Housing Starts

August 29, 2005
Dean Foust

I've cited from Merrill Lynch's housing research on several occasions recently, and that's because the folks there tend to regularly come up with a fresh take on what is a much-scrutinized topic. In a report this morning, North American chief economist David Rosenberg takes on the claim made by homebuilders -- who have been throwing up new housing at a rate of 2 million new units per year -- that demographics explain the sharp increase in new housing starts in recent years. To that, Rosenberg says bunk...

Rosenberg notes that total home sales in relation to the prime home-buying age cohort have doubled in the past decade, and is up 50% in just the past five years. And of course, in many hot markets, home prices have easily doubled over the past five years. But Rosenberg argues that home price growth sould be running no more than mid-single-digit growth based on affordability and demographic factors.

On the demographic front, Rosenberg notes that the demographics aren't favorable to housing, and certainly less favorable than was in the case in the 1970s. He notes that the growth rate in household formation among 35- to 44-year-olds have stagnated for four years now. The heyday for demographics was back in the mid-1970s and 1980s when annual household formation was between 3% and 6% growth. Now, total household formation is growing at less than 1% -- one of the slowest growth rates in the past four decades.

Rosenberg even takes on the claim by homdebuilders that the high divorce rate explains the greater need for housing -- since more divorces mean the same two people need two houses or condos, not one. "But even here we have bad news for you: the U.S. divorce rate (at 0.38%) actually peaked in 1979 and again in 1981 at 0.53% of total population and has been coming down since then."

So Rosenberg says there are only a limited number of other explanations to justify the yawning gap between home sales and starts and population growth: That we're tearing down or abandoning some 500,000 homes each year (which he thinks is improbable) or that foreign investors have stopped buying Treasuries and are buying U.S. homes (also unlikely) or that there's rampant speculation by investors who are buying a 2nd or 3rd home hoping to flip it at a profit to another buyer down the road. That's the explanation that Rosenberg appears to give the most credence to.

Miami condo crush luring foreign investors

Buyers from Europe, Latin America and the U.S. Northeast target city


The Associated Press
Updated: 5:41 p.m. ET Aug. 8, 2005

MIAMI - They have thought-provoking names like Opera, Axis and The Venture, condominiums that will line Miami’s bayfront skyline.

These high-rises are part of a condo crush spawned by the nation’s housing boom and buoyed by active investors from Europe, Latin America and the U.S. Northeast that target the city because of its worldly feel and relative affordability.

“When you look around the world and you consider the factors of the environment, climate, amenities, risk and appreciation, Miami ranks way high up there,” said Jorge Perez, chairman of The Related Group of Florida. The Miami-based developer plans to build more than 15,000 units in South Florida and Las Vegas in the next four years — with buyers already lined up for many of them

From Florida to California, condos are a growing housing option for people who have been priced out of the single-family home market or are seeking a more upscale, all-in-one lifestyle for a second home. They are also a growing market for speculators — many from abroad — looking for units to resell, or “flip,” to take advantage of low interest rates, cheap dollars and attractive supply and demand.

But prices are rising, community activists are railing against development, and observers are wary of a possible bust because of speculation fueled by investors in the pre-construction and condo-conversion markets. Perez and others say they don’t anticipate a collapse, but instead are preparing for a price correction that would level out the sales prices for condos.

According to the National Association of Realtors’ statistics, 960,000 condos sold this year as of June, 12.4 percent more than all of 2004 and up 46.1 percent from all of 2002. The average condo price was $223,500 in June, up 14.8 percent from last year and 57.1 percent from three years ago.

In Miami, thousands of new condo units have been built in the past three years, and more than 30,000 units ranging from about $120,000 to millions of dollars are planned within the next few years, combined with retail and office space for more than $13 billion worth of mixed-use development, said Otto Boudet-Murias, head of planning and economic development for Miami.

The supply of new units, either through converting apartments into condos or building brand new ones, is being met by an international demand.

Alberto Saiz, assistant professor of The Wharton School at the University of Pennsylvania, said several factors have fueled the condo boom. He points to low U.S. interest rates and the weaker dollar, but also to the steady stream of immigrants from South America who come with cash.

Vacation destination
Miami has long been a vacation or second-home destination for people from the Northeast United States, but low interest rates, economic problems in Latin America and the dollars’ struggles against the euro have led foreign investors to target Miami as a more affordable alternative to European real estate.

“We’re getting a lot of second home buyers from New York and Chicago and Boston,” Boudet-Murias said. “Miami is also the destination of choice right now for European buyers.”

One of the brokers seeking out new foreign investors is Igor Acosta Rubio, who regularly travels to Venezuela, Colombia and Mexico. Acosta said investors in countries such as Venezuela and Argentina that are experiencing economic or political instability are looking north.

“We’re the Latin American door for the United States,” said Acosta, of America Real Estate in Coral Gables. “People there are realizing there are other governments who are more reasonable in terms of investment.”

Acosta said many of clients prefer to “flip” the properties. With a 20 percent down payment, one of his investors bought a one bed, one bath condo at 650 square-feet for $225,000 a year ago near Miami’s downtown. It can sell for $350,000 today, Acosta said.

Hernan Gleizer, a broker for ReMax Best Seller Realty, prefers the skyrocketing condo-conversion market to lure foreign investors. According to Real Capital Analytics, 60,844 apartment units were bought in 2004 with the intention to turn them into condos, compared to 15,806 the year before and just 5,865 in 2002.

One of Gleizer’s clients is Marcelo Klucznik, 34, of Buenos Aires, who currently owns eight units and has been “flipping” condos for years. He said he first entered the Miami market around 1998, before Argentina’s economic crisis in 2001.

“Two years ago, if you asked me, I would have told you that I was done buying,” Klucznik said while on a visit to Miami. “But the prices have gone up 100 percent.”


Los Angeles-based real estate broker Carmela Ma also said she travels overseas, including Asia and Europe to conduct investment seminars and find potential clients. For foreign buyers, condos are “a better alternative in terms of insurance, maintenance, and security,” she said.

She said that while entry-level investors from Europe and Latin America usually target Florida, entry level investors in California tend to be from the U.S. West Coast and Asia.

“Japanese, Chinese, Koreans, Thais have always been heavy investors in this area,” Ma said.

Californians are also showing growing interest in condos as primary residences due to the high cost of single family homes, Ma said.

“The lack of housing is a serious issue and that means the price of a condo will continue to hold, especially if the interest rate remains like it is,” she said.

But some worry that speculators who are banking on a steady demand and a continued rise in prices are fueling part of the condo boom. These speculators put down 5 to 20 percent to buy a condo that won’t be built for 18 months, with the hopes that the unit will still appreciate to the point that they will be able to sell it for 60 percent more when it’s completed.

The problem? If the prices rise too fast and the buyers disappear, then “flippers” will find themselves with an expensive property they can’t sell and have to return to developers, who will be forced to find other buyers at a cheaper price.

Gleizer said that about 25 percent of his clients are speculators.

“That would worry me,” Saiz said. “With speculative buyers who are buying with a lower down payment, that may be a little more dangerous.”

© 2005 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

Could The Stock Market Benefit If Housing Prices Start To Cool?

Monday, August 29, 2005
By JONAH KERI

If the real estate market softened — or the bubble actually burst — would people funnel their money into stocks instead?

