Housing Bubble in Minneapolis?

On the Bubble?

by Jim Buchta of Star Tribune
Published July 21, /2001

Irrational exuberance?

Experts say that the real estate market is not in the midst of a bubble that's about to burst and that prices are justified. But steadily falling mortgage interest rates and strong job growth have helped drive home prices to their highest level ever.

Median Home Prices

Years of heady home-appreciation rates have some in the Twin Cities and elsewhere wondering whether housing prices have risen to unsustainable levels.

After Jeanine Steffens and her husband lost money on a stock a few years ago, they changed their investment strategy.

Since then, the Maple Grove couple have put most of their money into real estate, including a house and a lake cabin that they recently sold for double what they paid in 1996.

``Real estate is the only thing we've had that doesn't go anywhere'' but up, Steffens said. ``We look at each other and say we're glad we're not involved in [stocks] anymore.''

For many investors whose stock portfolios have been ravaged, the strong gains in their home values have been a welcome counterbalance. But some observers are questioning whether whole sections of the nation's housing market, like the stock market of three years ago, are in the midst of their own mania, with a noted California researcher saying his analysis now puts the historically moderate-priced Twin Cities market in what he terms a small bubble.

Some Twin Cities experts dispute that contention, but concede that the local market may be reaching a plateau after a decade of near-record growth.

For the economy, the implications of the debate are as large as the fate of the stock market. Two-thirds of all Americans list their home as their single biggest asset, with home equity now at a record $7 trillion, according to a recent report from the Joint Center for Housing Studies of Harvard University.

Buying a home

As interest rates rise housing affordability falls. Click here for a look at the effects of rising rates on a mortgage payment.

A boom-to-bust housing market in Southern California in the late 1980s and early '90s helped send that state's economy into deep recession, depressing spending not only in related industries but among consumers as well, since many homeowners were left temporarily ``underwater,'' owing as much or more on their mortgages than they could realize by selling their homes.

No one foresees the possibility of home prices making a Nasdaq-style freefall, particularly in the Twin Cities. They point out that real estate prices are a regional, rather than national phenomenon, and that demographic trends and wage growth also argue against a housing collapse.

The more likely scenario - one that some believe already is becoming evident - is that the heady gains that many homeowners have grown accustomed to will level off. If that proves true, some of today's buyers are investing at prices where rapid appreciation becomes much harder to realize.

Bubble lite?

Affordability Index

A score above 100 means that a family with a median income can buy a median-priced house, so the higher the score the more affordable the houses are in that market. Housing affordability plummeted when home prices shot up in 1998, but went up again recently when interest rates started going down again. the declines in affordability in boston and San Francisco follow those cities' rapid increases in prices. Click here for chart.

Jane Timm knows what a powerful wealth creator real estate can be.

A former renter, Timm bought a condominium 10 years ago with $1,000 from her parents, a few thousand more from a first-time homeowner program and a mortgage. After making $40,000 on the sale of her condo, the 44-year-old clerk for the city of Edina bought a west Edina home for $165,000 that's now worth about $225,000.

``I've had only good luck,'' Timm said of her real estate investing.

The magnitude of her gains isn't uncommon among Twin Cities home buyers. In the five years that ended in the first quarter of 2002, the metro area's median sale price increased an average of more than 9 percent a year.

Last month, the median home price in the Twin Cities rose to a record $188,900, almost 10 percent higher than it was in June of last year, according to the Minneapolis Area Association of Realtors. In some areas, the gains were as high as 20 percent.

The pace of appreciation in the past five years is topped only by the mid- to late 1970s, a time of dramatic inflation when people were ``buying anything they could just to make a profit,'' said George Karvel, chairman of the real estate department at the University of St. Thomas.

Market research company Case Shiller Weiss sees more appreciation ahead, but at a moderating pace - projecting an annual average price gain of 6.1 percent this year and 4.6 percent next year for sales of single-family houses. Case Shiller's analysis ranks the Twin Cities as one of the strongest housing markets in the nation.

