Housing Meltdown: Why home prices could drop 25% more on average before the market finally hits bottom

Posted by: Peter Coy on January 31, 2008

melting houses.jpg
Please check out this week’s cover story in BusinessWeek and let me know whether you agree or disagree with it.

I just finished it yesterday, but there are already a few thoughts I would like to add. They should give some comfort to the real estate agents and home sellers who will undoubtedly hate this story.

1. Houses offer a dividend that no stock will ever have: a roof over your head. So if you’re comparing the investment returns of stocks and housing, you can’t just look at price appreciation. You have to add the dividend, which is big for houses (the roof) and smallish for most stocks.

2. If house prices regress to the long-term inflation-adjusted trend line very rapidly, they might need to fall 25%, as the story says. But it’s also possible that they could drift horizontally for a decade. In that case, they would be invisibly losing value because of the ravages of inflation, but it might not seem as painful to homeowners.

3. As I said in the cover story podcast, I’m not advising buyers to stop shopping. If you see a place you really like, you think the price is fair and affordable, and you aren’t planning to move again anytime soon, you should seriously consider buying it. Sure, the price might go down more, but market-timing is tricky and in the very long run a 10% or even 20% difference in the price might not look that significant.

Reader Comments

Chuck T

February 1, 2008 12:56 PM

The logic makes complete sense. What most people fail to realize is that homes used to be an asset that you lived in and raised your family. The past decade they were in some cases like margin accounts in the late 90's that were booming with overvalue. Times are getting tight and I think this is going to be a long drawn out battle with the economy in the next 2-3 years followed by slow growth. Even if we don't enter official recessions, its not going to be fun for anyone that was living on the fringe, which is most of America. People with good fundamentals shouldnt have a problem weathering the storm as long as their jobs hold up.

But I just wish talking heads and overzealous realtors would stop telling me that low interest rates are going to make up for the sheer destruction of equity and debt in the fixed asset markets! Plus the media needs to get back the facts.. the worst shame would be a self fulfilling prophecy driven mainly by the media - much like the elections have been this year!

Chuck T

February 1, 2008 1:01 PM

Oh, and one more final gripe. I really wish the real estate industry would stop trying to fool us all into believing that average middle class neighborhoods are priced fairly when the average income can't buy the same homes at half the price!.. something has to change.. and I can bet it wont be my salary doubling this year!

PS this even applies to glorious places like Bergen County, New Jersey which is ripe with very outdated bi-levels and ranches built in the 1970's that are asking in excess of 900-1m.. ridiculous and offensive if you ask me. So please dont be offended when my offer is 25% less than your insane asking price.

By the way, I make a good buck and cant afford these prices. I feel sorry for the real average blue collar people out there that can't find a decent place to raise their families.

Wes

February 1, 2008 6:27 PM

25% sounds about right to me, about the amount to wipe out 99% of the gains int he past 7 years, which will result in a loss for many because of lost appreciation against inflation.

Many people won't like this article but every day more seem to be waking up to reality. The media and real-estate groups are doing a disservice by continuing to preach half-truths and best case (unlikely) scenarios. I'm sure home ownership has civic benefits and is a worth goal (and a store of value for many), but I'm disgusted with the second class status that renters have received in the past boom.

Chalres Schuler

February 2, 2008 5:17 AM

Peter, what a disingenuous individual you are. You predicted gloom and doom and now you're writing a retreat caveat here that most people would never see. Shame on you.

Mike P.

February 2, 2008 3:01 PM

Potential buyers (such as myself) don't need to worry about timing the housing market. Even after we "hit bottom", prices will simply return to their historic normal trend of keeping up with inflation/wages/rents in the area. Therefore buying anytime after the bottom is just as good as buying right at the bottom of the market (unless the bubble starts up again).

Savvy buyers understand the fundamental relationship between home prices and comparable rents. Why would I ever buy a house if it's actually cheaper to rent a similar property (and conversely, why rent if it becomes cheaper to buy in the same area)? This is the only question a potential buyer needs to answer.

So how can you determine when prices are reasonable? There is a long, drawn out calculation, taking into account tax benefits, maintainance costs, etc, but the rule of thumb is, a home is priced right when it is at or less than 160 times the monthly rent of comparable properties in the area.