The question isn't academic. Interest rates are rising and real estate stocks are weakening. Federal Reserve Chairman Alan Greenspan, warning of a possible damper on consumer spending, on Friday noted the potential for lower real estate prices.

The opposite switch between real estate and equities took place after stocks topped in early 2000.



"I knew fundamentally and especially psychologically that it would take a long time for the stock market to recover," said South Florida's Richard Schaffer, a onetime financial planner who became a day trader after making more than 50% on his stock investments in 1999.

"So I thought, 'What's the next safe haven?' " Schaffer recalled. "That's when I started directing all my resources into buying real estate."

He wasn't alone.

Many high-risk investors who got their kicks — and their cash — from day trading in the late '90s started funneling money into real estate. As housing prices surged, second homes begat investment properties, which led to more speculative buys.

Real estate in some high-growth areas is now so hot that developers conduct lotteries in which hundreds of people compete for the right to buy a still-unbuilt condo.

Some 8.5% of all homes purchased last year were for investment purposes, according to Loan Performance, a California housing data firm. That's up from an estimated 5.8% in 2000.

In some segments — for instance, Las Vegas condos — investors make up as much as one-quarter of all purchases, Loan Performance says.

Housing's boom, though strong, isn't quite up to the stock market's standards. The Nasdaq rocketed 974% from March 1990 to March 2000. It shot up 149% in the last two frenetic years of that run.

The U.S. median home price has climbed a more subdued 98% in the last 10 years. It's up 24% the past two years.

Some areas have climbed more sharply. Prices in California, Nevada, Florida and Washington, D.C., all surged 30% or more in 2004 alone.

And investment returns can be huge for speculators who buy homes with 0% down payments and flip them a year or two later — or maybe just a few months.

That trumps the stock market, where aggressive investors can use 50% of their own capital and borrow the other 50%.

Property improvements and rental income aren't an issue when flippers can turn around their purchase at light speed, with little or no money risked upfront.

Schaffer now owns a mortgage company and co-owns another mortgage firm as well as a title company.

He typically owns five to seven properties at a time in his own portfolio, mostly in South Florida. A beachfront condo he bought for $185,000 five years ago is now woth close to $1 million.

He's flipped several properties for more than $400,000 after buying in the $200,000 range. In all, Shaffer pegs his gains at well over 50% in each of the last three years.

With those kinds of gains, real estate has grown frothy.

In the second quarter it took 3.2 average household incomes to equal the average home price. The historical average is 2.6.

The value of all U.S. home equity equals 1.3 times the national GDP, also a high level.

Not everyone is convinced a housing bubble is about to pop. Some experts see a soft landing. And real estate corrections can take years to play out.

But if speculators switched from day trading to real estate when the Nasdaq cracked, they could reverse field if home prices do the same.

Stocks already are drawing more money. Mutual fund inflow, which hit a trough in 2002, has perked up since stocks started a bull run in March 2003, according to the Investment Company Institute, the national trade group for U.S. mutual funds.

"Money will gradually flow into stocks, especially if the country stays on the path it's on now — GDP 3.5%, unemployment around 5%, inflation not all that important," predicted Rob Stein, managing director of Astor Asset Management. "People can throw smaller amounts of money into the stock market and remain liquid, as long as businesses are still making money, and jobs and profits keep growing."

But a steep drop in home prices could take a bite out of the economy, noted David Wyss, chief economist for Standard & Poor's. While speculators might shun real estate for stocks, other investors might pause.

The reason: Most homeowners still live in their homes. A drop in home values could make them feel they have less money available to spend and could leave them with less to invest.

"It would become tougher to refinance and take cash out. A lot of consumer spending is tied to buying a house, between furniture and home improvements," said Wyss. "There could come a point where there just won't be a lot of money to use for investments."

What's more, if interest rate hikes accelerate, stocks could be hurt along with home prices. High enough rates could push investors into bonds instead.

On the other hand, a cooling real estate market could take pressure off the Fed to keep raising interest rates. That would help stocks, says Jason Trennert, chief investment strategist for ISI.

"If the housing market peaks," Trennert said, "the economy will slow down. If the economy cools, that should get the Fed out of the way, and that's good for the (stock) market."

Greenspan on the ending of the housing bubble

Greenspan Article

Housing-Bubble Talk Doesn't Scare Foreigners

By RUTH SIMON and JAMES R. HAGERTY and JAMES T. AREDDY
Staff Reporters of The Wall Street Journal

From The Wall Street Journal Online

Strong demand for mortgage-backed securities from investors world-wide is allowing American lenders to make more loans -- and riskier ones -- in a way that is helping prolong the boom in U.S. house prices.

The cash pouring in -- not only from U.S. investors but increasingly from Europe and Asia -- keeps stoking the housing market even as the Federal Reserve Board continues to raise interest rates, normally something that damps home prices. The market has shown a few signs of slowing recently, and talk of a bubble has grown louder, but prices continue to rise or remain at lofty levels as investors continue to gobble up mortgage-backed securities and banks keep lending.

"As the Fed has tightened, lenders have eased" terms for borrowers, says Mark Zandi, chief economist at Economy.com, a forecasting firm in West Chester, Pa.

Investment banks and other firms have been buying mortgage loans from lenders and packaging them into securities for sale to investors since the 1980s. But investor demand has surged in recent years, largely because in an era of low returns, mortgage-backed securities offer yield-starved investors much higher returns than government bonds.

U.S. lenders will make about $2.8 trillion in home-mortgage loans this year, according to the Mortgage Bankers Association. The MBA estimates that about 80% of these loans will end up in mortgage-backed securities. Mortgage-backed securities outstanding at the end of the first quarter totaled $4.61 trillion, up 61% since the end of 2000. In the same period, total Treasury securities outstanding grew 35% to $4.54 trillion.

Investors' strong demand for mortgage debt, besides allowing lenders to offer many borrowers better terms, has also made it easier to offer mortgages to borrowers who might not easily qualify for a loan. The growth of the mortgage markets spreads the risks around. But some mortgage-industry analysts say lenders have become less stringent in their loan terms because they can sell almost any type of loan to those who package mortgage securities for investors.

"Loose lending standards are probably the single biggest thing fueling the speculative fever we have today" in housing, says Kenneth Rosen, an economist who is chairman of the Fisher Center for Real Estate at the University of California at Berkeley.

In a world of low interest rates, the market for mortgage securities is simply too big and profitable for many investors to ignore. Investors can earn about 5.5% on mortgage securities whose payments are guaranteed by Fannie Mae or Freddie Mac, government-sponsored companies. Those who can stomach greater risk can buy subprime mortgage securities, which come with no guarantee but can yield as much as 15%, according to Bear Stearns. By contrast, 10-year U.S. Treasurys yield about 4.2%; the equivalent government securities in Germany yield about 3.2% and in Japan 1.5%.

The buyers of mortgage-backed securities include U.S. pension funds, hedge funds and insurance companies. But overseas investors are the fastest-growing source of demand. The trade publication Inside MBS & ABS estimates that foreigners held $280 billion of U.S. mortgage securities at the end of 2004, or 6% of the total outstanding. The foreigners' holdings rose 26% last year and have continued to bound ahead so far this year, Inside MBS & ABS says.