Where does that put our housing market?

In ``only a very slight bubble,'' according to John Burns, a California researcher who compiles a housing cycle barometer that analyzes home prices, income growth and other factors in markets nationwide.

Burns said that a bubble - a dramatic rise in prices relative to history - typically develops when homes become so expensive relative to local incomes that buyers and employers begin to leave an area, causing an imbalance in supply and demand.

That's not happening in the Twin Cities. People are still buying despite the price rises, thanks in part to low interest rates.

But the low rates aren't keeping the Twin Cities from becoming a more costly place to buy. Burns said that during the past 21 years the ratio between the median home price in the Twin Cities and local incomes has averaged about 2.5. The number has now risen to 2.9.

That figure still doesn't come close to what's happened in an expensive market such as San Francisco, where the ratio has gone from a 21-year average of 5.5 to 7.3, creating a more certain bubble environment.

But the Twin Cities trend is clearly toward a more expensive market.

A separate study by Harvard University researchers helps explain why - Twin Cities household incomes grew 10 percent from 1997 to 2001, while home prices rose about 33 percent.

Tiered market

Jobs

Job growth in the Twin Cities has been strong and steady relative to cities like Boston, where job growth has been move erratic, and San Francisco, where job growth has been nearly flat because of softness in the tech industry. Click here for chart.

The local market is beginning to show some effects from these developments, though not at all price levels.

Houses less than $250,000 remain in a robust seller's market, but it has become more of a buyer's market for upper-bracket houses, Edina Realty agent Sheri Fine said.

The first-time buyers' role in driving the market is reflected in appreciation rates for starter houses. During the past five years, the average price of a 1,040-square-foot house with one bathroom and a detached garage in the Twin Cities metro area rose 62 percent, according to research by the Minneapolis Area Association of Realtors.

Larger houses - those with 1,485 to 1,515 square feet, two bathrooms and a two-car garage - saw average appreciation of 47 percent in the same period.

Agents say that people trying to sell houses at $300,000 and up are now running into situations where it takes two months to find a buyer instead of two weeks, and that a price reduction might be needed.

There is more supply on the market now, too. In June the number of houses on the Twin Cities market was almost 15 percent higher than the previous year, according to the Realtor association.

Of course, the old saw about location still applies. Multiple offers are still coming for prime locations, such as the lakes neighborhoods in south Minneapolis and the Macalester-Groveland area in St. Paul.

Whatever softness is emerging, Karvel said there's no threat of a serious fall in prices. Minnesota real estate has never seen stock market-like fluctuations, he said.

``It's not a bubble market. Prices have gone up consistently over the last 50 to 55 years,'' Karvel said. ``The only difference is whether it goes up 2 percent or 10 percent, but it doesn't go down.''

He believes the housing market is more likely to suffer a slowdown in appreciation rather than a downturn.

``We've gone from a hyperactive economy needing a dose of Ritalin to a normal economy,'' Karvel said. ``And you've gone from a seller's market to a more normal market in housing.''

Nicolas Retsina, director of Harvard's Joint Center for Housing Studies, is more circumspect, saying that housing ``is not immune from major economic contractions.''

Harvard's State of the Nation's Housing report, a widely recognized annual assessment of U.S. housing trends, cautions that any weakening of demand at the lower end of the market could spread to other segments.

Karvel counters that housing markets lose their balance when households earning the local median income cannot afford a median-priced home. The Twin Cities have not crossed that threshold.

Sandy Loescher, a sales agent with Sandy Green- Realty in Minneapolis, said she thinks the big gains in home prices in recent years are because the Twin Cities had been an undervalued market for many years.

She and her husband and business partner, Ralph, recently paid $22,000 more than the list price for a south Minneapolis duplex. The sellers received three offers, and the Loeschers' bid wasn't even the highest.

``Prices are approaching their true value,'' she said.

