author:Geiger, Daniel
Publication:Real Estate Weekly
Date:Aug 17, 2005
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