Home buyers beware: Bubble could burst

Ocean sailors have a rule about reducing sail when the wind picks up: “If you wonder whether it’s time to reef, you already should have.”

Sure, the wind might ease, but calling it wrong can be fatal.

Which brings us to the current debate about whether we’re in a housing bubble: If you think we might be, better act as if we are.

As I said in a recent column, if we could identify bubbles for sure, they’d never form. Surely, though, one sign of a bubble is that more and more people start debating whether one exists – and these days, it’s near impossible to pick up a financial publication that doesn’t have a bubble story.

Grant’s Interest Rate Observer, a highly respected New York newsletter, recently offered a smart analysis by a real estate consultant in Hawaii.

He multiplies the number of home sales by the average price, then divides the result by the nation’s gross domestic product. This shows home sales as a percentage of the economy.

The figure averaged 9.2 percent from 1970 through the end of last year. By the end of March, it had hit 17.2 percent, adding to the pile of bubble evidence, according to Grant’s.

Most of the reasons for soaring home prices are clear. Low interest rates allow buyers to borrow and spend more, for example.

Less well-known is the soaring use in the past few years of mortgage-backed securities. The local bank no longer holds the mortgages it issues. Instead, the loans are bundled together and sold to investors as a sort of bond. The risk is thus passed from the lender to investors, allowing the local bank to give mortgages to borrowers it would have deemed too risky in the past.

This is one reason for the proliferation of risky mortgages: interest-only loans, loans to people with poor credit and loans that require low or no down payments. All increase the supply of money to buyers, helping drive home prices up.

Equally important is the fact that more and more people now view their homes as investments. This is natural. Anytime the price of something skyrockets, people figure they can buy now and make a killing later. Also, Americans disappointed by low yields on bonds and the lackluster performance of stocks are using homes as alternative investments.

Let’s assume for a moment that your home is an investment. In that case, it should be treated as such.

There’s an old Wall Street saying: “Bulls make money. Bears make money. Hogs get slaughtered.”

Greedy investors, in other words, get killed when they hold on too long and prices fall.

So, if your home is an investment, the smart play is to ride the boom, sell when you’ve made a nice profit, move to a rental or underpriced market and buy again after the bubble bursts and prices have fallen. That’s what you’d do with a hot stock, right?

Except that a house also is a home.

That’s a big part of the problem with today’s housing market. The property’s dual role clouds the buyer’s thinking: “If it doesn’t turn out to be a great investment, it’s still a great home.” “It’s more home than we need, but it’s a terrific investment.”

If you’re in the market for a new home, think about how each role could affect the other, and only buy a property if you can deal with all the possible outcomes.

What if it’s a good investment but doesn’t work out as a home? Would you stay there anyway, or sell for less than you’d get by waiting?

Suppose it’s a good home but turns into a lousy investment? Would you cut your losses and move? Or would you take the financial hit and stay?

As you can tell, I’m for shortening sail when the storm clouds gather. Even if home prices don’t fall dramatically, if interest rates jump, buyers will have less to spend. Many owners could be stuck with properties they cannot get rid of.

If that happens, the happy homeowners will be the ones who love their homes, are living within their means and haven’t pegged their futures to a big home-sale profit that will never come.