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What's Next for Real Estate?

In the horror movie that is the U.S. housing market — working title: Nightmare on Every Street — we're at the juncture where the worst of the carnage appears to be over. Existing home sales grew by a much higher-than-expected 10.1 percent in October, helping propel the stock market early last week, before the Dubai surprise sent the major indexes down. Average home sales prices actually rose 3.1 percent in the third quarter compared to the second quarter, after showing a similar gain in the second quarter, according to S&P/Case-Shiller home price data, and the official backlog of existing homes for sale has dropped 25 percent. Add in the recent extension and expansion of the first-time home-buyer tax credit, and it seems to be a fine time to peel our fingers back from in front of our eyes.

As any horror-flick aficionado knows, however, there’s always that penultimate scene in which the bad guy springs back to life with one last gasp of air, scaring the daylights out of you. In this case, a series of significant challenges from both the economy and the real estate market threaten to mow down housing’s green shoots in the coming months:

  • High unemployment and the possibility of a jobless economic recovery. While home sales are up off the mat, they are still anemic. The fact that one in six Americans is either unemployed or underemployed doesn’t bode well for buyer demand; it could also lead to more mortgage defaults.
  • The presence of a massive “shadow” inventory. The backlog of existing homes for sale dropping from more than 10 months to its current 7.4 months is merely a move from horrible to really bad. During the last recession it didn’t get longer than five months. Moreover, there is growing concern about banks accumulating a huge amount of shadow inventory — i.e., homes that banks have already foreclosed on but haven’t been put on the market, or loans that are in some stage of delinquency or default — that is not reflected in those official stats. RealtyTrac, which compiles foreclosure listings, reports that one out of every 136 U.S. households received a foreclosure filing of some kind in the third quarter of 2009, the highest level it has ever recorded. An analysis by Amherst Securities Group estimates total shadow inventory at 7 million houses, or another 16 months of backlog.
  • Less government support expected. The Federal Reserve’s aggressive $1.25 trillion purchase of mortgage-backed securities has pushed the rate on the 30-year conforming fixed-rate mortgage about one-half to three quarters of a percentage point lower than it would be normally. Now that it says it’s winding down this program, there’s concern the Fed’s “Great Exit” (so dubbed by banking analyst Meredith Whitney) could cause rates to rise. And if today’s 5 percent rate on a conforming 30-year mortgage rises to 5.75 percent, that reduces a buyer’s purchasing power by about 8 percent. That’s not what sellers need to hear right about now. Plus, the May 1 expiration of the home-buyer credits will remove another key piece of government stimulus (absent a third extension from Congress.) It is hard to distinguish if housing has the intrinsic ability to stand on its own without those government crutches,” says Mark Fleming, chief economist at First American CoreLogic.
  • Fallout from the commercial real estate mess. Woes in the commercial real estate market have yet to peak. And while this market doesn’t have a direct impact on residential prices and supply and demand, it can exacerbate the foul mood of lenders, making it less likely they loosen the screws on their tight loan-qualifying standards.

Given these looming risks, money manager Whitney Tilson of T2 Partners is not alone in viewing the recent spate of good housing news as “the mother of all head fakes.” Goldman Sachs economist Alec Phillips recently advised clients that “despite the better recent data the risk of renewed price declines remains significant, and our working assumption is a further 5 to 10 percent decline by mid-2010.” That’s in line with the Fiserv Case-Shiller forecast: an 11 percent decline in the 12 months through June 2010, with prices falling in more than 90 percent of the 350 metro areas the firm tracks.

When Will We Hit Bottom?

While things may not improve as quickly as hoped for, many economists expect home values to start stabilizing sometime in the second half of next year, assuming the overall economy continues to recover. “Yes, we have 10 percent unemployment, but that means we also have 90 percent employment,” says economist Karl Case, one-half of the ubiquitous Case-Shiller home price index. “If the economic outlook continues to improve, that’s going to boost the confidence of the 90 percent. That’s a lot of people who can boost demand.” Stronger demand could, in turn, help the foreclosure picture because lenders may be more likely to modify loans once home prices stabilize. Or perhaps the administration’s latest iteration of a homeowner bailout program will help stem the foreclosure tide (although earlier government efforts have been largely ineffective).


What about the ominous headlines of another foreclosure wave when “option ARMS” (adjustable-rate mortgages) issued in 2005 and 2006 come up on their 5-year resets in 2010 and 2011? First American’s Fleming says option ARMS represent only a small portion of the total housing pie (about 3 percent in a recent government survey), and a lot of these loans are already delinquent. Therefore, they aren’t necessarily a future risk because they are already somewhere in the foreclosure pipeline.

To be sure, economists warn that forecasting housing right now is an especially dismal science given the murky data on shadow inventory, as well as how fast and how much the unemployment situation will improve. What seems clearer, though, is that whenever a bottom does form, we’re likely to have an L-shaped recovery without any kind of substantial bounce back. “We are looking at three to four years of flat prices,” says David Stiff, chief economist at Fiserv. “That’s typically what we see after an economic downturn, and this time around we will have the added weight of the slow drip of bank-owned properties keeping inventory high.” And slow drip is a best-case scenario; Stiff says one of the wild cards for housing stabilization is whether banks slowly and methodically put their REO-properties on the market over the next few years, so as not to overwhelm supply, or instead speed up the process to get the properties off their books faster, as was more common in 2008.

Your Best Moves

While the bursting of the real estate bubble was a national event, the stabilization process is going to be a more classic, region-by-region story driven by existing inventory and the local employment picture. One national constant, though, will be that properties requiring jumbo mortgages will continue to struggle because there is no securitization market for jumbo loans right now, making lenders less eager to do business at the high end. Depending on where you stand in the real estate market, here are your best moves:

  • Buyers: As with stock investing, trying to time the bottom is not advised. If you attempt to wait for that last 5 percent to 10 percent of downside that Goldman expects in the first half of 2010, any potential savings could be offset by higher mortgage rates.
  • Sellers: Fence-sitting sellers waiting for prices to firm need to be careful as well, especially if you are in an area with high shadow inventory; that is going to mean a lot of cheap competition for a long time.
  • Owners: Let go of any lingering dreams that your home can finance your retirement or your kid’s college education. It is shelter first and foremost, with modest investment value beyond the sizable tax breaks for mortgage interest and property tax. The historic annualized long-term trend is for home values to rise about 1 percentage point more than inflation. “Housing growth is tied to income growth,” says Fleming. “We just got away from that for a few years. Now it’s back to the fundamentals.”

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