THE ECONOMIST:

High-flying house prices fueled by fervor can’t last

There’s no denying it — the housing market is hot. In the past year, prices have gone up nearly 13 percent in the Portland area and 12.5 percent nationally. Around the country big increases abound — Las Vegas is up 34 percent, West Palm Beach, Fla., 25 percent and even hot, smoggy Fresno jumped 26 percent.

Hard as it is to imagine, those high-flying prices may be coming to an abrupt — and for some, painful — end. The sad truth is we’re likely in the midst of a classic housing bubble.

Why do I say that? The first clue is the increase isn’t explained by fundamentals. Over time, housing prices closely follow changes in household income. But in the past five years, housing prices have outpaced personal income. In Oregon, per capita income is up 12.5 percent since 2000; housing prices have jumped three times as much, up 38 percent.

A second clue is all the frenzied behavior. Houses sell days — even hours — after being listed, often above the asking price. Plenty of people are speculating on housing; one-third of home sales have been to investors and second-home buyers, according to the National Association of Realtors. And everyone, it seems, has heard of someone who “flipped” a house or condo for a big gain in just a few weeks.

Third, the buzz about higher prices feeds expectations; at least for a while, those expectations become a self-fulfilling prophecy. If prospective home buyers think prices will jump in six months, they have good reason to buy now, not later. That pumps up demand for homes by bringing more buyers into the market.

At times like this, we forget prices can go down, not just up. Given human nature, there’s a centuries-long tradition of markets overshooting, then collapsing.

In the fabled Dutch tulip bulb mania of the 1630s, special varieties were named after Dutch naval admirals. Buyers paid 6,000 florins — 40 times the average worker’s annual earnings — for a single bulb. And a rare bulb was an acceptable dowry for a bride, according to a bulb mania Web site.

But manias can sour. Eventually buyers were left with purchase contracts for outlandish prices several times more than the bulbs were worth.

Does that remind you at all of just five years ago and dot-com “irrational exuberance,” dot-com millionaires and predictions of a 36,000 Dow Jones Industrial Average? Since then we’ve seen a raft of dot-com bankruptcies and a Dow stuck in the 10,000 range. While stocks are more volatile, housing prices aren’t immune to declines.

After several strong years, prices in Sydney fell 16 percent; London’s dropped 3 percent in the last six months.

Several factors come into play The growth in U.S. housing prices is fueled by a variety of factors: long-term interest rates remain near historic lows; lenders are offering generous terms, including no down payment, interest-only loans; and the local economy is growing again.

Ironically, measures viewed as helping consumers cope with rising prices — low and no down payment loans, interest-only loans and higher limits of government guaranteed financing — also push up the amount buyers are willing to bid. That just adds fuel to the fire.

Two special characteristics of the housing market make it prone to inflation. First, buyers look not so much at the price of houses as they do the monthly payments they can afford. Continuing low interest rates and creative financing enables buyers to bid more.

For example, suppose your family budget has $1,500 a month for a mortgage payment. Recently, you could take out a conventional 30-year fixed rate mortgage at 5.125 percent and borrow about $275,000. If instead you took out a five-year interest-only adjustable rate mortgage — with the same payment — at a rate of about 4.875 percent, you could borrow $355,000.

Second, most home buyers purchase their new homes, in large part, with the equity on their old homes. The rising price for your old house gives you more money to pay for your new house, again pushing up offers.

When we know it’s too late Can I be sure we’re in a bubble? The trouble with investment bubbles is they’re never really obvious until the pop. Living with a housing bubble is like driving a car with a bad tire — you don’t know when it’ll fail, if you’ll end up in a dramatic freeway blowout or wake up one morning and find your car listing on a limp, deflated piece of rubber.

The spike in the road ahead is the chance of a jump in long-term interest rates. So far, mortgage rates have remained low, even though the Federal Reserve has raised short-term rates several times in the past year, including one-quarter of a percentage point last month.

Higher interest rates would quickly put a crimp in what home buyers could afford to borrow and quickly boost payments for those with adjustable rate mortgages.

Most likely, we’ll have an experience like we did in the 1980s. Oregon’s housing prices jumped nearly 20 percent per year from 1976 to 1980, then increased only about 1 percent a year over the next decade. But housing prices actually fell in real terms — that is, housing prices increased less than the price of all other goods and services.

The stakes are high. For several years rising housing prices helped prop up the economy as homeowners use home equity loans to finance everything from cars to remodeling to credit-card debt. The housing boom has kept construction employment high, too.

But if prices flatten out — or worse, decline — the borrowing spree will end and construction may slump. Whether it ends with a bang or a fizzle, the fate of housing prices will have a profound effect on the local economy.

Joe Cortright is an economist with Impresa Inc., a Portland consulting firm that advises businesses and governments on the knowledge-based economy. He lives in Northeast Portland.