A Light at the End of a Long Tunnel

A year ago I began writing this article, but concluded that the “light at the end of the tunnel” was a train. Again last summer I set pen to paper on the same theme and came to the same conclusion. I tried in December and failed. As I write, I wonder that it might be a little too soon to release this. I was early when I wrote my article in April of 2005 entitled Bubble Trouble, calling for a major drop in real estate prices and I may be a bit early in suggesting we may be very close to a bottom in home real estate values.

There are still significant forces putting downward pressure on real estate values. These include the insane run up in values over the first 6 years of this decade; very tight credit markets; increasing unemployment; record foreclosures; excess capacity; and general market fear.

However, many of these forces may increasingly be “priced in” and are being replaced by positive forces that may create a real estate bottom in the coming months. These positive forces include the precipitous drop in prices from market peaks creating greater affordability; record low interest rates, a record drop in new home starts; the near trillion dollar stimulus plan; the $8,000 first time homebuyer tax credit; and the increases in the FHA and Conforming loan limits for both purchases and refinance transactions. Let us first take a look at where we are now before we dive into where we might be headed.

Falling off a Cliff
At the Chicago Mercantile Exchange (CME), where many financial instruments such as interest rate swaps, currencies contracts, and commodities are traded, options and futures on residential real estate also are available. These products are based on the most accurate real estate index available on the market, the S&P/Case-Schiller U.S. National Home Price Index. This measure is generally considered the best and most unbiased indicator of real estate prices. The index is calculated from data on repeat sales of single family homes, an approach developed by Yale economists Karl Case and Robert Schiller. The index is normalized to a value of 100 in the first quarter of 2000 and measures home values in the 20 largest US metropolitan markets or MSAs.


According to the Case-Shiller Index, average U.S. single family housing values peaked in the summer of 2006 (July to be specific) doubling in value since January of 2000. Since that peak, housing prices nationwide have fallen off a cliff, dropping about 30% on average. This drop varies significantly in the 20 Metropolitan Statistical Areas (MSAs) listed. For example, in Charlotte, North Carolina, home prices fell just 4% compared to Phoenix, Arizona where prices fell 45%. Coincidently, Bank of America, BB&T and Wachovia are all based in North Carolina. Maybe this explains why these banks were willing to make such aggressive bets in the residential mortgage market.


Forces Pushing Prices Down
In Real Estate Finance class, students generally are taught to assume a 3% appreciation rate for real estate growth in all financial calculations. This was always considered to be the historical long term rate of growth. For some reason, the rating agencies and large brokerage houses missed this in their Real Estate Finance class. Home values appreciated at a rate of about 14% per year from 2000 to 2006 due to low rates, easy credit and speculation. Assuming values revert back to the mean of 3% per year, we may still have a ways to go. Using the Case-Schiller Index values from 20 years ago in 1989, and projecting forward appreciation of 3% per year, average real estate values nationwide must fall another 9% from their year-end values before they reach a 3% year over year appreciation rate. While this is a big number, home values fell 6% in the forth quarter of 2008 alone. Thus it would not be a much of a stretch to see a 9% drop by summer.

Tight Credit Hurts
Tighter credit standards are hurting home buyers. Conventional and FHA loan standards have tightened dramatically. In addition, many of the mortgage products available to home buyers have vanished. No income verification loans, so called 80-20 loans, sub-prime loans and even competitivly priced jumbo products are no longer in existence. This means that few potential buyers can pick up the slack of excess homes.

Unemployment Continues to Increase
The unemployment rate, currently at 8.1%, is expected to continue to rise throughout this year and into next year. The Fed is projecting a rate of 8.8% by the end of 2009 and possibly higher in 2010. Unemployment has a direct impact on housing prices. As people lose jobs, they lose their ability to make house payments, and many lose their homes in foreclosure. Unemployment can be devastating to housing markets, but is a lagging indicator of economic activity and is likely to remain high well after the economy starts to grow.

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Delinquency Rates Increased in Q4 but Foreclosures Rates Began to Drop
The Federal Reserve reported that fourth quarter 2008 mortgage delinquency stood at 6.29% up from 5.2% in the third quarter. Mortgage delinquency is generally below 2% under normal market conditions. “Foreclosure filings were reported on 274,399 U.S. properties during the month of January, a 10 percent decrease from the previous month but still up 18 percent from January 2008” according to the RealtyTrac U.S. Foreclosure Market Report.



“The extensive foreclosure efforts on the part of lenders and government agencies appear to have impacted the January” said James J. Saccacio, chief executive officer of RealtyTrac.


“January REOs, which represent completed foreclosure sales to the foreclosing lender, were down 15 percent nationwide from the previous month.


Excess Capacity
Total housing inventory peaked in November at an 11.2-month supply meaning that it would take 11 months before all of the homes listed were sold at the current rate of absorption. However, at the end of December, this figure fell to a 9.3-months supply due to a substantial increase in home sales. “The higher monthly sales gain and falling inventory are steps in the right direction,” according to Lawrence Yun, chief economist at the National Association of Realtors, “but the market is still far from normal balanced conditions.”

