Dear Friends,
Just as it was impossible to pick up a newspaper or magazine in late 1999 that didn't have a story about over-priced tech stocks, so it is today when it comes to residential real estate. As Yale economist Robert Shiller sees it, talk — positive on the upside and negative on the downside — both creates and destroys financial bubbles.

That's not to say there is universal agreement that real estate prices are, in fact, headed for the kind of collapse the stock market experienced, where $7 trillion in value was erased.

It depends on whom you talk to.

What’s not in dispute is that the housing prices have been on a tear for at least the past five years, posting record gains in the past two. To be sure, not all areas of the country have seen the 31 percent appreciation experienced in Nevada or the 19 percent jump in home prices Arizona homeowners saw over a 12-month period. According to the Office of Federal Housing Enterprise Oversight, Texas, Colorado, Ohio, Oklahoma, and Indiana were among the states that had the smallest increases.

Nine straight hikes in short term interest rates have done little to dampen demand partly because, for reasons that even Federal Reserve Chief Alan Greenspan claims to not understand, long-term interest rates have not followed suit. (While short-term rates have the biggest impact on adjustable mortgages, the rates on fixed mortgages, which are tied to long-term bonds, have barely budged.) In fact, according to the National Association of Realtors, sales of existing homes in June were the highest on record, with nearly 7.4 million units sold. April and July of this year came in second and third, respectively. And the Commerce Department just reported that sales of new homes set a new record last month.

Although the economists and “experts” are scratching their heads over this, I can explain it! All you have to do is use common sense: If you were thinking about buying a home and saw interest rates going up, what would you do, wait? No way! The prospect of higher mortgage rates prods everyone who’s been sitting on the fence to finally sign on the dotted line and close the deal! That’s why housing sales have remained strong.

It runs counter to what you might think, but remember this: When interest rates start to rise, home sales go up, not down.

At some point, of course, interest rates will get sufficiently high that they drive up monthly mortgage payments beyond the reach of most buyers. That’s when you’ll see home sales slow down.

That’s also when you’ll start to see prices weaken. Because by just about any measure, they’re way out of whack in a lot of markets.

Edward Leamer, an economist who heads the prestigious Anderson Forecast at the University of California at Los Angeles, says one way to see this is to look at the real estate Price/Earnings ratio. As with stocks, it tells you how much you have to spend to generate a dollar in earnings. In the case of housing, Leamer compares the average price of a home versus the annual cost of renting a 1500-square-foot apartment in 46 metropolitan areas around the country.

Click on this (pdf) link to see the markets that have posted the biggest P/E increases in the past 5 years. Click on this link to see those that have had the smallest.

Leamer cautions that looking at P/Es across different cities isn’t that relevant because, in his words, it’s “not an apples-to-apples comparison.” What’s more important is the P/E trend exhibited by a single city.

For instance, take San Francisco, one of the “hot” housing markets. From 1989 to 2001 the price-to-rent ratio ranged from around 10 to 14. Then in 2001 it suddenly shot up to 16. Last year it hit 23, nearly double its long-term average. That indicates rents have been flat to lower while home prices have climbed higher.

With a stock, a high P/E is appropriate for firms expecting a lot of growth. Mature firms would have lower P/Es. Likewise, according to Leamer, if a region expected great economic growth in the future, demand for housing would go up as more people moved into the area. Rents would rise, pushing the P/E down temporarily. “However, most people will interpret economic growth as good, says Leamer, “and will be willing to pay more for a home.” As real estate prices increase, the P/E ratio returns to a more normal level.

But in the case of San Francisco, soaring real estate P/Es overlapped a decline in economic activity as the dot.com implosion wiped out much of Silicon Valley.

So what accounts for San Francisco’s high P/E ratio? Cheap money. In Leamer’s view, “because interest rates have been so low, anyone who crawled off the street could get a mortgage. So home prices got out of line.”

The obvious question is what happens when the prop of extremely low interest rates no longer exists?

