San Diego County's housing market has created much wealth for owners, but experts disagree over how long the boom will last

July 10, 2005

Previous bubble burst may provide clues

For San Diego County property owners, the past six years have been a modern-day gold rush. Median home values have more than doubled. Thanks to this soaring equity, the average San Diego homeowner is about $300,000 richer today than at the turn of the decade.

But will the wealth created by this historic run-up in prices last?

Over the past several months, San Diego's ebullient housing market has shown signs of exhaustion. Instead of receiving multiple offers within days of listing their homes, sellers are finding buyers reluctant to commit. More homes are for sale, and fewer of them are selling. From January through May – the latest figures available – the number of San Diego homes and condos changing hands dropped 8.5 percent from a year earlier, according to La Jolla-based DataQuick Information Systems.

This slowdown could signal an end to the region's housing boom. If that happens, the question will be whether prices crash as they did in Southern California 15 years ago or simply glide to a soft landing.

Just how the boom ends will be crucial to the economy, in which thousands of jobs in construction, real estate and home finance are linked to the housing market.

And not just in San Diego. While local appreciation rates have outpaced gains in most other cities, housing prices have been soaring in many cities around the world. A steep correction in the housing sector could derail consumer spending and contribute to a global recession as early as next year, some economists say.

About this report This is the first of a two-part report on the state of the housing market in San Diego County as well as in the country and throughout the world. Today: With signs of slowing in the local market, will soaring housing prices crash or just ease? Tomorrow: Markets in other U.S. cities and in other countries are soaring, too, but many face potential declines.

Although experts disagree on whether current prices represent an unsustainable "bubble," it is clear that the unprecedented, frantic rise in home values has made the housing market more fragile.

Prices have risen so far, so fast that only 9 percent of local households in San Diego County can afford today's median-priced home, according to the California Association of Realtors.

This lack of affordability makes the region's housing market more vulnerable to economic shocks, such as layoffs, rising interest rates or tighter lending standards.

It's the main reason that San Diego ranks fifth nationally on a list of cities most likely to see home prices drop in the next two years, according to research by PMI Group, a Bay Area provider of mortgage insurance. The company says the likelihood of price declines locally is just under 50 percent.

Would a drop, if it occurs, be severe? Most economists say the housing market doesn't work that way. Houses can't be sold as easily as tech stocks, so prices tend to be "sticky" on the way down.

"Housing bubbles don't pop; this is true. They deflate," said Christopher Thornberg, senior economist with the UCLA Anderson Forecast. "Prices tend to go flat."

Graphic: Appreciation of all homes

However, there have been exceptions. Many neighborhoods in Southern California saw double-digit declines in property values during the early 1990s, after the collapse of the region's aerospace industry.

Even a gradual decline could be painful, especially for recent buyers who stretched financially to get into a home. The stagnation could last for years. While housing prices historically have risen in proportion to incomes and rental rates, recent price increases have far outpaced those indicators. Experts say that if inflation remains low, it could take much longer to restore an equilibrium than in past housing boom-bust cycles.

Meanwhile, this housing bonanza has been fueled by new factors that make it difficult to predict how the boom will end. They include the rise of exotic and risky mortgages, the hefty debt load being carried by home buyers and the increase in speculators buying real estate.

A market correction?

Graphic: Will the boom continue? A look at San Diego County housing market indicators

In San Diego, signs of a housing-market correction have been emerging since late last summer, when the number of homes for sale jumped sharply. As of the end of June, 10,910 homes were for sale, a 64 percent increase from a year earlier.

Though home prices are still increasing, the pace has slowed. In May, the median home price of $488,000 was up 7.5 percent from May 2004, according to DataQuick. It marked the first time the annual percentage gain in the county's median home prices dipped below 10 percent in nearly six years. Also, the median price remains below the all-time high of $491,000 it reached in December.

Moreover, the number of San Diego County's 87 ZIP codes that showed annual price declines for resale homes doubled to 15 in May, compared with seven in April. The neighborhoods showing declines included Cardiff, Carlsbad, Rancho Pe×asquitos, parts of Encinitas, western Escondido, La Mesa/Grossmont and Tierrasanta.

"The demand is off from last year, and the inventory is up from last year," said Bob Weurding, a broker associate with Keller Williams in Rancho Bernardo. "There is a nervousness among buyers about whether they're buying at the wrong time. Nevertheless, we're still selling a good number of homes."

Julie and Josh Kenton found out about the softening market when they put their 930-square-foot condo in Rancho Bernardo on the market in March. The asking price was $350,000 to $360,000.

"Everyone we talked to said it was a fantastic place," Julie Kenton said. "'It's clean. You'll sell it fast. You'll sell it high.'"

The couple got two offers within a week. They accepted one that was within their range, but the buyer dropped out.

About a month later, the Kentons lowered their asking price and received an offer for $340,000. They countered at a higher price and lost the buyer.

By that time, the Kentons were living in a hotel in South Carolina, where Josh, a Navy psychiatrist, had been transferred. They found a house they wanted to buy, but the sale was contingent on selling the San Diego condo.

They lowered the price again. On June 17, they sold the condo for $330,000.

"We were a little disappointed," she said. "We had planned on more equity. But definitely we made money on the property. We had enough equity to buy a nice house in South Carolina and put 20 percent down. It's just a little bit of a downer, what happened."

'Doing pretty well'

With the San Diego County housing market leveling, some real estate experts predict a soft landing. The reason: The region continues to create jobs.

