After watching home values soar during the past few years it looks as if real estate reality is finally about to set in. The home-pricing forecast for 2006 is mild and modest with higher prices projected for the year but not the double-digit increases seen in 2005.

Then again, the forecast for 2005 was also mild and modest and it turned out to be wildly understated.

According to the National Association of Realtors existing home prices were expected to increase 5.3 percent in 2005. Now, however, NAR predicts that 2005 existing home prices will increase 12.7. If the most-recent NAR estimate is true, it would be the largest one-year price increase since 1979.

As to 2006, NAR says existing home prices should grow 6.1 percent.

In the context of what we know about existing home prices, a yearly increase of 6.1 percent hardly seems impressive — NAR records dating back to 1968 show that cash prices have increased an average of 6.4 percent annually. Also, it”s important to say that real estate is a localized commodity — what happens in a particular area may be radically different than what happens nationwide. It”s entirely possible that neighborhood prices may rise while national averages fall — and vice versa.

The result of NAR”s moderate forecast and the visible slow-down in price appreciation nationwide plainly raises two issues: First, is the “bubble” over? Second, what”s the next step for prudent buyers, owners and borrowers?

Let”s start by saying that there has not been a “bubble,” a term which suggests unwarranted appreciation. Instead, what we have seen is an unusual combination of circumstances which together have made real estate the investment option of the moment.

In the past few years we have had interest rates at historically low levels. For much of 2003 to 2005 you could finance or refinance at 6 percent or less. As interest rates get lower demand increases because more people can compete for homes and bid up prices.

In many metro areas new home construction is delayed, complicated and made more costly by restrictive zoning regulations and a declining supply of close-in buildable land. The result? Higher prices for those properties that are available.

Between 2000 and December 2005 the population increased from 282.2 million people to 297.9 million — that”s an additional 15.7 million individuals who need housing. Again, more demand pushes up prices.

In most areas — but not all — real estate has been a good place to invest, especially when one considers the alternatives. For instance, on January 14, 2000 the Dow Jones Industrial Average reached 11,722.98. By December 14th of this year — nearly six years later — the average was more than 800 points lower at 10,883.51. In contrast, typical existing home prices went from $139,000 in 2000 to $218,000 in October 2005 according to NAR.

Home prices have gone up in part for the simple reason that houses have gotten bigger. The National Association of Home Builders reports that in 1987 a typical house had 1,755 sq. ft. By 2004 the typical house had 2,140 sq. ft. More size produces a higher cost per unit.
What we’re seeing today is that some of the factors which have pushed up prices in the past few years are moderating.

Interest rates are now above 6.3 percent for 30-year financing — a terrific rate for much of the past half century but a full percentage point above the fixed-rate mortgage levels seen in 2003.

Higher interest rates mean two things: First, they limit the ability of borrowers to bid more. Second, they limit the number of bidders at any given price point. A $200,000 fixed-rate loan at 5.3 percent costs $1,110.61 per month for principal and interest over 30-years. At 6.3 percent and the same monthly payment, the borrower can only finance $179,428.

Not only have rates increased in 2005, there is reason to believe they will increase further.

The recent hike in energy prices, as one example, is nothing more than a universal tax on every transaction, product and service. It effectively raises costs that people, governments and businesses will try to re-capture through higher prices, taxes, wages and interest levels. Higher energy prices also directly increase the cost of homeownership.

What does it all mean? Look for a gradual and growing preference toward smaller, energy-efficient properties which cost less to buy and less to operate. With smaller appreciation, watch for reduced speculation which in turn will further shrink demand. Finally, look for savvy borrowers to limit future costs by refinancing now with fixed-rate mortgages — before rates go still-higher.

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