Today we take a final look at the housing market. Are we in a bubble or is it merely a period of overheated prices which will cool off? Is it the right time to buy (or sell) a home? If there is a bubble, how would we spot it?

A little full disclosure. Thinking about the housing markets for the past few weeks has been somewhat more than an academic exercise. I sold my last home a little more than four years ago, for family reasons unrelated to valuations or markets (time to downsize). I decided to lease for a time. My thought was to wait until a recession created a drop in values in the type of homes I wanted, and accompanied with low rates, would buy that perfect home. We would get the deal of the century. I persuaded my wife to go along with such an idea.

Because homes values have not really risen in my area (Fort Worth, Texas), I have lost no gain on a home. Renting, even after tax, has been relatively cheap. But now my wife is getting a desire to nest. She wants to turn her creative powers to work on her own home.

"How long," she wonders, "are we going to have to wait? So what if we can get a 15% better deal? Are we going to rent for another 2-3 years, waiting for your recession to come about? Further, if we buy, we are not going to sell for a long, long time. You tell me that a long, long time will cover that 15% and more. Why does everything have to be about a profit or making the most money? Homes are not over-valued in our town. I want a home now." Ouch.

So we come to this last e-letter on housing with a personal stake in the question of housing prices. Let's see where the facts and ruminations take us.

"And so you see I have come to doubt
All that I once held as true.
I stand alone without beliefs
The only truth I know is you" - Paul Simon, 1965

For many Americans, the "you" in the above Simon and Garfunkel Song could be said to be their home. It is what they have come to believe in, their one piece of the rock that they can count on to anchor their investment portfolio. It provides cash in a time of trouble, retirement savings and shelter. What better, more felicitous combination could there be?

Let's review a few facts from the last three e-letters on housing.

Housing is strongly related to consumer confidence. It is part of the American psyche, warp and woof of our economic contentment. For every dollar of increase in US home prices, consumer spending rises 15 cents, as compared to the influence offered by the stock market, where consumers spend 2 cents for every dollar rise in stock market capitalization.

Home prices for many areas of the United States have barely kept up with inflation, while in other areas it has risen 100% in just the last five years. There is a strong correlation to outsized growth in home prices in with high levels of regulation. That is because increased regulation artificially decreases the housing supply.

Overall, in terms of the last two decades, housing prices have not risen all that dramatically when compared to national incomes, especially as lower rates have reduced the cost of monthly payments. But in a few areas, especially on the coasts, median priced homes are simply no longer affordable by an average family. In some areas, less than 20% of the country could afford an average house. Further, housing prices have risen by 30% more than inflation in the last five years, which is a cause for concern.

On the other hand, the demand for housing will be reasonably strong over the next decade due to an increase in the number of households primarily from immigration and from boomers buying second homes.

Last week, we looked at data which showed that national home prices have fluctuated from high to low relative to average national income over the past almost 40 years. Using this index, you can feel relatively "safe" in buying a home when the ratio is low. When comparing the average income to home average prices, we find that today the ratio is on the (quite) high end of the scale, implying that either home prices will drop relative to income or that income will rise relative to housing over the next few years. Given the recent lack of any real upward trajectory of income, the study points to housing price weakness.

Also from last week, "In 1950, the average new house was 983 square feet and cost $11,000. In 2000, the average new house was 2, 265 feet and cost $205,000. In 1950, there were 3.37 people per household, and now there is but 2.6. In 1950, only 6% of homes had a two-car garage. In 2000, 65% had two-car garages and 17% had three (or more) garage spaces.

"In 1950, the average cost per square foot was $11. Today it is $91. Much of that is inflation, as inflation alone would increase prices to $76. The actual value of a square foot today is far more however. I grew up in one of those 1950 homes. No air-conditioning (in hot-as-hell Texas summers!), one bathroom, rudimentary appliances, heating was a space heater in the main room. And three young kids and two bedrooms. I truly enjoyed my youth, but I am not nostalgic for the old homestead."

A Harvard study showed us that owning a home was somewhat cheaper after-tax than renting. Not in all places, of course, as many readers noted. But we are speaking of national averages.

Almost 70% of US citizens own their homes, up sharply from 63% over the last 10 years, plus the population has grown. This is partially responsible for the increase in demand, but such growth in the percentages of those who own homes is unlikely to persist in the future.

