Beat the bubblicious real estate market

By Amey Stone

updated 3:12 p.m. ET March 16, 2005

NEW YORK - You've heard the conventional wisdom: Don't think of your house as an investment. Think of it as a place to live. But how can you not think of it as an investment when it has been such a good one lately?

The median existing home price in the U.S. rose to $189,000 in January, up 10.5 percent year-over-year. Indeed, homes nationwide have appreciated an average of 8 percent annually in the past three years. That compares to a three-year average annual return in a typical diversified stock fund of just 5 percent. Homes in metropolitan areas on the East and West coasts have risen at a faster clip — doubling in the past five years in many markets.

Can this continue? It turns out that caution may be in order for 2005. The good news is that purchasing or owning a house remains one of the best investments you can make over the long term. Historically, the real estate market often spurts, then pauses, and sometimes even declines slightly. Prices have never really plummeted on a national basis.

Troubling signs
Yet for three years, home-price appreciation has been running far ahead of rates of inflation, wage increases, and national economic growth. The kinds of growth chalked up since 2002 are likely unsustainable, in the view of most analysts who follow the housing market. That doesn't mean home prices will crash, but they might retreat some in your region, especially if they've risen extraordinarily fast in recent years and if a downturn hits your local economy.

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Even barring that, as interest rates rise (and long-term rates have spiked in recent weeks), fewer people will be able to afford current home prices. That may lead to flatter real estate prices even if demand stays robust. Overall, national home sales have cooled a degree from 2004's hottest levels, according to the National Association of Realtors (NAR). And luxury home prices in several markets, including Boston and Chicago, actually dipped in the last three months of 2004.

A few troubling signs of a real estate market top are emerging: An increasing percentage of home financings are done with adjustable-rate mortgages (ARMs), which indicates people are stretching to afford the homes they want. If rates rise quickly, buyers with short adjustment periods may face higher rates sooner than they expected. “That sets people up for a problem if something goes wrong,” says David Kelly, economic advisor to Putnam Investments.

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