The FED Hurls Another Warning

That's a lot like using a margin account -- a line of credit backed by securities in an investor's portfolio -- to buy stocks. During the 1990s, many investors used such accounts to buy shares in fast-rising tech stocks. When the dot-com bubble burst, the value of the shares bought on credit cratered and investors' borrowing worsened their losses. Economists say today's debt-fueled investment binge in real estate is fanning the flames of an already overheated housing market, and making demand from people who actually need houses to live in seem stronger than it truly is.

In some markets, this buying is adding to a glut of rental housing and causing rents to fall, which will make it more difficult for investors to break even. Already, there are signs that a few investors are starting to get burned.

On Friday, Federal Reserve Chairman Alan Greenspan suggested⁵ that house-price inflation in some parts of the country is starting to look excessive. "At a minimum, there's a little froth in the market," Mr. Greenspan said in response to a question at a lunch hosted by the Economic Club of New York. "We don't perceive that there is a national bubble, but it's hard not to see that there are a lot of local bubbles," he added.

He played down the idea that the market could suffer a dramatic crash like the bursting of the dot-com bubble, in part because homes don't sell as quickly as stocks do. Also, most people still have plenty of equity in their homes, he noted, so the prospect of mass bankruptcies in the event of a housing-market decline seems far-fetched.

Others express more anxiety. Dean Baker, co-director of the Center for Economic and Policy Research, a think tank in Washington, says many Americans are being "incredibly reckless" in assuming that real-estate prices will keep rising or, at worst, flatten out. "It's a classic phenomenon you expect to see in a speculative bubble," Mr. Baker says. He is so bearish on housing prices that he sold his own home last year and now rents.

In another sign of growing concern, the Federal Reserve and other bank regulators last week issued guidelines calling for lenders to tighten their criteria for making loans backed by home equity by looking more closely at borrowers' ability to repay under various possible future market conditions. The regulators are starting work on similar guidelines covering mortgage loans used to purchase homes. Among regulators' top concerns: the surge in popularity of interest-only loans, which allow people to pay only interest in the initial years and face the burden of paying back the principal later.

For now, however, so many Americans are racking up such huge paper profits in real estate that herds of new investors are crowding into the market every day. Thanks to rising home values, they have lots of money to spend.

Precisely how much home equity is being used for real-estate speculation and investment is impossible to determine because there are various ways homeowners can tap into their equity, and lenders often don't know how the money is being used.

What economists do know is that Americans are extracting huge sums of money from their homes, and mortgage brokers say more of that money is being funneled into real-estate investments. According to Economy.com, Americans pulled out roughly $705 billion of equity from their homes last year, up from $266 billion in 1999.

The bulk of that money came from capital gains made by people selling houses, and these profits often are used to purchase another residence. Many people also use some of the extracted cash to pay off credit-card debt, which is widely viewed as a sensible way to use equity. Another large chunk of the equity withdrawn goes into home improvements. Spending on such projects totaled $138.3 billion last year, up 38% from five years before, according to Harvard University's Joint Center for Housing Studies. Many people justify such projects on the assumption, not always correct, that money spent on new kitchens or decks will lead to commensurate increases in the value of their homes -- a mild form of real-estate speculation.

A riskier and more aggressive way to use home equity is to plow it into investment property, as the Epsteins did. A survey by SRI Consulting Business Intelligence, a research firm in Menlo Park, Calif., found that nearly 2.2 million households used their home equity to buy additional real estate in 2004, up from roughly one million a decade earlier. "As long as there isn't a major change in the marketplace or a bubble burst, it will go up again," says Larry Cohen, director of the SRI division that does financial-services research and consulting.

What Americans are generally not doing with their equity is letting it build, as homeowners traditionally did. The huge rise in home values translates into more equity for homeowners. But many of them have extracted those profits from their equity, and many people buying homes now borrow a larger share of the price than they did years ago. So mortgage borrowing has grown even faster than home values have. As a result, homeowners' equity as a percentage of the market value of all homes declined to 56% at the end of 2004 from 57% five years before, according to data from the Federal Reserve.

Financial-services companies promote the idea that home equity is available for spending or investment. "Your home is one of your biggest assets," says a brochure from Merrill Lynch & Co. "It's also a powerful borrowing tool." A Merrill spokesman said the home-equity loans it offers to consumers are "prudent."

Mark Balderston, a chiropractor in Shawnee, Kan., recently refinanced his home to extract money for a down payment of about $50,000 on a new home he and his wife are buying as a rental property. Mr. Balderston says he got the idea from a fellow chiropractor who has built a fortune on such investments in California. Though he's taking on more debt, Mr. Balderston figures that real estate is far less risky than the stock market. "If we can get a 5% or 6% return on our money every year, that's attractive to me," he says.