Mark

February 2, 2008 5:42 PM

Business week article good and accurate.
Homes are seriously overpriced and the US is in serious trouble.
Economists magazine did a study covering markets and Europe and America over the past 200 years and very conclusively showed that home prices in represent a big bubble they will deflate. Prices in California for example are at least 50% overvalued.
Over the long run all assets go to their mean and real estate is no different

R

February 3, 2008 12:16 PM

I agree. I'm looking for home in middle Virginia. I see people hanging on to the idea that 40 and 50% appreciation in 4-5 years is a normal thing. That's where their homes are priced. Supporting this lofty pricing are county assessments, realtors saying, "all is going to be better now that we have a stimulus package and lower interest rates"....right, can you put that in the contract? and finally I bet many homeowners cashed out some equity and they really don't want to reduce the price because they'll have to actually pay for some of the stuff they bought....and they can't.

Don Whittaker

February 4, 2008 10:37 AM

i just read your article on yahoo and had a few thoughts. I'm really feeling like everyone piling on the negative housing sentiment bandwagon is getting old. it's like a weatherman predicting more snow in the middle of a storm, what genius is there in that? Really, isn't it always smart to bet against the grain in life.

here are my reasons to be bullish:

- home buyers have been on the sidelines for over 2 years waiting and watching, these people won't rent forever.
- the tax benefits of home ownership make it very attractive in high income markets like, say, LA or SF
- metrics used to show the correlation b/w renting and owning do not apply in places like CA and NY. we just expect to pay more for housing period
- increased demand for renting in my market, northern ca, have pushed rents up making owning more attractive
- home loans are still widely available, even interest only loans. this credit crunch is really a bunch of hogwash. everywhere you look you see 18 months interest free financing on laptops, tv's, etc. car dealers offer no interest for 60 months.
- the raising of the jumbo loan limit, which is long overdue, will stimulate the ca market and cause refis
- have you been to the mall lately? after a quiet december the consumer is back in a big way. watch the retail numbers from jan, they're going to show there's no recession

and really, who the heck wants to pay rent at 65? people will always want to control their own destiny and home ownership will be back online sooner than later

Mike Shah

February 4, 2008 1:09 PM

Dear Peter

I read your article with great interest. I believe that you do have great deal of understanding about housing situation. However, I believe that you will be proven wrong because

You did not factor in declining power of dollar. Dollar has declined in value against euro by 50% in last five years. If you adjust that based on inflation and dollar decline, you will be suprized to know housing prices have NOT increased. You may also want to measure it against GOLD as currency, you will again be surprized to know that house prices have NOT increased.

One must measure the value of asset like house against equivalent assets/commodity like GOLD or stable currency. I would like to re-analyze your study and publish again. If you need further help, please let me know.

Sincerely
Manish Shah, PhD, MBA

Charles Moore

February 4, 2008 2:50 PM

Hello Peter-

I just finished reading your article on the current housing crisis here in the U.S. and the potential 20%+ decrease that potentially looms. There is quite a bit of disturbing material in there, but it is difficult to agree with history and the facts presented. Being a mortgage broker I would love to write the business, but for homeowners in trouble I would advise their first move be negotiations with their current lender. For homeowners receiving resistance from their lender they should try and get the National Foreclosure Hotline involved even if they are not to that point. I used to work for Wells Fargo Financial and have only been a broker since May of last year so I have definitely seen the worst of times so far in this business.

You did not mention this in your article, but there are current products out there to help out homeowners who are upside down on their homes. The FHA has a product that allows a CLTV over 100% with the FHA first being restricted to 95%. The backwards part about it is that the program is called "95% Cashout Refinance" so you have to take money out for it to classify even if it is only a few hundred dollars. This works well if the borrower is negative equity with a first and second mortgage with the first being 95% or less. Also FHA offers great rates and flexibility with credit.

Although they can be difficult to work with the lender US Bank will lend up to 100% LTV regardless of the CLTV and they have mortgage insurance built right into their pricing. The catch with both of these is getting the second position lien holder to subordinate. Having the National Foreclosure Hotline push their weight around with the second lien holder can help to get this accomplished though.