"There's this insatiable appetite for mortgage-backed securities world-wide," says Andrew Sciandra, a senior vice president at IndyMac Bancorp, a California thrift, who heads a team that creates those securities. In the past year, Mr. Sciandra has met with investors from places like Germany, France and Abu Dhabi. Asian investors now account for roughly 10% to 20% of mortgage securities sold by IndyMac.

For homeowners, the growing international demand for mortgages means it's increasingly likely that the money they borrow to buy a home or refinance their mortgage is coming ultimately from outside the U.S. When Claude Gaty, a chef and co-owner of a bistro in Las Vegas, recently refinanced the mortgage on his four-bedroom Las Vegas home, the lender was IndyMac. But the bulk of the money came from investors in Asia.

IndyMac pooled Mr. Gaty's loan with about 3,000 other mortgages that carry a fixed rate for the first three, five or seven years. Mr. Gaty is paying both principal and interest on his loan, but most of the loans in the pool are interest-only mortgages, which allow borrowers to pay no principal in the early years. When the $650 million offering of triple-A rated bonds backed by these mortgages came to market in June, it drew more than a dozen investors from Europe, Asia and the U.S., according to Deutsche Bank, which handled the deal. Such bonds typically yield 0.75 to 1.15 percentage point more than Treasurys, Deutsche Bank says.

The most recent entrant to the market is China. Its banks are rich with deposits from Chinese companies that earn dollars exporting to the U.S. Dollars have also been handed to some banks by the government in Beijing as part of its efforts to strengthen their balance sheets.

Until a few years ago, Chinese investors restricted U.S. investment mostly to Treasurys. Now, to boost their yields and because they consider the market safe, bankers from a number of institutions say they are devoting more of their portfolios to mortgage securities. Some bankers say their goal is to have 40% of their U.S. dollars in asset-backed securities.

China's government also is testing U.S. mortgage investment. The country's Bank of Communications, the only bank with a mandate to help manage China's $700 billion of foreign-exchange reserves, has recently put a sliver of those reserves into mortgage-backed issues, according to a banker there. The State Administration of Foreign Exchange, the government agency in charge of the reserves, declined to comment.

Zhu Kai, who helps manage U.S. dollar investments at Bank of China, says in a rare interview that his mortgage-backed portfolio has "plenty of room to grow." Mr. Zhu expresses confidence in the U.S. dollar and the health of the U.S. home market. Housing is so vital to the U.S. economy, Mr. Zhu and some of his counterparts at other Chinese banks reason, that U.S. authorities will prevent a bust.

Even the recent decision by the Chinese government to raise the value of its currency by about 2% isn't likely to lead Chinese banks to shift their plans. "The timing may be a little bit surprising but we will not change our investment portfolio," Mr. Zhu says.

While Asian investors have largely focused on triple-A-rated bonds, other investors are buying lower-rated debt. These bonds, which are created when bankers carve up pools of mortgages, offer higher yields, but also bear the first risk of losses should borrowers default. Investors who buy these bonds in effect set the standards for which mortgages are made by deciding how much extra yield they need to compensate for the added risks of lower-quality loans. They include real-estate investment trusts, hedge funds and investors from Europe.

Strong investor interest has also made loans available to borrowers with poor credit and many other people who might otherwise have trouble getting a mortgage. Subprime loans included in mortgage securities totaled $401.5 billion last year, nearly double the total for 2003, according to Standard & Poor's. Meanwhile, loans with less than full documentation of the borrower's income and assets accounted for 70% of mortgage securities rated by Standard & Poor's in this year's first half, double the level recorded in 2000.

"There's no question that [lending] standards have loosened over the past couple of years," says Arthur Frank, director of mortgage research at Nomura Securities International in New York. If house prices fall, "you may well have some pretty serious credit problems," hurting holders of the lower-rated mortgage securities.

Mr. Zhu, the Chinese fund manager, is sanguine, for now. The U.S. housing market is "maybe losing a bit of steam," Mr. Zhu says. "I think the monetary authorities, they don't want this housing market to burst. I don't think it is a bubble. But if things go on like this for another five years, it's a different story."

Email your comments to ruth.simon@wsj.com.

--August 25, 2005

Enter the Flipbusters

Increasingly, housing developers are trying to curb the practice of quickly buying and selling homes

By
TIM PADGETT
Time.com
August 25, 2005

Randy Bianchi is a firm believer that in America, "a person should be allowed to buy a second, third or fourth home if he or she wants." That goes for real estate investors and speculators, even those who "flip" homes—that is, people who buy a house or condominium for the sole purpose of quickly selling it off for a profit, usually before construction is completed and often without even taking title to it. But Bianchi, a real estate broker and co-owner of Paradise Properties in West Palm Beach, Fla., who says he may soon flip a luxury condo himself, admits that his convictions about the practice are being tested in today's housing-price boom when homes in his area of Florida are jumping 35% a year. "Flipping," says Bianchi, "is turning into a negative phenomenon. In reality, it's pushing the market up too fast."

Some of the nation's leading homebuilders call that an understatement. To them, real estate investors, especially flippers, are to the housing boom what day traders were to the disastrous dot.com craze: a scourge distorting the market. In fact, Steve Hilton, co-CEO of Meritage Homes Corporation in Plano, Texas, said in an interview last month with the Arizona Republic in Phoenix—one of the nation's hottest real estate markets—that many investors today are "parasites" who artificially "raise the price of housing" but "don't bring any value." Craig Robins, head of Dacra Developers in Miami, concurs: the investors, he says, are bringing a hyper-short-term mentality to real estate ownership that creates too much turnover and "diminishes both the financial and community integrity of any development."

Investors argue they're being unfairly scapegoated. Developers, they say, are simply frightened that outsiders like them are getting a piece of the action for once. They add that homebuilders, far from being the socially conscious lot they've cast themselves as in this dispute, are just as culpable with respect to skyrocketing housing prices. The developers, says Sean Claggett, a Las Vegas attorney who represents investors, are often the first these days to hyperactively raise home prices to levels that attract investors in the first place. "The investors are not the ones who dictate the market, so to just point the finger at them is inappropriate," says Claggett. "No one's happy when too many investors flood a market, but the builders have to take a large share of the responsibility for that."

Still, a growing number of developers nationwide are increasingly working "anti-investor clauses" and other "flip-buster" weapons into their sales contracts. Many now demand that buyers pledge in writing that they'll actually occupy the home they buy (or at least disclose whether the unit will be a primary or secondary residence or merely an investment). Others, like Robins, limit the number of units a person can purchase in any one development; and some, like StarPointe Properties of Arizona, are requiring investors to close on (and take title to) the property they're buying. Hilton and Meritage, as well as a host of other large developers like Pulte Homes, are playing even harder ball: they now demand that a homebuyer forfeit the profit if selling a home before the minimum period of one year (except for hardship reasons). Hilton says Meritage already has several cases pending in court against investors who violated those contract terms. "We weren't doing this a few years ago because the investors were few and far between," says Hilton. "But now it's an out-of-control activity that we simply can't condone."

"Investment homes," as they're often called, used to represent a fraction of U.S. housing sales, but according to the National Association of Realtors they made up almost a quarter of home purchases last year. It's one reason why U.S. home prices have lept 50% since the 1990s (condo prices have risen 57%) and why fewer than an estimated fifth of Californians can afford a median-priced home in their state. Developers complain that when investors snatch up units pre-construction and then sell them off before the sodded grass is even put down, it essentially means the developer ends up competing with the flippers for sales within his own development. At the same time, families and other buyers who don't have the time or wherewithal to play this game usually end up paying a higher price than they would had the home not been flipped. "It takes money off the table for the parties who are genuinely interested in building and living in the homes," says Robins.