Why are people like the Balderstons so confident of strong returns from real estate even amid growing warnings about the dangers of a housing bubble? "People form their expectations on a backward-looking basis," says Jan Hatzius, an economist at Goldman Sachs in New York. Based on the experience of recent years, they tend to see real estate as a very promising investment, he says, adding: "That's probably not correct.... You should think pretty hard about whether you want to increase your exposure to real estate at a time when it is trading at historically high valuations."

Like the Epsteins, who used their home equity to buy rental housing in Maryland, many real-estate investors see the stock market as far riskier. "If you buy stocks," Mr. Epstein says, "the next day they can tumble in the toilet." Home prices can't fall nearly as quickly as stocks, he reasons, because people tend to hang on to their real estate when prices are weak and await an upturn.

And unlike those who buy stocks with borrowed funds, home buyers don't face margin calls, or demands from their creditors for additional funds, when prices fall. Besides, many investors believe immigration and baby boomers' demand for second homes will keep the market solid.

Mr. Epstein, 48 years old, wants to continue building up his rental-housing investments, which already account for more than 90% of his net worth. He is keeping his day job as a manager at a home-building company, but his wife, Kelly, plans to leave her sales job to focus full time on managing the couple's rental units and pursue further investments. They rely heavily on advice from their mortgage broker, Bill Deavers of First Metropolitan Mortgage in Prince Frederick, Md., who also invests in rental properties. The Epsteins' favorite technique is to buy houses from people who are on the verge of losing their homes to foreclosure. The sellers then often become tenants of the Epsteins.

Tim Gamber had $35,000 in his retirement account when he used a mortgage on his home to buy a piece of investment real estate nearly seven years ago. Mr. Gamber started buying property as a sideline five years ago and made it a full-time job after he lost his job as a title examiner two years ago. "I started leveraging myself as much as I could," he says. "I was really scrambling to secure my financial independence." Today, he owns about 40 properties that he values at about $25 million; he puts his debt load at $15 million to $16 million.

To make the deals work, Mr. Gamber turned to so-called option adjustable-rate mortgages, or option ARMs, which carry introductory interest rates of less than 2% and give borrowers multiple payment choices. Option ARMs can be particularly risky because the interest rate adjusts as often as once a month. If rates rise, borrowers who elect to make the minimum payment can see their loan balance grow, a plight known as negative amortization.

But for Mr. Gamber, they are a way to maximize his buying power. Buying real estate "wouldn't be as attractive" without the option ARMs, he says. With the low rates, option ARMs increase his cash flow, allow him to "leverage and buy more property and bet on appreciation," Mr. Gamber says.

Some investors are already tripping up. Bruce Drogsvold was desperate to find an investment property last summer when he spotted a five-bedroom, three-bath home in Boulder, Colo. Mr. Drogsvold, a real-estate broker, and a partner had earned $30,000 apiece on a previous real-estate investment. Their plan was to fix up and flip three or four homes a year.

The pair purchased the house in Boulder for $340,000 last June, then spent about $25,000 on improvements. To finance the purchase, each partner took advantage of a home-equity line of credit, tapping the appreciation in his existing home. By July, the refurbished house was back on the market, priced at $410,000.

But selling the house proved more difficult than expected. The pair cut the asking price to $389,000. Meanwhile, the Fed was pushing up short-term interest rates in an effort to hold down inflation. Because home-equity lines are typically tied to the prime rate, the Fed's moves raised the partners' borrowing costs. "We are starting to bleed," Mr. Drogsvold said in February as his outlays rose. By March, the monthly payments on the two credit lines had climbed by a total of roughly $500. They finally sold the home that month for $380,000, for a loss of about $10,000 after calculating their financing and other costs.

The experience hasn't soured Mr. Drogsvold on real estate, though. Next time around, he says, he will figure a year's carrying costs into the equation. "I have a big line of credit on my home," he says. "If something juicy comes along, I want to be able to act on it."

What makes this get-rich-quick formula more dangerous is that many investors are willing to buy properties on which the rent is too low to pay for financing and other monthly costs. Their bet is that rising property prices eventually will make these deals profitable.

Others invest with no immediate prospect of rental income. Jaime Nack, an event producer in Santa Monica, Calif., recently used a home-equity line of credit on her one-bedroom condo to come up with a $27,000 deposit on a Miami condo that will soon begin construction. She's hoping that the Miami condo will be worth more when construction is completed in two years.

When will this frenzy die down? "The way the consumer operates, they usually don't back away from winners until they become losers," says Joseph G. Carson, chief economist at Alliance Capital Management LP in New York.

Write to James R. Hagerty at bob.hagerty@wsj.com⁶

and Ruth Simon at ruth.simon@wsj.com⁷