The Sub-Prime Mortgage Markets

Why has there been such an increase? First, as rates have come down, homes have become more affordable. Further, the growth in so-called sub-prime mortgages has been quite large. Fed Governor Ed Gramlich offers the following data in a speech last May. (www.federalreserve.gov/boarddocs/speeches/2004/20040521/#table1.) Sub-primes loans grew by 25% per year over the nine years from 1994-2003. In 1994 sub-prime loans accounted for 4.5% of all mortgage loans. In 2000, it was 13.2%. In 2003 it was up to 8.8% of all mortgages.

(Side note: Inside Mortgage Finance shows the volume of sub-prime loans has risen from a total of $17 billion in 1995 to over $195 billion today. And no money down loans have ballooned from les than $1 billion to $80 billion in that time - NY Times and Weldon's Money Monitor.)

A great deal of sub-prime lending was to minority and first time buyers, which I contend is a very good thing. The relationship between home ownership and the overall quality within a given neighborhood is very high. Interestingly, the data shows that the sub-prime share of the number of home purchase loans is not all that different from lower income (10.9%) to middle income (11.2%) to higher income (9.0%).

There is a disconcerting increase in the mortgage delinquency rate, but this is to be expected as the number of sub-prime loans increase. There is a reason those who get sub-prime loans pay higher interest rates.

In the world of prime mortgages, the serious delinquency rate is 1.12% and dropping. By serious they mean over 90 days or in foreclosure status. That is about 1 on every 100 households. Given the number of divorces, unexpected job losses and the normal vicissitudes of life, that is pretty good. The total number of all prime loans which are 30 days or more past due is 3.96% (which includes the serious the serious delinquency loans.)

But the sub-prime world tells a different story. The serious delinquency rate for 2003 was 7.36%, with over 16% of sub-prime loans being over 30 days or more past due. But that also means that the large majority of sub-prime loans are also healthy.

One can make an argument that the "heat" on many housing prices has begun to fall. Housing prices in the US have only risen 1.5% this year, about in line with inflation, and many areas are experiencing a fall in prices. Greg Weldon notes that the mean price for new homes sales in May was down $5,800 and the median price of homes sold was down 9.9%.

And the Envelope, Please

So, there are lots of facts that should make us nervous and others which give us reason to be a housing bull. But that still does no answer the question, is there a housing bubble?

I believe the short answer is "no" for all but a few areas of the US. Over the long-term, I think most homeowners will see reasonable returns from their homes. But that does not mean you should rush out and buy an investment house or that housing prices cannot drop significantly from where they are today.

What goes into the price of a home? What makes one location costly and another only a few miles away cheap?

Housing is shelter. It is a roof over our heads, and there is a simple shelter factor that fits into the basic cost of housing. How much does it actually cost to build a home? What would it cost to rent a similar shelter? How "comfortable" is a home?

Housing prices fluctuate with school districts. It fluctuates with local amenities. Beach front costs more than inner city. We value the relative safety of the neighborhood. Housing prices are a function of how much we value our time, as homes closer to where we work are generally higher than those which cause a two hour commute. We also value the neighborhood and the ambience. Are you looking for certain types of neighbors?

Our homes, for better or worse, make a statement, and "statement" adds (or subtracts) value. Some people are willing to pay significantly more for a home in the "right" (read rich) neighborhood than for a similar home only a few miles away. In fact, they might be able to get a clearly superior home (in terms of size and construction value) within a short driving distance, but the status of the location means more than the size of the home. Of course, over longer periods, that local status of a neighborhood can change dramatically.

The operating costs of a home figure into the cost of a home. Older homes which require more maintenance and cost more to heat and cool typically sell for less per square foot than a new energy efficient home on the lot next door. High local tax rates can hurt the value of property. Real estate sales commissions figure into costs and realized returns.

Are the home prices in a town so high that those providing the basic services cannot afford to live there? If there are long commutes involved, it will increase the cost of fire, police and city workers as well as for things as prosaic as restaurant staff and other local business employees.

What about the weather climate, recreational opportunities, and availability of local jobs? For me, I want to know about the variety and quality of the local restaurants. Are mountains or beaches a big deal to you? Is it a second home for those get-away periods?