What's also at stake, say the developers, is the status of the "home" as something more than a commodity as instantly tradable as pork-belly futures. When the prime purpose of a house or condo becomes hedging instead of living, they argue, it eventually loses the cachet of residential and community stability that keeps property values strong in the long term. "If there is no sincere interest or care about the actual use of the property," says Robins, "it won't be worth that much over time. It jeopardizes the market." In an exchange this month on the Inman News website, a leading real estate news service, a prospective Las Vegas condo buyer told columnist Robert J. Bruss he didn't like the "smell" of the developer selling units pre-construction to speculators. Bruss didn't mince his response: "There should be a law against real estate speculators who hope to tie up a property before construction without ever taking title or adding any market value."

Investors counter that the flip-busting measures are a violation of free-market practices and a worrisome, if not illegal, form of real estate discrimination. The enforceability of anti-investor clauses is still in question, but Hilton says Meritage's attorneys have assured him that his company's pending cases against investors "will stand up," and no investor has yet filed a suit against the anti-investor measures. In the meantime, it appears the investors may have trouble erasing an image, fair or not, as the bad guys of this housing boom.

Housing Hasn't Hit the Ceiling

Housing Hasn't Hit the Ceiling
Realtors' July data may seem to indicate the property market is slowing. But put the numbers in context, and this sector is still sizzling

Starter-Home Index - August 22, 2005

Cracks in the Ceiling

Cracks in the Ceiling
Of the Housing Boom

By MARK GONGLOFF and DAVID GAFFEN and ED LEAMER and SCOTT PATTERSON
Staff Reporters of The Wall Street Journal

From The Wall Street Journal Online

This week's Trading Shots column welcomes UCLA professor Ed Leamer. Dr. Leamer is director of the UCLA Anderson Forecast, which provides quarterly economic projections for the nation and the state of California.

Mark Gongloff: If you're trying to find a slow leak in a tire, you can submerge it in water and look for tiny bubbles of escaping air. That may be the best way to look for signs of a deflating housing market, too.

After all, just going by the big indicators, the housing market still looks plump. Sales of pre-owned homes, the bulk of the housing, hit record pace in June, with prices posting their biggest gain since the Carter administration. But there are tiny bubbles escaping, which shouldn't make you feel happy or fine (apologies to Don Ho) about the boom.

The most important indicator is probably the growing length of time "For Sale" signs are sitting on lawns across the country. The Wall Street Journal and New York Times recently published big-picture reports on that, but smaller papers, from New Hampshire to South Carolina to Palm Springs, Calif., had already presented the tiles for that mosaic. "This happens in every cycle," says Wellesley College economics professor Karl Case, who has published several studies of the housing market with Yale economist Robert Shiller. "The first sign [of a slowdown] is always time on the market and inventory."

Yet there are other, even tinier bubbles rising to the surface. New-home construction has plateaued in the past year, though at a high level. Mortgage applications have fallen in four of the past six weeks. The inventory of foreclosure properties rose nearly 5% in July, according to Foreclosure.com, and is up 10% in the past year. Sales growth at home-and-garden centers and furniture stores has slowed sharply from a peak in early 2004, according to Commerce Department data. As of the second quarter, Home Depot and Lowe's were still making money hand-over-fist, but their share prices have flattened in the past month, with investors worried that higher interest rates will hurt business. Furniture sales have fallen in three of the past five months.

Another leading indicator could be a slowdown in the pace of new-home sales, says Richard DeKaser, chief economist with National City in Cleveland. Unlike homeowners, who tend to resist cutting prices, homebuilders are more willing to slash prices on brand-new homes to get rid of them, if they have to. "If a price adjustment is required, we will see it there first," he says. "My read there is that we may be seeing price-softening already in the process of playing out." The National Association of Home Builders' index of new, single-family home sales fell for the second straight month in August, matching its lowest level of the past year.

If these are simply signs of a healthy market adjustment, that's good news. But more of a slowdown could also hurt the broader economy, which, together with higher interest rates, could put even more pressure on this overinflated tire.

David Gaffen: At least three television shows today -- one on the A&E channel, no less -- extol the virtues of buying, renovating and selling houses for a quick profit. TV shows about "flipping" is the real-estate equivalent of what JFK's dad, Joseph Kennedy Sr., said about the 1929 stock scene: It's time to sell when the shoeshine boy starts talking about the market.

The Learning Channel has "Property Ladder," hosted by "veteran real-estate investor and flipper Kirsten Kemp"; its sister network, Discovery Home, has "Flip That House." That competes with the just-as-imaginatively named "Flip This House" on A&E (we could spend all day arguing whether flipping is an art, entertainment or both). All three premiered within the last two months. And why not? Housing has been a terrific investment -- Freddie Mac says the annualized five-year rate of home price appreciation was 8.38% as of first quarter, the best it has been nationwide since 1982. Still, the idea of several TV shows explaining how Joe Sixpack can make easy money in real estate through what amounts to speculation should trip an alarm or two.

There is an old adage that magazines and books are great contrarian indicators. Business Week's famous "The Death of Equities" cover in 1979 and James K. Glassman's "Dow 36,000" tome from 1999 are storied examples. Life Magazine in February 1970 published a cover foretelling how America beat inflation -- just before inflation boiled over. There is an interesting twist, though: While magazines and other publications can be churned out quickly to ride a trendy wave, studio productions often takes months of work, and by the time they hit screens big and small, there is a real danger that the peak is well in the past.

Oliver Stone's "Wall Street" was poignant, but it premiered nearly two months after the 1987 crash. Meanwhile, two drop-dead awful TV shows, "Bull" and "The $treet," premiered in 2000 just in time to follow the market into the toilet. "Television is so removed," says Barry Ritholtz of Maxim Group. "By the time an idea has totally infiltrated the public ... it's usually very late in the stages of that trend."

Sure, home renovation has always been a part of TV since Bob Vila's "This Old House," and TV shows like "Extreme Makeover: Home Edition" have somewhat noble agendas. But those shows are about bettering quality of life; flipping is about making quick bucks in a difficult game to play. Once the cameras start rolling, the losers are likely to turn up fairly quickly.

Ed Leamer: The history of residential investment offers a Hobson's choice: either a housing-induced recession or a war the magnitude of Vietnam or Korea.

The figure here depicts real residential investment per worker since 1948, with the official recessions shaded. (Residential investment includes new homes and brokerage fees, but doesn't include housing appreciation.)

This spending on homes varies from recession lows of about $2,500 per worker to expansion peaks near $4,000. During the recession of 2001, we were at that high $4,000 level, but we ploughed right through the recession without noticing it, and in the second quarter of 2005 we achieved the all-time high -- $5,233 per worker. Cut that back by $1,000 to get it into "normal high" range and you lose $1,000 times 140 million workers. That's $140 billion in lower spending. That's enough to cause a recession, if it occurs rapidly.

Can we get out of this mess? There have been two "false positives" -- problems in the housing sector that didn't precede recessions. One was in 1966-67. Spending on the Vietnam War saved the economy that time. The other was 1950-51. Then it was the Korean War. Pretty dismal news, for sure.