You have a much wider audience than I do so if you found this information useful please pass it along. I can provide more details if you would like as well. Have a great weekend and take care.
--
Thank you,
Charles Moore
Denver, CO 80202

Geoffrey Lenart

February 4, 2008 2:51 PM

Mr. Coy:

Thanks for writing the article.

It only confirms in my mind that we are hitting bottom in the housing sector. I can always
tell when it is time to buy as the GLOOMSTERS and DOOMSTERS are lined up on the streets espousing fire, brimstone, and foreclosure. It is just the opposite when every Tom,
Dick, and Idiot is out there pushing real estate, commodities, or tech stocks as the sure
fire way to riches.

I think a lot of these so called economists are letting their own personal bias and
egos get in the way of their better judgement. The housing market has always been,
still is, and will always be driven by liquidity. Liquidity provided by monetary and fiscal
policy. Both are in the strongest of expansionist and accomodative modes right now.

There are those on Wall Street this week who thought it was wise to fight the FED. They
found out otherwise as they were forced to cover a lot of short positions in the financial
sector.

When the FED cuts interest rates by nearly half in a period of 5 months, I dont blink.
I dont hesitate. Time to buy and back up the truck.

When prices are 25% higher and the GURUS of economics are all still pooh-poohing GDP
growth as it steam rollers past 5%, I will be cashing out the first part of my purchases.
The GURUS will go back to writing about the make-believe economy that exists in their
minds. Once again, they will be wrong. Just like before and the time before that.

Thanks,


G. Lenart
Real Estate Investor

Ray Snow

February 4, 2008 2:56 PM

Mr. Coy,

Read your article quickly on Housing Meltdown. I may have missed it, but I think a major problem that I have not seen discussed is the "trail" of upside down/negative equity properties going years into the future. Here in Florida it is safe to say that EVERY person who bought a property in the last 4 years (as of today) with a mortgage is upside down. That is thousands and thousand of people who would not be able to sell except for short sale/foreclosure many, many years into the future till presumably we would be back to the elevated late 05/06 levels. A real mess going way past the time point of "the bottom".

Ray Snow

Naples, Fla.

W. Kern Hendricks

February 4, 2008 2:58 PM

The rapid rise in housing prices during the early to mid 2000’s may be only partially caused by exuberance, demand and easy money. I suspect that the growing scarcity of available land in most metropolitan areas has been a significant contributing factor also. This is certainly the case in the Greater Seattle area as I’m sure it is in other areas also. As long as there are good paying jobs around city centers people will be willing to pay decent prices for good close-in homes to avoid long commutes.

I did not see this mentioned anywhere in your article.

Donnie McGean

February 4, 2008 3:01 PM

Aloha Peter;
I bought a home in Sacrament in 1989 for $102,000 for my sister to live in. In 1991 she got married and moved out. The house in 1991 was worth about 87,000. It continued to decrease in value for several more years. I could have walked away and left it to Well Fargo Bank, but I rented it out and had to wait until 2001 when the market turned upward.
I was able to put the house on the market and sold it for a hefty profit. Your article seems to imply that if you are upside in your loan value to house value that you are in big trouble. The truth is that if you live in your house and can afford your mortgage, the dollar value of your house is meaningless. The value of your house is that it is your shelter where you will live and perhaps raise a family. Not until the nineties were people interested in what their homes were worth on a regular basis. I don't know your age (I'm 53) but do you ever remember your parents talking about the value of their home while you were growing up? Maybe the reason people lived in their homes for a lifetime was that the homes never appreciated enough to make it worthwhile to sell. We may be going back to that time when people live in their homes for more than just a few years before trading them in.

Perhaps if there were more articles about the positives of owning a house excluding the monetary value, people would not be losing sleep thinking they bought at the wrong time or paid too much. In my lifetime I have seen three busts in California, the mid eighties in San Diego, the mid nineties throughout California and the present. If you had overpaid in the mid eighties for a property in San Diego, didn't panic, lived in it and paid the mortgage, do you think today that you had overpaid for the house? Time has a wonderful way of correcting things.
Probably ten years from now we will look back and say we wish we had bought a home back then when the market was so unsure.