General Market Fear and the Herd Mentality
The same factors that pushed housing up to insane levels are now pushing it down at an even faster rate. In 2006, buyers were willing to enter bidding wars and in some cases write “escalator” clauses to compete against as many as 20 or more purchasers on the same property. Today, fear of further price deterioration has kept renters from buying, which in turn stops the move up buyer from moving up the chain. I call this the “Herd Mentality”. It is what creates all bubbles and eventually busts.

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Now for Some Good News
Ok, enough of the bad news, lets look at the positive factors that may be establishing a floor in housing. Why is this important? I believe that the fall in housing prices led us into this recession and a floor in prices will spark the end of the recession.

Affordability
The National Association of Realtors, biased though they may be, reports that their Housing Affordability Index is at 135, which means that the average American family can not only afford to purchase a home, but also will have excess money for living expenses. According to the association, a score of 100 indicates that a typical family would have the exact amount required based on a 20% down payment and monthly payments of no more than 25% of their household income.

I did my own calculations based on Fairfax County’s numbers. For the past few years, an average Fairfax County couple earning the median household income of $105,000 per year could not even afford to purchase a home in Fairfax County. Now that prices have fallen 30% from 2006, a home that used to cost $600,000 now costs $420,000. Using the a conventional loan limit of $417,000 or the new higher FHA loan limits of $729,750, this couple can now purchase this home with 10% down with a conventional loan or as little as 3.5% down at a rate near 5%. Add Obama’s $8,000 first time home buyer tax credit and things get even better. These first time home buyers are the key to the real estate chain. As they buy new and existing homes, existing owners are free to sell their homes and possibly move up. This is a huge step to establishing a floor on real estate values.

Record Low Rates and New HUD and FNMA Guidelines
As of February 26th 2009, the national average mortgage rate is 5.07% with an average of ¾ of a point according to Freddie Mac’s Primary Mortgage Market Survey. This rate is near all time lows and allows buyers to afford significantly more house for the money. For example, mortgage rates were approximately 8% in the year 2000. In that year, the Case-Schiller Composite 20 Index was set at base of 100. Today the index stands at 152 showing a 52% increase in home values from the year 2000. Should homes be worth 52% more today than in 2000?


Considering real income are the same today as in 2000 and the population has grown by less than the number of new homes built, not likely. But if rates were at the same level as they are today, then home buyers can afford a 35% larger purchase price. This has a direct correlation on home values. This would put the index at 135 vs. 152 where it stands today. Combine that with the new max FHA insured loan amount of $729,750 and the more lenient FNMA guidelines on refinance transactions indicates that we may be approaching the bottom.

Record Drop in New Home Starts
According to Bloomberg, “U.S. builders broke ground in January on the fewest houses on record as a lack of credit and plunging sales exacerbated the worst real-estate slump since the Great Depression. Housing starts plunged 17 percent.” While this may seem like bad news it has a very positive impact on future home inventories. Eventually the demand for housing will exceed supply again and home prices will begin to recover. This may take some time but a virtually moratorium on new homes certainly helps.

Government Stimulation
Over the next two years our government will spend nearly a trillion dollars stimulating our battered economy. While one can debate the value of this stimulus, there is little debate that it will have a positive impact on stemming foreclosures, increasing employment, and providing prospective purchasers a nice credit of $8,000 to purchase a home in 2009. The administration will also use $75 billion to bring down mortgage rates and encourage loan modifications to stem repossessions. “The problem with the build-up in inventory is coming from the increasing number of foreclosures,” Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies in Cambridge, Massachusetts, said in a Bloomberg Television interview. “It’s about time the government intervened so directly in the problem.”

So Where Does This Leave Us?
As I explained earlier, falling real estate values led us into this recession and stabilizing values will mark the beginning of the end. If one can accurately predict when and at what level home values will stop falling, one can predict when the stock market will likely turn positive and when the economy will truly begin to rebound. We live in a world of uncertainty, and it is this uncertainty that defines risk and ultimately opportunity or failure. Predictions on when the real estate market might begin cannot be relied upon at all. There are far too many factors that are still unknown. However, now that I have hedged myself, here is a summary of my thoughts on the light at the end of the tunnel.

A bottom in the current residential real estate cycle will be reached between April and September of this year at a value of 11 to 15% below year end 2008 values. While an additional drop of this magnitude will be painful, it will be reached shortly. Capitulation caused by short sellers and foreclosures will likely end this spring. Thus some of the best buying opportunities may be right around the corner. If my predictions are correct, this would mean a peak to trough decrease in values of about 37% and put properties priced at their 2002 levels. These estimates are based on national averages and will vary significantly in different parts of the country and in different price points in each MSA. For example, property values inside the Washington DC Capital Beltway have fallen by less than half that of those further out. So if you are in the market for a home and plan to stay at least 5 years, 2009 might just turn out to be the ideal time to buy.