For perspective, Defense Department spending on Iraq and Afghanistan was 4.8% of gross domestic product in 2004 according to the Bureau of Economic Analysis. During the Vietnam and Korean wars it was as high as 10.2% and 15% of GDP, respectively.

Scott Patterson: The stock market is often a step ahead of the economy. Markets usually plunge well before recessions strike, for instance, as seasoned investors catch an early whiff of the slowdown. Could shares of home builders be telling us something about the housing market?

DR Horton is off 17% from its 52-week high. Also off highs are Hovnanian Enterprises (down 19%), Pulte Homes (off 12%) and Toll Brothers, which has coughed up 18%. The Dow Jones Home Construction Index has declined 10% so far in August. July saw the most insider selling of home-builder stocks on record, 5.1 million shares, according to Thomson Financial.

There are some stock-specific reasons for these declines, but general worries that rising interest rates could reverse the housing boom are taking a toll across the board. Home builders got whacked particularly hard recently after the Labor Department reported strong jobs growth in July, which caused investors to bail out of bonds, sending yields higher. Bonds tend to decline on signs of economic growth, such as rising employment. Since mortgage rates are tied to Treasury yields, home-builder stocks are especially sensitive to the bond market.

Hovnanian took a hit after it said the number and dollar value of net contracts in the West declined in its third quarter due to development delays. Net contracts also declined in the Northeast. Toll Brothers sports a bruise from an Aug. 4 downgrade by Wachovia Capital Markets analyst Carl Reichardt. One reason cited for the downgrade: His firm's July neighborhood-watch survey showed signs of a sharp slowdown in Washington, D.C., where Toll Brothers does a lot of business. Rising prices for homes were making it difficult to find buyers, sales managers said.

Sales managers are also hinting at trouble in northern California, said Mr. Reichardt, where prices have started to hurt traffic and sales. What's more, PMI Mortgage Insurance's U.S. Market Risk Index, which estimates the probability of house-price declines based on affordability, recently showed that the risk of falling prices increased in 36 of the nation's 50 largest housing markets. Four California markets -- San Diego, San Jose, Santa Ana and Oakland -- had a more-than 50% likelihood of price declines, according to the index.

Email your comments to rjeditor@dowjones.com.

--August 23, 2005

Some States Now Limit Price Rebates to Buyers

From The Wall Street Journal Editorial Page

Why are Governors and state legislatures enacting regulations to make buying and selling homes as expensive as possible?

We ask this question because in recent weeks three normally level-headed Republican Governors -- Matt Blunt of Missouri, Rick Perry of Texas and Bob Riley of Alabama -- have signed into law legislation that protects Realtors from discount competitors.

About a dozen other states have also buckled to the National Association of Realtors lobby. They've effectively become partners in what looks suspiciously like a price-fixing scheme, whereby discounters are prevented by law from charging fees below the industry norm of 5% to 6% of the home sales price. The financial victims of this cartel are middle-income home buyers and sellers who are required to pay brokerage fees that can easily be several thousand dollars above a competitive market price.

Real estate brokers are under increasing price pressure from Web-based home-buying services and other discount brokers. With state lawmakers so often bellyaching about the decline in "affordable housing," one would expect politicians to salute these low-fee entrants to the market.

Instead, state legislatures and real estate commissions -- which happen to be populated by Realtors -- are enacting laws that make price competition illegal and thus treat Realtors as if they are members of a closed shop union.

The Realtors argue with a straight face that their political efforts are somehow in the interests of the home-buying public. Maybe we're missing something here, but in almost every other consumer industry -- booksellers, retailers, home appliances, insurance, banking, stock brokers -- the introduction of Internet and discount sellers has been a phenomenal financial benefit to customers. Discount airlines have cut airfares by 60% or more, to the economic benefit of everyone with the exception of the incumbent competitors.

* * *

Economists call this process of squeezing out transaction costs "disintermediation." If any industry is ripe for this, it is the $70 billion-a-year real estate brokerage market. Yes, fees have fallen modestly to about 5.1% on average in recent years. But a new study by the Brookings Institution and American Enterprise Institute concludes that in an unimpeded free market, fees should be dropping much faster -- particularly amid a real estate boom that has doubled home values over the past decade. Many, if not most, of the services that Realtors provide don't vary with the sales price, so the percentage fee should fall as home price rises.

The problem is that state lawmakers are squashing such competition through two types of laws. First, they make it illegal for brokers to provide rebates on their commissions, which is an overt impediment to price competition. So, for example, LendingTree.com is prevented under these laws in about 10 states from continuing its popular practice of providing several thousand dollars of rebates and coupons at Home Depot to homeowners who use its real estate services. Discount real estate agents would also be prohibited under many of these laws from advertising their lower prices in newspapers.

The second legal device used to restrain trade are "minimum service requirements," which prevent real estate brokers from providing limited services to home sellers for a negotiated fee. These rules outlaw the increasingly popular choice of home sellers who contract with an agent to list their homes for a flat fee of typically around $500, but then handle all the other aspects of the home sale themselves in order to save $5,000 to $10,000 in additional fees.

More than a dozen states (see nearby list) have enacted these requirements, which are analogous to telling McDonald's that it can sell french fries only if the customer also buys a hamburger and Coke. We'll also note the supreme irony that states and the federal government sued Microsoft for illegally "bundling" its software, whereas in the real estate market the states are requiring bundling. In either software or real estate, the choice should be up to the individual sellers.

In some states, real estate agents collude to boycott homes that are being sold by agents who provide commission discounts. This practice is a clear breach of the fiduciary duty of the agent to find the best home at the lowest price for clients. Instead, the brokers are in effect finding homes for their clients that will afford them the highest fee structure. To our knowledge, neither the National Association of Realtors nor the state real estate commissions have ever sanctioned a real estate agent for this breach of ethics.

How large is the restraint of trade rents in this industry? One back-of-the-envelope way to quantify the costs to consumers is to compare the 5.1% standard fee in the U.S. to the industry average in other countries, which is estimated at about 3.6%. This means Americans are paying about $20 billion a year more for real estate services -- or about $3,000 on an average priced home -- than are home buyers in other nations.

In its own internal documents, the Realtors association acknowledges that the purpose of its state lobbying is to keep competition out and fees high. In an April 22 memo to its state affiliates, the national office urged members to keep agitating for "state laws that are designed to replace competition with regulation." The memo added that "Realtors have the right to lobby for legislative and regulatory action -- even if the effect of such action would be anti-competitive."

In response to a recent U.S. Justice Department complaint against a Kentucky Real Estate Commission policy that prohibited brokerage rebates and "other inducements to attract customers," the Realtors also acknowledged that these laws are intended to keep prices as high as possible.

The brokers admitted that the policy "inhibits free trade" but defended the regulation by arguing that it was necessary to "avoid a bidding war" and to protect against a "lessening of profits." And this was their defense. The Kentucky Real Estate Commission reversed itself, though the brokers no doubt will now scurry off to the state legislature to get a new law enacted.

* * *

The Realtors have the First Amendment right to lobby for such anti-consumer legislation. But let's please dispense with their pretense that these laws are intended to "assure that the market for the sale of real estate functions efficiently and in the interests of buyers and sellers."

We have nothing against real estate agents or their trade. In fact, we think the Justice Department is wrong in its recent antitrust complaint demanding that the National Association of Realtors allow online sellers access to its Multiple Listing Service. The listing service is a privately owned data base, not a public utility, and the Realtors should have the right to share it with whomever they wish.

