Homeowners may take bath as housing bubble bursts

Did a real estate bubble form here in 2009? Did home prices really rise significantly? And what does the future hold? Will home prices continue to climb, or will the trend reverse, sending prices southward?

To examine and possibly answer some of these questions, I chose to focus on the market segment of medium-sized, 3.5-4 room apartments. This segment accounts for 40%-45% of the apartments built in Israel over the past 35 years.

Unlike small apartments measuring 1.5 to 2.5 rooms, which have lately become very popular as investments, most buyers of medium-sized apartments are families who intend to live in them.

Most of these families also have to take large mortgages to finance their purchases. Apartment prices in many parts of the country have been creeping upward for the past two years, causing many people to wonder if we are living in a real estate bubble that could burst in our faces.

Prices for medium-sized apartments in the Sharon region, for example, did not cross NIS 950,000 from 1997-2003, but have been on an upward trend since 2004, with the exception of 2007.

An analysis of the price trends, based on a comparison of prices relative to the previous year, produces a somewhat cyclical pattern: After a year or two of price hikes, there is an inflation-adjusted decline in prices.

This pattern begs the question of whether home prices have actually been simply adjusting themselves to our increased wages.

The answer to this question can be determined by examining the cost of homes in terms of monthly salaries. How many monthly salaries does it take to buy a home?

I examined the purchasing power of the average Israeli with respect to a 3.5-4 room apartment, by quantifying the value of such apartments in terms of months of work by salaried employees. I also divided the average price of an apartment throughout Israel by the average wage, in order to obtain the value of an apartment in terms of monthly salaries, assuming that an employee's entire gross wage is used toward paying for the apartment. The results indicated that 1988 was a slump year for the price of medium-sized apartments.

That year such an apartment could be purchased for 75 average monthly salaries. In 1996-1997 the "price" of a 3.5-4 room apartment hit a record high of 115 monthly salaries.

In the first nine months of 2009 this price rose to about 117 average monthly salaries, and in the final quarter of the year the average price of these apartments soared to 126 salaries. Thus even from a countrywide perspective, a bubble has formed.

Record-breaking prices

Next I examined the prices of apartments in various regions of the country, in terms of monthly salaries. In Haifa and the surrounding Krayot region, the picture was quite clear: prices in that area were 22% lower in 2009 than their record highs in 1997.

In Tel Aviv, the record high up until last year was 195 monthly salaries but in the first nine months of 2009 the average price rose to 216 monthly salaries, and in the fourth quarter of the year surged to 268 monthly salaries. This can genuinely be defined as the development of a bubble.

In Jerusalem the record until last year was 159 monthly salaries (in 1996), but in the first nine months of 2009 a medium-sized apartment cost 160 monthly salaries, and in the fourth quarter that figure rose to 172 monthly salaries.

In the Sharon region the record prior to 2009 was 130 monthly salaries for a 3.5-4 room apartment, but that record was broken in the first nine months of last year, when the price soared to about 151 monthly salaries. In the final quarter of the year prices continued to rise, to 156 monthly salaries. This too can be considered a bubble.

Low interest rates boost the market

Another factor that affects home prices is the interest rate on mortgages. A look at the average rates (in percent, based on data provided by the Bank of Israel) for a mortgage on 3.5-4 room apartments in the Sharon region reveals an inverse correlation between trends in interest rates and prices - when interest rates dipped, prices rose, and vice versa.

Mortgage interest rates are at a historic low and are expected to rise during 2010, based on the anticipated increase in the prime lending rate. If past trends repeat themselves, apartment prices will decline.

Home buyers who were enticed by low interest rates and took big mortgages will likely be unable to meet their mortgage payments when interest rates rise, and some of these buyers will have no choice but to sell their homes, either at their own initiative, or via a receiver. Many apartments will be put on the market, pushing prices into a retreat.

The cyclicality of apartment price trends (stagnation and slumps following a year or two of price hikes), combined with the higher prices making apartments beyond the reach of the average renter and the government's plans to rezone more land for residential construction, all contribute to the assessment that in the near future (one to three years), average prices of medium-sized apartments will not rise, and will likely decline by 10%-15% in regions where a bubble has formed.

The writer is an economic consultant. Visit www.melnikadvisory.co.il for reactions and questions.