"Prices only drop when people have to sell, either because of job relocation or a layoff, and there aren't many of those people around today," said G. Christopher Davis, director of the Paul Merage School of Business at the University of California Irvine.

In a study this spring, the Federal Deposit Insurance Corp. examined housing booms and busts nationwide over the past few decades. In every instance where a boom was followed by a bust, there was a significant economic upheaval that led to job losses, including the Southern California defense and aerospace collapse in the early 1990s and the Texas/Louisiana oil bust in the early '80s.

Such an upheaval doesn't appear to be on the horizon this time around locally. In San Diego, economists expect local companies to add 15,000 to 20,000 jobs this year.

"If you look at San Diego and where people work today, we are not overly concentrated in any one industry," said Ray McKewon, an executive vice president of San Diego sub-prime mortgage company Accredited Home Lenders. "And in every industry where we do have a meaningful employment base, we're doing pretty well."

McKewon argues that even if home prices drop, home buyers will keep their homes as long as they have a job. "Are there any regions of the country on the cusp of economic disruption and job loss?" he asked. "Most analysts I've heard speak on this topic say no."

There are two types of buyers, however, that real estate experts are watching closely as the local housing market slows from last year's scorching pace – first-time homeowners who stretched to get into a house using exotic and risky mortgages, and speculators who buy property, hold it a short time and then sell it.

First-time buyers could become stressed because they're counting on appreciation to refinance out of their risky loans. If home values flatten or interest rates rise, they could get stuck with ballooning monthly payments on their mortgages within the next few years.

Speculators are considered a risk because they're more likely to dump their holdings quickly in a slow market, boosting supply and depressing prices.

"I think we could see some drop (in values) on the basis of these two groups," said Gary London, a San Diego real estate consultant. "The real issue is, how much of the market is that?"

In San Diego County, London estimates that 4,000 to 5,000 home buyers, at most, are seriously over-extended or are speculators.

Is that enough to topple the local housing market? London and other real estate experts don't think so.

"When you sit back and think about all the existing real estate in California, you've got a percentage out there that's extremely leveraged," said Russ Valone of MarketPointe Realty Advisors in San Diego. "But as a group, they're a very insignificant percentage of the marketplace."

Not everyone agrees. For bubble believers, overextended homeowners and speculators are only part of the problem. They believe housing fundamentals are out of whack, with a widening chasm between home prices and household incomes, along with a cost gap between renting and buying.

In the past six years, when housing prices accelerated, the median household income in San Diego County increased 21 percent for a family of four. Apartment rental rates, which historically have tended to rise at about the same rate as home values, have increased about 31 percent. Median home prices, meanwhile, have increased 140 percent.

"Rental prices remain weak. Mortgage rates are flat. Income growth is mediocre," UCLA's Thornberg said. "There is no reason that a house should be worth 40 percent more today than it was two years ago."

To afford a median-priced home today, a household would need annual income of nearly $110,000, assuming a 10 percent down payment and 30-year, fixed-rate financing at current interest rates.

Of course, most buyers today can't afford conventional loans. So they're opting for interest-only loans and other new, creative loan products.

In 2004, 63 percent of home buyers in San Diego used interest-only loans, compared with 1.6 percent in 2001, according to First American/Loan Performance, a San Francisco mortgage research firm. Nationwide, only 30 percent of mortgages are interest-only.

While such loans generally allow buyers to afford 20 percent more house than they could with conventional mortgages, they're also risky. They hold down monthly payments initially, usually for two to five years. But they require much higher payments in future years.

These borrowers are betting their incomes will rise so they can afford the monthly payments when their loans adjust. Or, they're betting that interest rates will remain low so they can refinance out of the loans to conventional financing, tapping their equity for down payment.

If the housing market slows, however, those bets become more flimsy.

Most interest-only loans are one flavor or another of adjustable rate mortgages. In May, 82.4 percent of home buyers countywide chose adjustable loans to finance their homes, according to DataQuick.

Experts say adjustable mortgages, interest-only loans and other creative financing products don't necessarily mean trouble for borrowers if they're aware of the risks.

"Most of these loans that are out there, when they convert to adjustable, they're still good loans. They're not death-knell loans," said James Endicott, a real estate agent and mortgage broker in San Diego. "Even if you have no equity, you can refinance and roll the dice for another 24 months. The key is you've got to have good credit."

Speculators a concern

For many speculators, the boom has meant quick profits. But Federal Reserve Chairman Alan Greenspan recently cited the growing number of speculators as reason for concern.

Just how many speculators are operating in San Diego is unclear. But in certain neighborhoods, such as downtown's high-rise condo towers, investors have been active. According to DataQuick, almost 30 percent of new or converted condominiums downtown that were sold in 2004 were bought by nonresidents.

Nonresidents make up only 15 percent of homeowners countywide.

The inventory of resale condos for sale downtown at the end of June stood at 403 units, compared with 105 units a year earlier. In addition, hundreds of new units are coming on the market.

"We feel that the market is slowing. I track inventory on a weekly basis and it's pretty much tripled since a year ago, especially downtown," said Alex Flores, 29, who began investing in real estate two years ago. "I really think downtown is going to slow down."

Flores and a partner have bought eight condos downtown, all pre-construction. They've sold five and have a sixth on the market. Using $30,000 from a cash-out refinancing of his house as seed money, Flores figures he and his partner now have $1.3 million in equity.

"I've always known that real estate is the way to go," he said. "It's about leverage. There's not any other investment where you can put $5,000 down and make $200,000 (in appreciation), at least for now."

 Staff writer Roger M. Showley contributed to this report.