Sincerely,
Donnie McGean
Kihei, Maui

BusinessWeek Economics Editor Peter Coy

February 4, 2008 5:45 PM

Thanks to all for your comments. I'd like to respond to Charles Schuler, who said I was disingenuous because I made some points in the blog that I didn't make in the article. He wrote, "Peter, what a disingenuous individual you are. You predicted gloom and doom and now you're writing a retreat caveat here that most people would never see. Shame on you."
I'm not retreating from what I wrote in the cover story, which is that on a national average, prices could fall an additional 25% over the next two or three years.
The cover story was tightly focused on exploring that point and its ramifications. This blog is a place to broaden out the story and get into other issues that didn't fit naturally in the cover story.

John Schneider

February 4, 2008 10:09 PM

Peter,
you seem to have all the answers.

According to you, there are just two possibilities, "house prices regress to the long-term inflation-adjusted trend line very rapidly, they might need to fall 25%" OR "it’s also possible that they could drift horizontally for a decade".
That's it huh, just those two possibilities,

John Schneider
www.thefoothillstoday.com

Brandon W

February 5, 2008 12:22 PM

I would have to disagree that jobs in city centers will keep housing prices up. Jobs have been moving out of city centers and into the suburbs for 2-3 decades. It's one of the biggest difficulties with the implementation of public transit systems - particularly light rail. We have moved to a multi-nodal network rather than a network centered at the city core. The push to city-centers is a New Urbanist ideal that is failing in most places because our society has changed. The ones that are doing reasonably well are more like tourist destinations. How many downtown condos are sitting empty nowadays? I know that even Seattle, despite it's seeming-stability at the moment, is having a bit of a condo glut.

For prices of anything, return to the first day of your Intro Economics course; it's all about supply and demand. In the short run, all sorts of financial gimmickry may distort things, but in the long run the rules of supply and demand will win. In the housing market the supply is too high and the demand is too low (too many people can't afford these prices with declining wages!). The rules of supply and demand dictate that housing prices must come down a long way.

As for the people who have been sitting on the sidelines for two years, they will wait longer. It's still a lot cheaper to rent than buy in most places, and if wages don't allow people to buy they won't. The demand simply won't materialize. I'm in the process of moving out of Michigan (where the economy is a disaster), so I've been investigating cities all over the U.S. I can tell you that there are many, many places where you can rent a nice apartment for $800-$1000, but a starter-home would run $2200/mo+. Would people prefer their own home to renting an apartment? Sure. Do they have the extra $15,000/year income to do so? Many don't.

BusinessWeek Economics Editor Peter Coy

February 5, 2008 6:11 PM

To John Schneider:

Of course you're right that there are many possibilities for the housing market other than falling 25% soon or drifting sideways for a decade. For all I know, prices could start going up again tomorrow. All I was trying to say in that note is that you can get a big decline in the real value of homes in ways that are less conspicuous to the general public, such as a slow erosion by inflation.

Wes

February 7, 2008 12:05 AM

Manish Shah, PhD, MBA

Let's be realistc. While you may have a point, what matters to Joe 6 Pack on the street is how much he pays for a house in salary, generally paid in US dollars. To all people working hard to barely make ends meet with house prices that are clearly unaffordable and appreciation clearly unsustainable, the relative price of a house to Gold, which is not an official currency of the United States, doesn't matter. As a PhD you should know that dollar currency is a facility of exchange, and if people were buying houses with Gold, then we can talk about prices of houses in gold, or hankerchiefs, or cars, or whatever your medium of exchange happens to be.

What typical housing bulls (like Mr. Lenart above) never understand is how they are going to make any money when 80% of your buying market is priced out. Are current owners only going to trade houses amongst themselves?

Glenn Booth

February 7, 2008 10:18 AM

While I first was doubtful about the prospects for such a large decline, I then took into consideration the growing college debt load that young professionals are now carrying.

With the average annual college tuition approaching an eye-popping $50K, many of today's young graduates will be spending the next 10 years trying to pay down debt, rather than spending it on housing. According the the WSJ, more and more professionals in their mid and late 20s are moving back home. Doesn't sound promising.

Steve B

February 7, 2008 2:57 PM

-There's no question in my mind that Housing prices will decline double-digit. How much, nobody knows.
-I also think, this will be a "healthy" correction in the long-term, as it may teach borrowers to be on better behavior and more responsible for their long-term financial prospects.