The gains also were fueled by a major jump in household income during the 1990s, a trend driven in part by increases in the number of two-earner families. The Twin Cities metro area had the fourth-highest household median income in the 2000 census, up from 14th place in 1989.

Growth in Twin Cities' personal incomes is expected to trail the national average this year, growing 3.2 percent instead of the 4 percent nationwide, according to the Federal Reserve. For 2003, the area is expected to keep pace with the rest of the nation.

The future

If Twin Cities home prices have soared this past decade thanks to an unusual combination of events - an undervalued initial market, interest rates at generational lows, low unemployment and a dramatic rise in household incomes - what will keep them rising in the future?

30-year fixed mortgage

Mortgage interest rates have fallen to a 30-year low, prompting record home prices and several refinance booms. Rates last week were under 7 percent for a 30-year fixed-rate conventional mortgage. Click here for chart.

The area's economic diversity and projected population growth are expected to be powerful forces in maintaining and boosting real estate values over time.

In many states, the major economic center, the state capital and the major university are all in different cities. But in Minnesota, the Twin Cities are home to all three, creating one of the most recession-resistant areas in the nation. Further, the state economy doesn't rise or fall with the fortunes of any particular industry. Minnesota's unemployment rate has been lower than the national average both in the boom times of the 1990s and during this recent recession. In May, the state's jobless rate was 4.3 percent, while the nationwide figure was 5.8 percent.

The Twin Cities area also is projected to add a million residents to its current population of 2.6 million by 2030. Ted Mondale, chairman of the Metropolitan Council, the planning agency for the seven-county area, said he thinks the region will be 50,000 housing units short of the number needed to accommodate those new residents, with a resulting strong demand for homes.

``I don't think you're going to see prices drop,'' Mondale said. ``If the economy goes south, you'll see that, but there are no indicators that's going to happen over a long period of time.''

A rise in interest rates poses the single greatest threat to home prices.

The large gains during the 1970s were brought to a halt by the Federal Reserve in the early 1980s when mortgage rates rose to the mid-teens. During most of the 1980s and early 1990s, annual appreciation rates in the Twin Cities stayed under 5 percent as rates generally stayed high.

It wasn't until rates fell significantly again in the mid-'90s that rapid appreciation began again, culminating in an annual increase of 14.8 percent during the first quarter of this year.

No one can predict interest rates long term, but Paul Anton, chief economist with Anton, Lubov and Associates in Minneapolis, is optimistic they will rise only slightly as the economy recovers.

``I don't see a huge risk that long-term rates will rise dramatically,'' he said.

Even a restrained increase in interest rates could mean a major shock for the market.

A 30-year mortgage at 8.5 percent, instead of 6.5 percent, costs about $250 more per month for a $180,000 mortgage. That could push some buyers out of the market, said Kris Wilson, a loan officer with Summit Mortgage in Bloomington.

``It makes it more difficult, and a certain number will drop out - they'll have to,'' Wilson said.

While an interest-rate spike is considered unlikely, it has occurred several times in recent years. Wilson recalled 1987, when rates quickly went from 8 percent to 10.5 percent, sending shock waves through the housing market.

Perhaps the best caution for buyers now, Karvel said, is to consider the possibility that the market levels out, bringing returns more in line with historic averages.

That's especially true for the growing number of homeowners thinking about increasing their mortgage debt. According to the National Mortgage Bankers Association, more than half of all mortgage applications now are for refinancing.

And some of those borrowers have turned from incurring more debt to buy stocks to incurring more debt to buy real estate.

Doug Winter, area manager for Wells Fargo Home Mortgage in Minneapolis, said that during the last refinancing boom many people took out cash to invest in the stock market. Now, Winter said, the refinancing proceeds often are being used to buy a second or third home.

``People feel secure with the fact that they can actually touch it, feel it, use it,'' Winters said of vacation property. ``People have lost faith in the stock market and aren't willing to put more money into it.''

- Staff Writer Larry Werner contributed to this report.

- Jim Buchta is at jbuchta@startribune.com.