According to figures compiled by the National Association of Realtors (NAR), the trade group for the industry, home prices have grown increasingly unaffordable since 1998. Back then, a household earning the U.S. average family income had 41 percent more income than necessary to qualify for a mortgage on the average-priced home. Today, that margin has shrunk to 20 percent. Not as generous, perhaps, but still acceptable.

The problem is that this is the nationwide figure. Because of geographic differences in housing appreciation it doesn’t begin to paint an accurate picture of the real situation. The chart below breaks down housing affordability on a regional basis, based on household income and home prices.

As you can see, the cost of buying a home is now out of reach for the average family that lives in the western part of the country. In just the past two years, prices have risen so far so fast that the “typical” family only has 80 percent of the income necessary to qualify for a mortgage on the “typical” home.

“Affordability is declining, even with very low interest rates,” says Lawrence Yun, senior economist for the National Association of Realtors. “Prices have risen so much it’s becoming difficult to buy a home.” He says home prices will continue to grow less and less affordable as mortgage rates increase.

Still, Yun says there are “fundamental reasons” why we’ve seen the recent boom in home prices, including those markets that have experienced double-digit increases. “Going forward we don’t anticipate similar dramatic increases in prices, but we do anticipate further increases.” He expects residential real estate appreciation will revert “back to its historical rate of 4-6 percent per year.”

But you have to wonder: if home prices have been going up faster than incomes for years, who’s going to be able to buy these properties in the future? At some point, either prices have to come down, or sellers will have to wait until the incomes of potential buyers catch up with their asking prices. Either way, we’re talking about housing cooling off.

And contrary to what a lot of so-called “experts” are predicting, Leamer, believes the pain will be felt on a national level, not just locally. As an economist he’s much more concerned about the broader implications of a slowdown in the housing market than about the price bubbles some areas are experiencing.

“We’ve had ten economic downturns since World War II and eight of them started in the housing sector. It’s the first component of gross domestic product that starts to weaken,” says Leamer. He keeps a close eye on what consumers spend on housing because it has a ripple effect, pointing out that a decline will lead to layoffs in construction, banking, and the real estate industry, to name just a few areas.

In Leamer’s view, the housing market appears to have peaked “in California and elsewhere. It will take more than a year for this weakness to turn into job losses and to affect the economy in general.”

And, yes, he’s using the “R” word. As in “recession.”

Leamer lays the blame squarely on the Federal Reserve for leaving interest rates too low for too long. Now, he says, we’re not only heading for trouble in the housing sector, but in the auto industry — another market that got drunk on historically low rates.

Low borrowing costs accelerated future sales by enticing consumers to trade up to bigger homes and new vehicles sooner than they might have done otherwise. Instead of waiting to buy a new family car in a couple of years, folks said, “Oh, what the heck. Financing is so cheap we might as well get it today.” As a result, car dealers lose the sale they would have gotten two years from now.

As rates creep higher, consumers happily driving their new cars or living in their larger homes have no motivation to purchase additional ones. Since consumer spending drives two-thirds of our economy, when consumers close their wallets, the impact is far-reaching.

While the real estate bubble itself may be all about “location, location, location,” in Leamer’s view the coming housing slowdown will have national implications, although areas that have benefited most from the housing boom are likely to be hit hardest. For example, Southern California, where Leamer lives. He says the strong housing market “created a lot of jobs — in construction, in banking, in real estate. If that disappears, a basic driver for the local economy disappears.” In his view areas with a more diversified income base, such as manufacturing communities, are likely to weather the coming economic decline better.

If you’ve been shopping for a home, Leamer says you “need to recognize the risk and do some hard-nosed thinking” about whether you should take the plunge. He points out that on the one hand, mortgage rates are “incredibly attractive.” But he suggests you add up all the monthly costs and benefits (such as tax deductions) of owning versus renting. If buying still makes sense, his advice is: “Think long term — seven to 10 years. Avoid adjustable rate mortgages. Lock in a low, fixed interest rate.”

He minces no words when asked if he has any advice for someone considering buying a house in one of the “hot” real estate markets: “If you’re not sure you’re going to be living in the home in two to three years, don’t buy it.”

Hope this helps,

Gail

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