That being said, I don't see this as 1925 all over again, for several primary reasons:
1) Credit: There's still plenty (FHA, etc) of good, flexible and cheap credit out there);
2) Wall Street has far too much power over the Fed & government to allow Housing to take down the entire country. I.E. Harking back to FDR, raising the Jumbo limit, etc,may occur.
3) A fairer comparison of Housing Pricing would be versus the Dollar and Gold value, versus just comparing to the rate of Inflation.
4) Land Prices: Will continue to increase.
5) Demographics and people still prefer to Own vs. Rent, even if.......renting may be a better financial alternative. Its the "American Way".

Thus, I predict the Average House Value will be higher in 2011 than it is now.

Robert Fulton

February 8, 2008 12:42 AM

The problem is not the market it is the new fraud. Lenders are pushing the market low with soaftware appraisals. Realtors are entering short sales and foreclosures as arm length real sales. When a realtor enter bad information it starts a bad trend.
If A is a foreclosure and B list then the foreclosure is a comp once A sales now you have a real comp. Appraisers are using foreclosures as comps on appraisals driving the price down. The Desktop sofware lenders are suing are showing lower prices and there fore not letting people refi out of bad loans therefore making more foreclosures.
I published the finding yet no govet want to tell the people that bought high in the market they are being taken again.

JanB

February 10, 2008 2:05 PM

Don Whittaker--

Step away from the NAR Kool-aid Buddy...just say no, stop drinking that stuff cold turkey!!

I know you are a Realtor, and wanting for the good old days, but those days are GONE. These artificially-driven up prices are going to collapse because there is just nothing there to support them anymore. Demand for Debt Traps is tanking, and inventories will sky rocket!!--Trust me, I wish the news was better, but you ain't seen nothin' yet!!

Sub Prime was just the tip of the iceberg, what we have coming is wave after wave of defaults that the FED will be unable to stop, (ALT-A, followed by Prime, followed by Commercial, followed by Credit Cards, Autos, etc, etc.

You would have to be an absolute FOOL to buy this year!! Prices will have to take a 30% haircut in most areas to even return to the Historical mean. The biggest housing bubble in history will be followed by the biggest BUST..it's just simple math my friend.

Randall Bostick

February 18, 2008 5:56 AM

Excellent article.

It is a difficult concept for most to grasp that housing prices will likely revert back to their pre-bubble value (as adjusted for inflation.)

Would it be difficult to convince someone that if a ball is thrown upward, an unexplainable force will magically reverse its course and return it back to Earth? No, most are not surprised when this happens.

Why? The behavior of gravity is considered to be "normal". Personal experience is usually more convincing than any rational. No explaination of how gravity does what it does is required. Understanding the behavior is enough.

Most lack personal experience and are unaware of how "normal" asset bubbles have been and why it should be expected that prices will return back to Earth.

wikipedia.com has an excellent article on the subject. Just type in "housing bubble"

Jack

July 25, 2008 9:00 PM

Every economist in the country was warning about this bubble except the shills from the real estate industry.

Enable a borrower with a 3% interest only loan, with a $1800 a month payment he has the ability to service a $720,000 mortgage. Add a healthy dose of hype where prevailing belief becomes housing is a can't miss way to get rich and you have people bidding up home prices to levels that can't be sustained. Now, in 2008 this same buyer still has the same $1800 to spend, but now it's 6.5% fully amortized. His payment now can only services a $284,000 mortgage. The difference between the 720k and the 284k is the bubble.

Home buyers shouldn't act foolishly and blindly plunk their money down without doing some homework and learn what drives home prices. I ran across a website www.UsHousingMeltdown.org where you can type in your zip-code to find out the income levels and whether homes area overvalued or not.

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About

BusinessWeek editors Chris Palmeri, Prashant Gopal and Peter Coy chronicle the highs and lows of the housing and mortgage markets on their Hot Property blog. In print and online, the Hot Property team first wrote about the potential downside of lenders pushing riskier, "option ARM" mortgages and the rise in mortgage fraud back in 2005—well ahead of many other media outlets. In 2008, Hot Property bloggers finished #1 in a ranking of the world's top 100 "most powerful property people" by the British real estate website Global edge. Hot Property was named among the 25 most influential real estate blogs of 2007 by Inman News.

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