First of all, are these people thinking that as soon as I buy a house the market will suddenly turn around and start to appreciate?  What is the basis of this logic?  I can’t find any.  Housing increased substantially here in the Twin Cities and has barely begun to get back to normal levels. 

To be more accurate, it is a BETTER time to buy than it was in 2006 or 2007.  But that trend will continue for at least two more years.  It will be a better time to buy next year than now.  Not until we reach 2010 will it be “the BEST time to buy”.

To understand why home prices will continue to drop and for how long, it is helpful to look back at what happened in the last 10 years.

Note:  If you need to sell a house, you will fight everything I say here (if you even bother to continue to read).  If you want to sell a house but also plan to buy a house in the near future, you want to read this.  If you are in the market to buy a house but don’t have to sell one, you will enjoy reading this. 

The bottom line is that the huge increase in home prices during the recent boom will vanish, since it was based on temporary demand.  Here is why the housing boom growth was temporary:

1.  Low Interest Rate Sparked Home Demand:  Home buying began to escalate in 1998 because of the lower mortgage interest rates which fell to an average of 6.75%.   The rate dropped further to 6% in 2002 which drove demand up even more.  With cheap debt, more people could afford to purchase a home or upgrade to a better one.  This higher demand pushed home prices upward.  But this demand is not long-term, but instead dependent on low rates.

2.  Demand for Mortgages as an Investment Increased:  In the 1990s banks began selling mortgages to secondary companies, who pooled all the mortgages together and sold them as mortgage-backed securities (MBS) bonds to investors.  Purchasers of these bonds include investment banks, hedge funds, insurance companies, and public pension funds.  A large portion of these bonds were rated and insured as low risk because in the event of defaults, this portion of bonds would get paid back first, before the other bonds. 

The problem is that bond rating agencies erroneously rated these bonds as low risk, giving them an AAA rating, while in fact these bonds are actually high risk, since they include subprime and other types of risky mortgages.  This type of demand for mortgages is short-lived because of the high risk, as many borrowers could only afford the loans at the initial “teaser” low rate, and started to default when the loans reset to higher rates.  Once people realized the real risk of these investments, demand dropped quickly. 

3.  Easy Commissions Encouraged Lenders to Create More Loans:  In addition to a strong demand for MBS bonds, brokers, lenders, appraisers, and real estate agents made a lot of easy money with each commission.  Furthermore, originating banks did not keep the loans they created, so there was no accountability.  Here is when the subprime market really took off.  With all the money to be made, there was an incentive for these folks to not be fully truthful to their customers.   Unfortunately the government did not step in and regulate the creation of these loans.

 

So now people with low incomes and/or no savings could purchase homes. The justification told to borrowers was that higher home prices in the future will allow them to pay off any debt or to refinance.  As a result, prices of homes were again inflated temporarily as more borrowers were approved for loans, increasing the demand for homes.   But in reality home prices were not going up based on a fundamental or long-term reason, and unless these borrowers sold their house during the boom, they would have a difficult time getting more equity out of their home in the future. 

 

4.  Speculators:  So now just about anyone could get a home and the demand for homes continued to increase.  Since it was believed by many that housing prices can only go up, speculators started buying up houses, which further increased the demand. These people purchased homes only because they hoped to sell them in the near future for a higher price.

 

An interesting comparison to this type of temporary, non-fundamental demand is the Dutch tulip bulb mania in the 1600s.  Demand grew so high that at one point in 1637 a single bulb sold for the same cost as a house on the canal would sell during that time!   But just like housing, this type of demand was not sustainable, since it only continued as long as there was the belief that prices will keep climbing.

Now that you’ve seen why home prices went up, here is why home prices will continue to decline:

 

1.  No fundamental reason for growth:  For prices of homes to continue to rise, there needs to a sustainable reason for growth that would continue for a long period. Fundamental basis for growth include things like a higher demand due to an increase in population, a lower supply of homes, home building moratoriums, substantially more expensive construction costs, a loss of comparable options (renting), or higher incomes.  There is none.

 

2.  Foreclosures Increase the Supply of Homes:  It was just a matter of time since the number of subprime mortgages sky-rocketed and prices of homes escalated, yet incomes remained almost the same, that people would be unable to make payments and foreclosures would result.  These foreclosed homes increased the supply in the housing market, causing the market to change from high demand to a high supply.  With interest rates on teaser and adjustable-rate loan payments beginning to rise, more and more people can no longer afford the mortgage payments, increasing the number of foreclosures.  Many adjustable-rate loans will reset, or increase to a higher rate, both this year and next year.

 

Furthermore, many people that could afford their first mortgage debt saw the value of their homes almost double, and decided to use some of that "equity" now by taking out a second mortgage. But unless they have already sold their property, the equity from the spike in the last decade wasn't real, since the growth was just temporary.  Today many of these folks are also choosing to walk away rather than pay off loans against a depreciating asset, adding to the increasing foreclosure rate.