However, with their lobbying for state-imposed restraints of trade, the Realtors are the ones doing financial damage to millions of home buyers and sellers. We don't know who is more at fault here: the Realtors who maintain that such protectionism benefits consumers, or the pliant state lawmakers who actually believe them.

-- This editorial was originally published in The Wall Street Journal on Aug. 12, 2005.

Email your comments to rjeditor@dowjones.com.

--August 19, 2005

The three myths of condo investing

Don't be sucked in by these three myths of condo investing.

August 20, 2005: 1:35 PM EDT

NEW YORK (MONEY Magazine) - The growth in condo-investing mythology may be more worrisome than the risk of overbuilding. Here are three whoppers that need reality checks.

MYTH: Get in early and you'll be guaranteed a profit.
Remember the lust for Internet IPOs? Ordinary investors bid up the stocks of hot little companies that hadn't even registered their first sale yet. Today's version is a preconstruction condo, where investors jockey to get into a project not yet built, certain the units will jump in value when completed.

But getting in early doesn't guarantee riches anymore. That's because developers have caught on to the demand and are now selling preconstruction properties at market prices, says Kimberly Kirschner, a Miami agent who specializes in new condos.

Also, developers are requiring buyers to reserve their units earlier -- as much as three years in advance. That's an awfully long time to assume a hot condo market will continue to boil.

So when it comes to preconstruction, skip that line. Instead, buy an existing unit. While preconstruction purchasers can wait up to three years with very little to show for it at the end, you can collect 36 months of rent to put toward paying off your mortgage and building equity. If prices continue to appreciate, great. But that's a cherry, not the whole sundae.

MYTH: Creative mortgages lower your payments and guarantee positive cash flow.
New twists on adjustable-rate mortgages and interest-only loans can make condo investing seem like a lark. But some of these things could slaughter you if prices fall when you have to sell.

The riskiest is called an option ARM, which features several payment choices each month, including a standard interest-and-principal payment, an interest-only payment and an interest-only minimum payment that's so low it doesn't cover the month's interest charge. The unpaid interest is rolled into the principal, meaning that -- yes -- you're charged interest on your unpaid interest.

Fort Lauderdale resident Bruce Palmer, 50, recently signed up for an option ARM that cuts his monthly payment on a $417,000 investment condo by $500. As a result, his two-bedroom in Fort Lauderdale should generate a profit of $350 a month.

Palmer, a commercial pilot, says he sees the risk. Paying the interest-only bare minimum means his mortgage is growing, not shrinking. If local prices were to drop, his loan balance could exceed the condo's value.

But Palmer is confident, building a war chest to snap up properties. "If I could leverage more," he says wistfully, "I would."

Gary Eldred, author of "Make Money with Condominiums," worries about such sunny thinking. Most condo investors should avoid option ARMs, he says, and either put down more money to lower the monthly payment or consider buying -- gasp -- a less expensive unit.

Whatever your choice, Eldred says your expected rent should cover at least 70 percent of your total monthly costs. Tax write-offs on condo losses can help close some of that gap, he notes. (Up to $25,000 in losses, excluding mortgage-principal payments, can be charged against total income of less than $150,000.)

And he argues that rising rents should, over time, cover the rest. (With condo prices soaring, Eldred predicts that condo rents will follow as would-be buyers get priced out and rent.) More cautious investors would want their rent to cover 100 percent of carrying costs or more.

MYTH: You should buy in your backyard, where you know the landscape.
Too few condo investors recognize one of the best reasons to buy: It can help diversify your real estate holdings so that your portfolio doesn't rise and fall solely on hometown economics and events. (Even if property is a relative bargain in your area, buying wisely elsewhere can make more sense than buying too much property locally.)

New York City attorney Richard Savitt, 40, never thought about all this 18 months ago, when he abandoned hopes of investing in Big Apple condos and bought in Philadelphia instead.

"We just thought New York prices were crazy," he explains.

But it sure looks wise now. Savitt and four partners bought four one-bedroom condos, each around $300,000. Similar units now list for as much as $450,000.

To help you determine where to invest, take the average price at which units are selling in a city and divide it by the annual rent the average apartment there generates. That will produce a price-to-rent ratio. The lower the better. Houston, Atlanta and Philadelphia, for instance, still look relatively good, while New York City and San Francisco do not.

In Minneapolis, Chris Cowen and four other condo investors who've become pals gather at a bar for their fortnightly meeting. Jahn Dyvik, a 42-year-old engineer who sold his Porsche Boxster to help fund more condo buys, says lower prices in neighboring St. Paul make that city the better bet.

The rest of the group is sticking with Minneapolis, where they think prices will rise faster. Two others have also sold their cars. All have home-equity loans.

Where are prices headed? Cowen's not sure. The long-term case for condos looks good, but all the building out there makes him nervous. "People have unrealistic profit expectations."

Not him, of course. "No one has a crystal ball. But the condos I've bought are going to go up."

Get in early! Get out fast! Sound familiar?

Everyone knows how the dotcom party ended. Right? Right?



August 18, 2005: 1:33 PM EDT
By Stephen Gandel


NEW YORK (MONEY Magazine) - Late May, early evening. Chris Cowen cools his heels in a Minneapolis restaurant, waiting for a table. His buddy Keith is 15 minutes late.

Cell phone rings. It's Keith. Got a proposition for you, Chris: a one-bedroom condo under construction in Scottsdale, Ariz. -- 1,800 miles away -- for $135,000. The catch: Only 60 seconds to decide. Sight unseen. Over the cell.

"It was a no-brainer," recalls Cowen, 32, who owns 28 condos (solo or with partners) in various stages of completion. Two months after his impulse buy, Cowen figures the unit's ultrafast appreciation has covered his $3,500 cash down payment 10 times over.

"I've already made $35,000," he crows.

Know this guy? If you don't, you probably will soon, because condos are to the real estate boom what Internet stocks were to the 1990s bull market. And like the Internet day-traders before them, the new condo flippers, with their talk of instant riches and easy money, are about to become the life of every cocktail party.

And why not? Condo prices have soared 80 percent in the past five years, making the same period's 40 percent rise for single-family homes look almost pokey. Developers are constructing new condo units at nearly twice the pace they were in 1999, and investors are literally lining up to buy one, two, three or more. In Miami, as much as 75 percent of some condo towers are investor-owned.

No cash? No problem. Banks, with their loosened lending standards, no-money-down loans and teaser mortgage rates, are making it easier than ever to be a mogul-in-training.

Chris Cowen is betting his retirement that the wonder years won't stop soon. He cashed out his 401(k) to put $246,000 into a highly leveraged condo portfolio that he thinks could sell for $6.2 million. Estimated equity so far: $868,000. Cowen is so bullish, he quit his corporate job at Siemens to develop his empire full time.

"Even if you make six figures, you still work for someone else, paying 40 percent taxes and putting in 60 hours a week. What do you get for that?" he scoffs.

A volatile mix
Mix it all together -- rising prices, record levels of construction, fast-and-loose mortgages and swelling ranks of new investors -- and you get a market more volatile than Tom Cruise.