In short, there are a thousand things that go into the value of a home. But all those things do not create some intrinsic, guaranteed value.

At the end of the day, the price of a home is subject to supply and demand. In the late 80's, the housing slump was a result of over-supply and falling demand. Many areas, especially on the coasts, saw a drop in values of 20% or more.

Home prices have nothing to do with replacement costs. In Houston in the 80's, home prices fell to a fraction of what they had been only a few years earlier. Had there been a housing bubble? No. There was simply no demand.

The Twin Hinges of Housing Prices

The culprits? Employment and actual demand, or lack thereof. And it is upon the twin hinges of employment and demand that housing values swing.

High employment creates demand for housing. Rising unemployment is typically bad for housing. But, you ask, why did not the recent downturn create a housing slump?

Because, in the first instance, the recession was not all that severe in terms of jobs. Secondly, lower rates and creative financing made it possible for many who had a job and were renting to be able to afford a home. Demand never really dropped, and as noted above, there was no over-supply, as home builders carefully monitored their supply situation, as opposed to earlier recessions.

Let's look at one exception. San Jose saw its home values drop as Silicon Valley saw a serious rise in unemployment following the dotcom bust. To the south, San Diego saw nowhere near the problems, and home values rose, especially as millions of people over the past few years poured into southern California.

Given all we have looked at over the last few weeks, what would I predict about the future of home prices over the next 10-15-20 years? Except for bubble areas (which we will discuss below), I would think that average US home prices would rise in line with inflation. Near-term, the recent rapid rise over inflation suggests a slowing of increases or even a retreat back to "trend."

Further, as I think the next recession will be more severe than the last one, and that the new demand created from low rates and creative sub-rime financing will probably not be anywhere near the level of the last recession, we could see a short-to-medium term drop in home values. In some areas where employment drops too rapidly, home values could also drop significantly.

After the recession and over time, the increased demand from a growing number of households and an economic recovery will serve to bring home prices back to the rising trend.

What does that mean in practical terms? Let's say your area is not one where there is a bubble and home values in your neighborhood still drop 20% in the next recession. If you do not need to move or sell, while you will be uncomfortable in the interim, over time values will rise and you will pay down your mortgage. If you have to sell at the wrong time, you will lose money over what you could get today. If you know you are going to need to sell within the next few years, you might want to consider what your local market will look like during a recession.

If your area is somewhat immune to employment and demand fluctuations, then your decision would be different. Think of homes which appeal to retiring boomers in very desirable retirement areas. There are a lot of wealthy boomers looking for that perfect spot for the golden years.

I would also expect that mortgage interest rates will drop during the next recession, which will help bolster sagging values.

How to Recognize a Housing Bubble

I recently was invited for drinks to a home in La Jolla, California. I think it is the most spectacular home I have ever been in. Recently built at a cost a many millions, it is sitting on the highest and most spectacular view of California coast from Santa Barbara to the tip of Baja. What is such a home worth? If my friend was forced to sell it quickly tomorrow, perhaps not what it cost him to build. Perhaps much less in a fire sale.

But because of the unique nature of the home, it is also possible that a Bill Gates could walk up and offer to double his costs in one day, just to have that one of a kind, nowhere else view. Pocket change for Bill. And my friend and his creative wife (who was responsible for the beauty of the home) have no intention in selling their dream home, so speaking of value and bubbles is somewhat irrelevant. If they sold at double their costs, would that be a bubble in local values?

But when we speak of bubbles, we are not speaking of the special homes in one of a kind situations. Those will always be worth what someone will pay. We are talking about the homes in your neighborhood.

As noted over the past few weeks, most areas of the country are not in a housing bubble. Let's think about what we mean by bubble. The NASDAQ in 1999 and 2000 was a bubble. Gold and silver in 1980 was a bubble. Japanese stocks in 1989 were a bubble. The characteristics of most bubbles are a final rapid price rise and then a quick drop. It is accompanied by rampant speculation and lots of stories about why "this time it's different."

Bubbles are different in character from a normal bear market. Prior to a normal bear market, valuations get high, the economy softens and then prices fall. After a typical bear market, the economy recovers, earnings increase over time and GDP growth and inflation do their magic, and stock prices recover. Maybe it is a few years and maybe it is 10 years, but they do recover.