 

In fact, foreclosures are accelerating just about everywhere in the country.  Call your local county sheriff's office if you need to verify this.  As the supply of homes for sale continue to increase, the prices of homes will decline and get back to “fundamental” prices.

 

3.  Demand for Mortgage-Backed Securities Eliminated:   Unfortunately, risky subprime loans were lumped in with low-risk loans.  When people stopped paying their mortgages, for the simple reason that people can’t afford the mortgages, there was no money to pay these bond holders, even for those first in line.  Getting paid “first” was the reason the bonds were rated AAA, but it isn’t all that great when there is no money coming in.  Bond insurers like MBIA and Ambac failed to do their job of correctly rating the risks.  Once people realized the real risk, demand for these bonds disappeared. 

 

4.  Fewer Buyers Qualified by Lenders:  Demand for risky loans dried up and instead lenders require people to qualify for loans.  It’s hard to fathom that it’s a major change that lender’s now qualify people to make sure they can pay back the debt.  And so now the demand for homes fall even further since there are fewer buyers in the market. 

 

5.  Government Can’t Manipulate the Housing Market:   At least in the long term.  It can delay the correction of the errors listed above.  But for the most part the decline of home values is just too big for government to solve. Seventy percent of our economy is dependent on consumer spending. And consumer spending is dropping because the debt is maxed out. Look at Wall Street to see the current effects of reduced spending. Credit card companies are raising rates to even good cardholders. 

 

A few dollars from the government in rebates to consumers, or business tax breaks for equipment purchases, are not going to increase sales and help stimulate the economy to any significant degree.  A close look at refinancing “solutions” show that they are temporary.  There are currently over $250 billion in just option arm loans in the country, in which many people did not understand that paying the "option" amount each month meant the mortgage debt would grow. With home prices already dropping, not only can many not stay in a house they can't afford with the principal balance increasing; they don't have any incentive to pay these mortgages because they can't sell their home for more money later, as promised.

I predict that home prices will continue to drop in 2009 and 2010. The percent of decline all depends on the percentage increase during the boom.  One rule-of-thumb is the further away your area is from urban cities, the smaller the boom, and therefore the smaller the upcoming decline.  On the other hand, the higher the increase, the steeper the decline, as today’s trend is showing.  At the earliest it will take another two years before home values will be more in line with its long-term historical value.  In the last century, most homes went up in value equal to the rate of inflation, between 3% and 5% on average.  Taking out inflation, that average price increase was 4/10 of a percent.

To roughly calculate what your home will be worth in a few years, go back to the price levels in 1997 for your area, and add 4% per year.   The difference is how much the prices of homes will drop.  For example, if the median value in 1997 was $100,000, the value in 2011 will be $173,000.  This is a 73% increase over 14 years.  If a seller is asking for $200,000 today, they may get it, since prices will not be corrected until 2011.  But if that seller is asking $250,000, and they drop the price slowly over the next two years, they will lose money.

An even easier rule-of-thumb is to simply use the value of the home in 2002.  That year’s value is roughly equal to the pre-boom normalized value, plus an annual inflationary increase of approximately 4% that would have occurred through 2008.

Important note to sellers: If you absolutely have to sell your house, and you are listing your house for much more than this historical value, you would be smart to adjust your price down sooner rather than later, since each month the value is dropping.  But many sellers are only looking backwards, not forward. The market will continue to get worse, not better.  Holding out for a better price is guaranteed to get you less next year.  If you stand to lose a lot of money, I think you should either drop your price quickly and get out of the market, negotiate with your bank for significantly better finance terms, try for a short sale in which the home is sold for less than the mortgage and the bank agrees to forgive the balance, or accept a foreclosure, but at least save your health and your marriage. 

Important note to buyers:  Go ahead, but look around to see if the prices in your area are still high.  Even if you get 10% off, know that it is likely that housing prices will continue to drop over the next two years.  Only buy if you plan to be in the house for more than 4 years.

Because the lowering of housing values means a large loss for many sellers, getting back to "fundamentally-priced" homes is painful.  The sooner we get to the correct, real level of home prices the sooner people can start spending, and the sooner the economy can start to grow again.

I think my opinions here are somewhat unbiased.  I don’t have to buy or sell a house.  I wasn’t a broker of any kind in the past.  I was a financial analyst for most of the last 20 years providing financial forecasts, sometimes in the real estate market.  My majors at UW-Madison were real estate and finance.

Please, when you read about today’s housing fiasco, consider the source.  Does the author have something to gain by persuading you to buy now?  I can understand why the National Association of Realtors keep trying to paint a different picture than reality, since it worked for so many years. Unfortunately the NAR is willing to say anything and even manipulate housing data, which just confuses everyone, even agents, who are just as desperate as sellers to believe.  I appreciate those agents who focus on educating sellers, helping them understand their options in this difficult market, rather than painting pretty-but-completely-inaccurate pictures to potential buyers.