"To some degree, what's driving condo prices is sheer greed," says economist Gleb Nachayev of Torto Wheaton Research, which forecasts a relatively mild drop of as much as 3 percent for U.S. housing prices overall in the next year. "Condo prices have increased faster than single-family homes -- and they will fall faster."

As they did little more than a decade ago. Overbuilt and over-concentrated in city centers, the condo market collapsed in the early '90s, smashing overstretched owners in the process.

No one knows when history will repeat itself. But c'mon: The easy money has been made. The right time to invest is not after a record five-year run-up in prices. It's not when the supply of new product is set to nearly double.

If you're really drawn to the market, you need a deeper understanding of what's driving prices up -- and what can drive them down. Above all, don't confuse what's worked in the recent past with what will work over the long haul.

The case for boom
Condos still have plenty going for them -- namely, 76 million baby boomers. You know the demographic drill by now: As they become empty-nesters and retirees, they'll sell their rambling homes in the burbs and move into yard work-free condos (or at least purchase them as second homes).

They're expected to continue flooding into aging-friendly locales like Arizona, Florida and Nevada, but they'll also be flocking to traditional city centers as downtowns become safer.

Don't forget the children of boomers, adds veteran condo investor and National Association of Realtors chief economist David Lareah. They'll need affordable places to get started, and many already see entry-level-priced condos and townhouses as a great way to build equity so that they can trade up.

"It's hard to concoct a scenario where condo prices collapse in most markets," Lareah argues.

A good condo pick that's soundly financed can be about as hassle-free as real estate investing gets. Gary Eldred, author of "Make Money with Condominiums," notes that association fees typically cover the standard repairs you'd have to oversee on a traditional house.

"Condos," Eldred says, "are perfect for people who want a passive investment."

The case for doom
Even the best investments can get overvalued, however. Condo fans cheer the 15 percent average annual spike in prices these past four years, but fail to remember that number was about 2 percent in the '90s. Last year, for the first time, the median condo cost more than the median home -- $9,500 more.

Prices in some parts of the country look even more ridiculous when you compare them to the low rents that condos currently generate.

In Minneapolis, for instance, the average downtown condo sells for just over $256,000, up 77 percent from mid-2000. But area apartments rent for a measly $915 average a month, down from $918 four years ago, according to Torto Wheaton Research.

Even with a 20 percent down payment, a 30-year fixed-rate mortgage would cost $1,150 a month. This condo investor is $235 a month in the hole -- even before paying association fees and taxes.

Growing fears of overbuilding are also cause for pause. With so many condos being built today, one has to wonder: Who's gonna rent them? Apartment vacancy rates have been rising.

"My guess is construction is growing faster than demand in some markets," says Raphael Bostic of the University of Southern California's Lusk Center for Real Estate.

Perhaps most worrisome: The growth in condo-investing mythology. Here are three whoppers that need reality checks.

MYTH: Get in early and you'll be guaranteed a profit.
Remember the lust for Internet IPOs? Ordinary investors bid up the stocks of hot little companies that hadn't even registered their first sale yet. Today's version is a preconstruction condo, where investors jockey to get into a project not yet built, certain the units will jump in value when completed.

But getting in early doesn't guarantee riches anymore. That's because developers have caught on to the demand and are now selling preconstruction properties at market prices, says Kimberly Kirschner, a Miami agent who specializes in new condos.

Also, developers are requiring buyers to reserve their units earlier -- as much as three years in advance. That's an awfully long time to assume a hot condo market will continue to boil.

So when it comes to preconstruction, skip that line. Instead, buy an existing unit. While preconstruction purchasers can wait up to three years with very little to show for it at the end, you can collect 36 months of rent to put toward paying off your mortgage and building equity. If prices continue to appreciate, great. But that's a cherry, not the whole sundae.

MYTH: Creative mortgages lower your payments and guarantee positive cash flow.
New twists on adjustable-rate mortgages and interest-only loans can make condo investing seem like a lark. But some of these things could slaughter you if prices fall when you have to sell.

The riskiest is called an option ARM, which features several payment choices each month, including a standard interest-and-principal payment, an interest-only payment and an interest-only minimum payment that's so low it doesn't cover the month's interest charge. The unpaid interest is rolled into the principal, meaning that -- yes -- you're charged interest on your unpaid interest.

Fort Lauderdale resident Bruce Palmer, 50, recently signed up for an option ARM that cuts his monthly payment on a $417,000 investment condo by $500. As a result, his two-bedroom in Fort Lauderdale should generate a profit of $350 a month.

Palmer, a commercial pilot, says he sees the risk. Paying the interest-only bare minimum means his mortgage is growing, not shrinking. If local prices were to drop, his loan balance could exceed the condo's value.

But Palmer is confident, building a war chest to snap up properties. "If I could leverage more," he says wistfully, "I would."

Author Gary Eldred worries about such sunny thinking. Most condo investors should avoid option ARMs, he says, and either put down more money to lower the monthly payment or consider buying -- gasp -- a less expensive unit.

Whatever your choice, Eldred says your expected rent should cover at least 70 percent of your total monthly costs. Tax write-offs on condo losses can help close some of that gap, he notes. (Up to $25,000 in losses, excluding mortgage-principal payments, can be charged against total income of less than $150,000.)

And he argues that rising rents should, over time, cover the rest. (With condo prices soaring, Eldred predicts that condo rents will follow as would-be buyers get priced out and rent.) More cautious investors would want their rent to cover 100 percent of carrying costs or more.

MYTH: You should buy in your backyard, where you know the landscape.
Too few condo investors recognize one of the best reasons to buy: It can help diversify your real estate holdings so that your portfolio doesn't rise and fall solely on hometown economics and events. (Even if property is a relative bargain in your area, buying wisely elsewhere can make more sense than buying too much property locally.)

New York City attorney Richard Savitt, 40, never thought about all this 18 months ago, when he abandoned hopes of investing in Big Apple condos and bought in Philadelphia instead.

"We just thought New York prices were crazy," he explains.

But it sure looks wise now. Savitt and four partners bought four one-bedroom condos, each around $300,000. Similar units now list for as much as $450,000.

To help you determine where to invest, take the average price at which units are selling in a city and divide it by the annual rent the average apartment there generates. That will produce a price-to-rent ratio. The lower the better. Houston, Atlanta and Philadelphia, for instance, still look relatively good, while New York City and San Francisco do not.

In Minneapolis, Cowen and four other investors who've become pals gather at a bar for their fortnightly meeting. Jahn Dyvik, a 42-year-old engineer who sold his Porsche Boxster to help fund more condo buys, says lower prices in neighboring St. Paul make that city the better bet.

The rest of the group is sticking with Minneapolis, where they think prices will rise faster. Two others have also sold their cars. All have home-equity loans.

Where are prices headed? Cowen's not sure. The long-term case for condos looks good, but all the building out there makes him nervous. "People have unrealistic profit expectations."

Not him, of course. "No one has a crystal ball. But the condos I've bought are going to go up."

Tax Implications Of Selling Your Home

By TOM HERMAN
Staff Reporter of The Wall Street Journal

From The Wall Street Journal Online

While the Internal Revenue Service and Congress have declared war on tax shelters, nobody is threatening to touch America's most popular shelter: home, sweet home.

Tax laws long have offered favorable treatment to homeowners. But that treatment became even more favorable because of a 1997 tax law and Treasury Department regulations interpreting that law. As a result of those changes, millions of people who sell their primary residence don't owe a penny in capital-gains taxes.

