Not Much Pain in Coming Housing "Corrections" - Real Estate Investment Opportunity Article

SAN FRANCISCO July 6, 2005--Before discussing the California housing market, I will state the following for the sake of full disclosure: 1) I own a house which I could barely afford eight years ago and which I most certainly could not afford at its current valuation; 2) I owe my regular paychecks and my mortgages (therefore, my life as well) to an extremely benevolent institution that happens to be a major real estate lender in the state.

These facts, of course, have nothing to do with my view that no housing bubble exists in California . Perhaps my definition of a "bubble" has more to do with it. For me, the definition of a bubble is simple -- if it pops (i.e., leads to a dramatic decrease in nominal prices), then it's a bubble. If it doesn't pop, then no bubble.

I become, therefore, a little weary when someone says, "This is a bubble, but it will deflate" (without popping, without a drop in price). I also get uneasy when an analyst claims that, based on his valuation model, some markets are consistently overvalued. The term "overvalued" implies imminent price corrections. But if, quarter after quarter, the same markets are overvalued, doesn't that mean the model is consistently underestimating and perhaps a bit faulty?

Further, some analysts frequently mention housing market "corrections," but they often refer to something other than prices, such as sales volume or construction activities. When homeowners hear the word "correction," however, they immediately think of a drop in the nominal price (not adjusted for inflation) of their home. I have yet to meet a homeowner who could tell me what her home was worth ten years ago, adjusted for cumulative inflation over a decade.

For these reasons, some experts' casual use of the words "bubble," "overvaluation," and "corrections" may be confusing to the general public and even irresponsible. While many markets in the country can potentially experience some adjustments, they are not likely to affect the great majority of homeowners, and the process will be largely painless.

National home price corrections are unlikely

Since the end of World War II, home prices in the United States have never declined. Again, I am talking about nominal prices. In some years, the rate of home price appreciation was lower than the rate of consumer price inflation; therefore, homes did lose some "real" value. But typical homeowners are oblivious to this kind of adjustment.

Even in 1982, when the mortgage rate approached 20% and the housing market experienced a dramatic slowdown, nominal home prices rose 3%. (The annual inflation rate during the year was 6.2%.)

A nationwide decline of home prices probably occurred during the Great Depression, but we do not have reliable data from the era. All recent (and well-documented) home price corrections were local phenomena -- Texas in the '80s and Massachusetts and Southern California in the '90s. These corrections all happened in the context of local economic crises, triggered by huge losses of employment.

Incidentally, the chronic housing shortage in the San Francisco Bay Area seems to have saved the region from a similar fate in the aftermath of the dot-com bust.

Nominal home prices are slow to fall

During most housing market slowdowns, nominal home prices are the last thing to fall. Individuals selling their own homes dominate the residential real estate market. Since their chief concerns are nominal prices, many sellers exit the market rather than accepting lower prices. This behavior provides strong support to nominal prices. On the other hand, professional investors who dominate the commercial side of the property market are more willing to dispose of their assets at whatever the market bears.

Consequently, one likely outcome of the softening housing market is a volume correction, because sticky prices make it more difficult to strike deals. As the accompanying chart shows, the sales volume has been far more volatile than home prices in California . In the early '80s, when home prices kept rising nationally, prices in California were virtually flat (fell only 0.1% from peak to trough). However, the sales volume dipped 61.5% between 1978 and 1982. During the major housing correction of the '90s, home prices in California declined 11.7%, but the sales volume dropped more dramatically, by 24.7%.

As you can also see in the accompanying chart, volume corrections tend to begin earlier than price adjustments. In fact, presently a volume correction seems to have already started in California . The latest California Association of Realtors report shows that statewide, single-family home sales decreased 5.9% between April and May 2005, while the median price rose 2.5%. The volume was 2.1% lower than a year ago, but the price was 12.8% higher.

Are homeowners fretting about sales volume corrections? Except to real estate agents, escrow officers, mortgage brokers, and others whose businesses are tied directly to sales activities, volume corrections are largely invisible.

Another common correction is a "real value" adjustment. Even when nominal prices remain stable, inflation can erode the real value of properties. There are eleven states in the union where home prices rose less than the cumulative consumer price inflation of 133% since 1980. In those states, real property values decreased, but few noticed (or cared).

If the California housing market cools sufficiently, we will have real value adjustment, but, as stated earlier, most homeowners will not regard it as a problem.

We will almost certainly see a slowdown in construction of new homes in a year or two. This adjustment will involve a little pain, because recently, construction has been the fastest growing industry in California . Fortunately, construction is not the only industry generating jobs in the state. Service-sector jobs have also been growing at a healthy clip.

The next big housing correction will be elsewhere

This brings me to my third and final point. California is not where the big correction is likely to occur. How do I know that? Well, all recent housing crashes happened when a large number of jobs disappeared in local markets. The Golden State now enjoys strong job growth, stronger than the rest of the country. Jobs are being created in all regions of the state. When people are employed and their income is rising, nominal home price corrections are possible but not likely.

Even the state's total output has been growing faster than overall U.S. Gross Domestic Product (GDP) for three consecutive years since 2002. (See the chart below.)

Worried about the possibility of higher mortgage rates? Then re-read the section about what happened in 1982. With double-digit mortgage rates, home prices still rose 3% nationwide and were flat in California .

Nationally, there are some troubling signs, such as large job losses in Midwestern industrial states, the wear and tear of sub-prime mortgage portfolios in some markets (mostly in other states), and increasing speculation in residential properties. However, if you are a California homeowner concerned about the value of a primary residence, future housing "corrections" should cause you little pain.