But in a bubble, market valuations do not just get high. They get ridiculous. And the resulting collapse will take decades to recover, if ever. It will be many decades before the NASDAQ sees 5,000 again. The New York Stock Exchange Index, however, with a far larger representation of stable older companies, is only 7% off its all time high. It merely went to high valuations as opposed to a bubble. It is entirely possible that we could see new highs on the NYSE within a decade or less (give or take a year) from its top.

All real estate is local, and you need to determine for yourself if your home values are part of a bubble and subject to a decades long valuation problem, or simply subject to the normal ebb and flow of prices.

If home values are rising in line with reasonable demand and positive local circumstances, then there is probably not a bubble. Prices could be over-heated, but that does not mean a bubble. It might be simply high valuations. Above trend increases will eventually modify and even drop during the eventual recession, but that is part of the normal ebb and flow. Over time, long term home investors will see their equity increase.

But if you have seen a significant rise in your area, I would look at the source of the demand. Is it from people who want to move in to your area and live there long-term? Or is it from speculators who use cheap leverage to buy property with the intent to flip it quickly? Is it from people who are moving in with the intent of living in the neighborhood for a few years and then moving on, hoping to double their money? Did they buy the most home they could possibly afford on an ARM mortgage?

Real estate can be a great way to get rich slowly. In nearly every area, there are locals who know the market and invest. Who is doing the buying in your area? Is it the old time locals who know the market? Or is it a bunch of newcomers who have only known rising prices? Are they buying homes to tear down and then build "spec" property at ever larger values?

What does it really cost to replace a home? Is the bulk of the cost in materials and labor, or is it in land?

As I look around the country, I think much of what bears might call a bubble I see as simply very valuations. Barring a depression, or a very long and deep recession, time should cure the problem of valuation. You might not get the returns you expect. In fact, you might not get any real returns. Looking back at historical data, there are lots of times in every area of the country where housing prices suffered.

Ultimately, you buy a home because it is where you want to live and it suits your lifestyle and financial abilities.

And speaking of homes and values, let me recommend a great publication called International Living. My old friend Bill Bonner started publishing the letter over 25 years ago. They write of homes you can buy all over the world that are still great values for the more adventurous. It is fun to read and dream. You might want to take a look at it. For $49, it is fun and if you have a thought of buying a home outside of the US, it is worth the price. The following is a link to their promo page: http://www.agora-inc.com/reports/il/wilve600

Old Friends, Wedding Bells and San Francisco

I am speaking three times at the next Money Show event in San Francisco. You and a guest qualify for FREE admission on September 22-24, 2004, at the San Francisco Marriott. Attend over 150 FREE educational workshops, 14 panel discussions, and general sessions focusing on economic and investment presentations and browse over 100 exhibits... all FREE. For complete details or to register online click the link below or call 800/970-4355 today. Don't forget mention me (John Mauldin) and Thoughts From The Frontline, along with priority code 003336. See you there. http://www.moneyshow.com/main/main.asp?site=sfms04i&cid=default&sCode=003336

This next Monday, Henry, my oldest son (all 265 pounds of muscle and brains) is getting married. That is always a special time for a Dad. It does remind us of family and relationships, but also that we are getting a little older. Such events always cause a little reflection upon my own life journey.

And that reflective bent was intensified last night. I went with my bride and some friends to watch Paul Simon and Art Garfunkel at their reunion concert tour. If you can get to one, buy the best ticket you can. It is an investment in nostalgia that has huge dividends. It is their 50th anniversary of knowing each other, and as Paul put it, their 48th anniversary of fighting. But last night, it was nothing but perfect harmony. Throw in a set by The Everly Brothers, and this aging child of the 60's hippy was transported to a time when there was little fat on his body and much more hair.

And then they sang Old Friends. The lines, written in 1968, hit home.

"Can you imagine us years from today
Sharing a park bench quietly?
How terribly strange to be seventy.

"Old friends, Memory brushes the same years
Silently sharing the same fear."

Yes, in 1968, it was terribly strange to think about 70. Yet, today, it seems like 70 is just around the corner. But Old Friends make 70 not such a bad thing.

Your glad he has a lot of Old Friends analyst,