Business: Real estate: Boom or bust

By Jeffrey Lipsey

I have been trying my hardest to stay away from the real estate boom/bust argument, not wanting to get in the speculation of when or if it will eventually crash. Everyone has a different opinion on the matter, so I suggest you do your own research before taking any action either way.

Unless you have been living in the cellar for the past few years, you would have noticed the U.S. real estate market booming. In March of 2005, PBS NewsHour reporter Jeffrey Kay stated that according to a recent government report, 55 urban areas are experiencing booming conditions. reports the top five markets are in Florida and Arizona while homes in the southern California area sell for more than twice the nationwide average.

We all know that the real estate market was booming, however, it is the future that everyone is speculating about. On Tuesday, Reuters reported record growth in the month of October, when new home sales rose 13 percent. Reuters went to say that this news comes as a surprise as economists forecasted sales to drop slightly during that month.

On Wednesday, reported that mortgage applications fell for the sixth consecutive week and reached the lowest level since June of 2004. I believe this is a leading indicator of future problems.

Obviously, when most people buy a home they take out mortgages. The most popular mortgages during the real estate boom are Adjustable Rate Mortgages, where interest rate and monthly repayment vary over time.

Interest only mortgages, a form of ARMs, are very common recently and have some distinct advantages. The loan contract specifies on whether it is a 7/1, 5/1, 3/1 or 1/1 (or other combination) loan with the 5/1 and 3/1 the most common. The first number reflects how many years before the interest rate changes meaning that the interest rate will not change in a 5/1 ARM for five years, but then will change every year after that (as accordance to the second number).

After the first five years in the 5/1 ARM, you begin to pay off the principal of the mortgage. However, one disadvantage is that if you pay off the entire loan before the five year period is up, you must pay a penalty; after the five year period you are able to refinance the loan with no cost.

If you do not plan on keeping the property past five years, then a 5/1 ARM (or other terms according to the period of time) may be right for you. Since in this plan you only pay interest the first five years, you have the entire principal as cash, or in this case, in real estate. But, if after the five-year period your investment (real estate) is not worth the principal of the loan, then you could face heavy losses.

This brings me back to another point. If the real estate market does “bust,” the demand for houses could significantly decrease and drive the price of houses down. Then, the people that bought these interest-only mortgages will lose money as they are not able to get their initial investment for repayment.

In my opinion, the decrease in mortgage applications demonstrates a decrease in the future demand for real estate. It is quite possible that October was among the last months of significant growth, and I would not expect future home sales to be as high in the next few months. With the Fed raising interest rates and the upcoming holiday season sure to decrease demand, home sales can not keep up this pace.

My last piece of advice to offer this week is that before you buy real estate, think to yourself: “Will the demand in five years still be at this location?” If the answer is yes, then it might be a worth a further interest.

Stock Pick of the Week

In the wake of the holiday season, I believe the one retailer that will remain stable both pre- and post-Christmas is Target Corporation. Retail stocks the past few years have been dwarfed by their online counterparts but Target has continued to post increasing income and cash flow the past couple years. I believe Target is a safe choice this holiday season for any long term portfolio if you want to get involved in the retail sector. Price: $53.51.

Jeffrey Lipsey is a senior in Business. His column appears on Thursdays. He can be reached at featur[email protected]