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Real Estate's Bubble Cities


One of the miracles of the recent recession has been the way home prices have held up. Average prices of existing homes were 10.4% higher in June, 2002, than they were a year earlier, according to the National Association of Realtors.

Small wonder that investors have been moving money from the stock market into residential real estate. But now the critical question is: Are we inflating a residential real estate bubble?

"Yes," is the answer in about a third of the major metropolitan areas in the U.S., according to a new study of housing affordability by John Burns, a real estate analyst who runs his own consulting firm in Irvine, Calif. Unfortunately for the residents of Boston, San Diego, and Fort Lauderdale, these areas seem to have the most hot air (chart).

Burns has created a "Housing Cycle Barometer" that measures the affordability of housing in a given metropolitan area, compared with its long-term average. Affordability is based on housing prices, downpayments, mortgage payments, and median annual income.

If housing in an area is as affordable as it has been historically, then the market will get a rating of 5. A rating above 5 means that housing prices and/or mortgage payments have outstripped income growth. Ratings of 7.5 or above point to a bubble that will likely burst at some point, although these markets' momentum could fuel price rises for a while yet, says Burns.

In housing markets that scored from 5 to 7.5, such as New York City, the long-term prognosis is not as clear. Although housing is less affordable in these markets than it has been historically, that may reflect a permanent lack of housing supply because of space or zoning constraints. Instead of a bubble, "it may be that this is the new reality," says Burns.

In these markets homebuyers should watch for evidence of speculative buying, according to Mark Zandi, chief economist at Economy.com Inc., which has its own real estate study that supports Burns's conclusions. Realtors buying and flipping properties, sales at two to four times the asking price, or a practice of skipping inspections are signs of a speculative market, he says. "If you're seeing 20%-plus price gains on a consistent basis, supply restrictions aren't enough to explain what's going on," Zandi cautions. Business leaders in the euro zone have long railed against an array of structural rigidities, from stringent laws against layoffs to costly state-sponsored social security systems. But such barriers to economic growth could soon be lowered following a recent shift to the political right in France, Italy, and several other European countries.

France and Italy, the euro zone's second- and third-biggest economies, are taking the lead on reform. France's new conservative Prime Minister Jean-Pierre Raffarin and Italy's Prime Minister Silvio Berlusconi are pushing for private pension schemes that would bail out the public system and reduce the cost to businesses. And both are trying to improve the flexibility of their labor markets by changing layoff laws.

Even Germany, the Continent's largest and most hidebound economy, may soon see reform. In June, the Hartz Commission, a government-mandated committee headed by a senior official at Volkswagen, issued a report showing that jobs could be created by cutting red tape for the self-employed and reducing jobless benefits. Faced with Germany's 9.8% jobless rate and near-zero growth, the winner of this September's general election will be under pressure to implement these findings.

All of these relatively modest reforms will help to reduce rigidities and create jobs, says Jean-Franois Mercier, an economist at Schroder Salomon Smith Barney in London. That could spur gross-domestic-product growth of up to 3% in the euro zone without creating an inflation problem. In the two years after Congress passed sweeping welfare reform in 1996, caseloads dropped, the number of single parents finding work surged, and the official poverty rate slid from 13.7% in 1996 to 12.7% in 1998. On paper, the government's statistics looked promising. But a new Urban Institute study by Sheila R. Zedlewski, Linda Giannarelli, Joyce Morton, and Laura Wheaton finds that, using a more complete measure of income, the number of families with income 50% below the poverty line--those termed "extremely poor"--rose from 1996 to 1998.

The study suggests that for many families, the hike in cash income, if any, was not enough to offset a decrease in participation in government-assistance programs. The Census Bureau's official figure overlooks the harm some families suffer because it includes only cash income. The Urban Institute measures disposable income, which adds food stamps and earned-income-tax credits to cash income and deducts federal taxes and out-of-pocket child-care expenses.

The drop in participation in benefit programs appears to be partly due to the 1996 reforms. Many families either left or chose not to join benefit programs under pressure from the states to work rather than collect welfare. Some also were put off by the increasingly complex eligibility rules.

The study suggests that the government could raise benefit-participation rates by using the same income standards, wealth tests, and job-hunting requirements for all programs. In many states, for example, it's easier to get Temporary Assistance for Needy Families (the technical name for "welfare") than food stamps. Zedlewski says full participation could cost state governments up to $23 billion more.


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