The changes add up to an "extraordinarily generous tax break," says Bob Trinz, senior tax analyst at RIA, a New York-based tax information and software company and a unit of Thomson Corp.

Linda Goold, tax counsel at the National Association of Realtors in Washington, calls it "the most taxpayer-friendly provision I've seen during my career, which is almost 30 years now."

Surging home prices in recent years have made these rules even more important for growing numbers of homeowners, says Rob Hanson, a partner at Ernst & Young in Washington and a former Treasury tax legislative counsel who helped write the regulations. The national median existing-home price for all housing types was $206,000 in April, up 15% from $179,000 in April 2004, according to the National Association of Realtors.

But not everyone benefits from the 1997 tax-law changes. In some cases, homeowners may even have to pay more in capital-gains taxes than they did under the old regime.

Here is a primer on the rules and the latest regulations, who wins and who loses, and advice from tax lawyers, accountants and advisers on how to take advantage of the changes.

THE BASICS

The general rule of thumb is that if you sell your primary residence, you typically can exclude a gain of as much as $500,000 if you're married and filing a joint return with your spouse (or $250,000 if you're single or married filing separately) and meet certain conditions.

To be eligible for the full exclusion, you typically must have owned the home -- and lived in it as your principal residence -- for at least two of the five years prior to the sale. These exclusion amounts aren't indexed for inflation. (When calculating your cost basis, don't forget to include additions and other "improvements," such as a new roof, deck or heating system. However, this subject -- and other adjustments you may need to make -- can be tricky. For details, see IRS Publication 523.)

Real-estate agents say there is considerable confusion about the exclusion. Some people, for example, think this is a once-in-a-lifetime offer. It isn't. Homeowners can take advantage of the full exclusion every two years.

Some people also think the $500,000 exclusion is for everyone. It isn't. It's only for married couples filing jointly. Another point to bear in mind: This break applies only to your primary residence, not vacation homes.

Here's an example: Suppose you're married and file jointly. You bought your first home in the mid-1990s, have lived in it ever since, and your cost basis is $100,000. This year, you sell it for $600,000, giving you a $500,000 profit. Because of the 1997 law, you typically wouldn't owe any capital-gains taxes to Uncle Sam because your profit didn't exceed the maximum exclusion of $500,000.

What if you make a profit of more than the exclusion? If you sell your home this year for, say, $1.1 million, you wouldn't owe any capital-gains tax on $500,000 of your $1 million gain -- but the other $500,000 would be included in your taxable income.

Even if you have to sell your home in less than two years, you may be able to avoid Uncle Sam's grasp. The law allows a reduced maximum exclusion if the sale occurred because of a change in your place of employment, health reasons or "unforeseen circumstances."

Let's assume you're married and file a joint return, and you move from New York to California to take a new job. And so you have to sell your home after having owned it and lived in it for only one year. In that case, you typically would qualify for half of the maximum exclusion of $500,000, which means as much as $250,000 of your home-sale profit could be tax-free.

And what are "unforeseen circumstances"? Congress didn't define them in the 1997 law. But Treasury officials later issued detailed regulations offering numerous examples. Among them: divorce or a legal separation, multiple births from the same pregnancy, or the loss of your job. You may even qualify for a reduced exclusion if you or your spouse changes jobs and takes a pay cut that results in an inability to pay housing costs and reasonable basic living expenses.

WHO WINS -- AND LOSES

Most homeowners who sell are likely to benefit handsomely from the 1997 rules. But some people got hurt by the changes. That's because when Congress changed the law, it erased an old law often referred to as the "rollover" provision.

That provision generally allowed homeowners to defer the capital-gains tax on their gain if they sold their home and bought a new one that cost as much as, or more than, they got for the old one. The change simplified life for most home sellers and also greatly helped those who wanted to downsize. But it could hurt some people in real-estate markets where prices have risen especially rapidly and where owners have built up very large gains. Some of those people now would owe capital-gains taxes that they could have deferred under the old law by buying another residence.

Suppose you are single, sell your home for $500,000, netting a gain of $400,000, and buy a new home right away for $600,000. Under the old law, you could defer the capital-gains tax because you had rolled over your proceeds into the new home. Now, however, you would owe capital-gains tax on $150,000, the amount above the maximum $250,000 exclusion for a single person.

The 1997 law also replaced an old law that allowed a once-in-a-lifetime exclusion of as much as $125,000 for someone age 55 or older.

Ken Kies, a former chief of staff of Congress's Joint Committee on Taxation, recalls getting peppered with questions in 1997 from concerned tax lawyers in New York City. Those lawyers didn't think the exclusion amount was large enough for people living in hot real-estate markets such as New York City or Los Angeles.

"They suggested the exclusion should be bigger if you were in places in the country like New York or Los Angeles than if you were in less-active real-estate markets like Des Moines, Iowa," says Mr. Kies, now managing director of Clark Consulting's Federal Policy Group in Washington. "They were saying $500,000 wasn't enough for them. I told them I felt their pain but I didn't think anyone else would."

Some tax-policy wonks think the exclusions should be indexed to reflect inflation. But that hasn't happened yet and isn't likely to anytime soon, given growing congressional concerns about huge budget deficits.

MAKING THE MOST OF IT

Because home prices have surged in so many places, more homeowners may be bumping against the exclusion, or may even have bigger gains. What to do?

Some homeowners with king-size gains should consider holding onto the home and leaving it to their heirs, says Mr. Trinz. Under current law, all built-up capital gains typically disappear when the owner dies. The cost basis of the home to the heirs generally will be its fair-market value as of the person's date of death, not what he or she originally paid for it.

Another idea: Suppose you have a gain that's larger than the exclusion and you're thinking about selling your home this year. Consider also selling stocks or other capital assets that have tumbled in value, says Martin Nissenbaum, national director of personal income-tax planning at Ernst & Young in New York. Those losses can then be used to offset some or all of the gain on the sale of your home, which would otherwise be taxable, he says. "You can also use any capital-loss carryovers for that purpose."

First, capital losses can be deducted against capital gains. Second, if the taxpayer's losses exceed the gains, that person can deduct up to $3,000 ($1,500 if married and filing separately) of net losses each year against wages and other ordinary income. Excess losses are carried over to future years.

P.S. You can't deduct the loss on the sale of your primary residence.

WHEN TO GET HELP

Part of knowing how to take full advantage of tax laws involves knowing when to give up trying to understand them and seek professional help.

Who needs help? Mr. Trinz of RIA says the rules can get especially complicated if you marry someone who has recently used the exclusion, if the home is part of a divorce settlement, if you inherit the home from your spouse, sell a remainder interest in the home or took depreciation deductions on the home.

Also, questions have been raised about how to define your "principal" residence. The short answer is that it's typically where you spend a majority of your time during the year, but the issue can be considerably more complex.

For further information about this and other nuances, check out the IRS Web site (www.irs.gov) and search for Publication 523, "Selling Your Home." For the do-it-yourself crowd, RIA (ria.thomson.com/homesale) sells a publication called "Making the Most of the Home-Sale Exclusion."

There also may be tricky state-tax considerations, so check with your state tax department. An easy way to get general details is to check out the Web site of the Federation of Tax Administrators (www.taxadmin.org) and click on "Links."

Email your comments to rjeditor@dowjones.com.

--June 15, 2005