Maybe you call it a bubble; maybe you don’t. But whatever descriptive label you prefer, the real estate market looks set to figure prominently in economy in 2006, one way or the other.
Indeed, some pundits think Joe Sixpack’s relationship with housing will reach a critical juncture this year. With that in mind, the Levy Economics Institute of Bard College has penned a fresh analysis of real estate, provocatively titled: Are Housing Prices, Household Debt, and Growth Sustainable?

The answer is necessarily unclear, as are all peeks into the future. Nonetheless, more than a few dismal scientists have been warning that the economy’s zing of late is due in no small measure to the buoyancy of the housing market. As such, all eyes are firmly locked on real estate trends in search of any early signs of what lies around the corner for the American economy.
On that score, there’s reason to worry, or at least wonder, the new Levy paper suggests. In fact, the report cuts to the chase in the first paragraph, laying out the challenge and the presumed end game, as the authors see it:

Rising home prices and low interest rates have fueled the recent surge in mortgage borrowing and enabled consumers to spend at high rates relative to their income. Low interest rates have counterbalanced the growth in debt and acted to dampen the growth in household debt-service burdens. As past Levy Institute strategic analyses have pointed out, these trends are not sustainable: Household spending relative to income cannot grow indefinitely.

Everyone knows that, of course. Only the timing is in question. And for the moment, it’s easier to maintain a sunny disposition and point out that the economy continues to sail along nicely, thank you very much–especially considering the hodgepodge of threats it’s faced and largely overcome in 2005. From trade deficits to budget deficits, from terrorism to oil-price spikes, Joe Sixpack has kept on spending, and trading up to newer and bigger houses, assuming ever larger mortgages, both in absolute dollars and as a percentage of household wealth. If that was the best shot at derailing the American dream machine, then it looks like Uncle Sam passed the audition. In short, the pessimists have been told to bug off, and get a life.
Point taken. But at the risk of being shouted off the digital stage, we can’t help but notice that there’s a small but growing list of cracks in the housing armor. So far, it hasn’t added up to much as far as the wider economy is concerned. And yet…
Consider, for instance, that Manhattan real estate is showing signs of tiring. To be more precise, the soaring prices that prevailed in the first half of 2005 turned into something dramatically less in last year’s second half, according to two recently published reports from New York City brokers via The median sale price for co-ops and condos in Manhattan advanced a scant 1.3% in the final three months of 2005 to $760,000, according to one survey. Another advised that the median sales price shed 4% in 2005’s fourth quarter.
Granted, Manhattan real estate is in a world by itself. Yes, it may be destined for a slowdown, if not correction, but that doesn’t necessarily mean prices in Peoria will collapse. In fact, there’s quite a bit of evidence out there suggesting that to the extent there’s a real estate bubble in the U.S., much of it’s found on the East and West coasts, in cities like New York and San Francisco. So what else is new?
The question is whether a crack in the high-end markets could spill over into lesser property realms? Stay tuned.
In any case, the fact remains that a robust real estate market has been instrumental in recent years to the broad economy’s top-line growth, which is a cute way of saying that low interest rates have made buying–and speculating on houses attractive in recent years. But as we all know, interest rates have been going up. Not dramatically, but going up just the same. Even the Fed’s baby-step hikes are starting to add up, considering that they began in June 2004. Is this the year Joe takes note?
Ah, but there’s the rub, you say. Short rates have been going up, but long rates have been less than eager to follow. Thus, the brief encounter with the inverted yield curve last month, in which short rates exceeded long ones.
Perhaps, then, the key to keeping the economy humming is praying for an inverted yield curve to prevail, and at the same time hope that its traditional message–recession–doesn’t follow this time. Alternatively, one can dismiss the seemingly persuasive list of smoking guns in the Levy paper that suggest that the margin for error from here on out is tiny when it comes to the link between real estate and the economy. In which case, we submit the following points highlighted in the report for your dismissal:
* The price-to-rent ratio (housing prices divided by rent) has soared to more than 20 at the end of 2004 from around 15 in the early 1990s. In order for it to fall, either house prices must fall or rents must rise.
* The debt burden on households has also soared in recent years. The household debt to disposable income ratio, still below 95% at the end of the 1990s, has recently jumped above 120%–a record high.
* Recent borrowing by the household sector has also taken flight into record elevations. Borrowing, as a percent of household disposable income, has recently leaped to nearly 14% from around 3% in the early 1990s.
And the list of potentially troubling statistics rolls on. If you’re in the mood for an ominous read, cuddle up with this paper.
The stock market, however, pays no attention to any of this, or so one could argue. Today is the third trading day of 2006 and, as we write, the third day of gain for the S&P 500. Meanwhile, the yield on the benchmark 10-year Treasury continues to trade below its 2005 close.
The market, of course, is always right…until and if it’s wrong.