Why rising rates haven’t sunk real estate - yet

updated 5:32 p.m. ET Aug. 12, 2005

SAN FRANCISCO - Rising interest rates are supposed to be an economic sedative, but the hyperactive real estate market has retained its vigor even as the prime lending rate has climbed to a nearly four-year high.

One of the biggest reasons for real estate’s unusual behavior is that home mortgages are less expensive than they were 14 months ago when the Federal Reserve Board began to push up the short-term cost to borrow money.

That inflation-fighting effort has raised the prime rate from 4 percent in June 2004 to 6.5 percent today, making it more costly to buy cars, appliances and almost anything else on credit.

Meanwhile, home mortgages have remained a relative bargain. The average rate for a 30-year fixed-rate mortgage stood at 6.05 percent through Thursday, down from 6.41 percent during the first week of June 2004, according to HSH Associates, an industry research firm.

Those low financing costs mean home buyers can qualify for larger loans — a major factor why real estate prices have continued their steady ascent in neighborhoods scattered across the country.

The trend troubles Federal Reserve Chairman Alan Greenspan and many other economists, who worry cheap mortgage money is contributing to a real estate pricing bubble that could trigger a traumatic recession.

“It’s very hard to understand the psychology of any market,” said UCLA economics professor Edward Leamer. “But it’s fundamentally clear that the housing market is in a fragile and dangerous situation.”

The risks of a real estate meltdown aren’t the same across the country because mortgages aren’t the sole factor influencing home prices. Other key considerations include an area’s desirability, the supply of available housing and the strength of the local job market.

The housing markets most susceptible to a sharp downturn in prices are in California, Massachusetts and New York, according to PMI Group Inc., a mortgage insurance provider based in Walnut Creek, Calif.

Based on a recently completed analysis, PMI predicted six major metropolitan areas face at least a 50 percent chance of enduring a drop in home prices within the next two years: Boston-Quincy, Mass.; Nassau-Suffolk, NY; San Diego County, Calif.; Santa Clara County, Calif.; Orange County, Calif.; and a two-county area east of San Francisco.

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