A Look at the Housing Market

The housing market has been in a downturn for most of 2006. There have been rumblings from many corners about rising home values causing a market bubble. Normally, housing is not subject to huge downswings in prices. Values do fluctuate according to various local market demands. It is not like the stock market where it is easier to be a buyer or seller. The main purpose of housing is to provide a permanent place to reside.

A home is usually thought of as a longer term investment. But for most people, it is not considered to be the same as investing in stocks or mutual funds. After all, if you sell your home you will still need a place to live. It is generally assumed that prices will continue to rise over the long term. Or, at least keep pace and stay ahead of the inflation rate. So what is happening now in the housing markets? Are housing prices about to crash and leave our economy in a full blown recession?

The real problem was created when housing became the near perfect speculation vehicle. This occurred mainly because of falling interest rates and the lack of any other rising markets. Speculative money will always follow the rising markets. Five or six years ago, the stock markets were peaking and falling from favor. The commodity markets were basically going nowhere. However, interest rates had peaked and were beginning to fall; thus ushering in falling mortgage rates. The hot money now had a place to flow to since the opportunity cost was favorable.

In short order, demand for housing picked up and the speculators jumped right in. Over the last three or four years, a higher and higher percentage of housing transactions were created by speculators. The buying of properties and, after a rather brief holding period, selling them for a quick profit became a popular fad. As with any rising market, eventually the “non” investor gets into the act. The professional speculators lead the way in the earlier stages and gradually the public becomes infatuated with the unbelievably easy profits.

This is the cycle that occurs with any bubble situation. The belief is that housing is generally immune to any real price corrections since most properties are bought and sold over very long periods of time. Except for specific local markets, we have not seen a major price crash affecting the entire housing market. In 2005, about 40% of all housing purchases were either second homes or investment properties. This was the highest number ever recorded. The belief in rising markets is that prices will never go down. But they always do at some point.

So the main complication in the housing market is how much of the recent buying has been other than primary residences. Prices simply cannot keep going up astronomically. When they do, the potential number of buyers will always be shrinking. It is the affordability factor that keeps the market buoyant. Continuously rising prices will make it difficult to find new buyers. At some point, the potential for owning a second residence is going to make less sense to many people. We are in that position now in the housing market. Owning a second home is usually not a priority among the average home buyer.

With easy financing and creative mortgages, the lenders again have stretched the limits of affordability. The specialty properties in high demand areas may hold their values. This is the playground for those that have money to burn and affordability is not a factor. But for the other 95% of the market, prices may continue to tumble. Of course, as prices fall, housing becomes more affordable for more potential buyers. If mortgage rates do not rise much higher, that could stabilize the housing markets.

Just about every builder in the country has forecast lower earnings in the coming months. We now have the highest number of unsold homes on the market in the history of housing. Also, the number of new homes is at an all-time record supply of almost 600,000 units. Unless these numbers begin to fall, prices will have to come down to create demand. That is the big question at this point. Will a 10-20% drop in prices do the trick or perhaps 30-40% before the market reverses. Predictions are all over the map. Certain areas may only fall slightly while other markets completely crash. It is kind of scary if you are sitting on a property that was worth $300,000 a year ago and might fall in value to below $200,000 in a year or two.

One other factor that needs to be looked at is the bond market. Mortgage rates are directly tied to bond rates. Right now, there is a huge speculative position built up in the 10 year treasury note market. There is a “net long” position in treasury futures of almost 450,000 contracts. This is the highest proportion in over 15 years by a wide margin. As with any market, when things get to far out of balance, the pendulum usually swings the other way before to long. If for any reason these positions need to be unwound, bond prices will sink like a stone. And then, mortgage rates will rise through the roof. Does anyone remember mortgage rates above 8% or higher?

You won’t hear any bad news coming from the government. They will pretend the economy is just fine. The talking heads on TV will insist that things are really not that bad. Many real estate brokers and advisors will look the other way and give you a reassuring pat on the back. But the fact is that the housing market has been fueled by rampant money-happy speculators. They have added the froth to what should be a relatively stable market.

It is virtually impossible to predict future prices because of the nature of housing. There are several domestic factors that can impact demand and prices. Trends show that prices have likely reached an apex. It happens every time in every type of market. Prices rise to climatic heights and then peak when everyone believes they can never fall again. Will falling prices lead to a recession? The party in power will do everything it can to look good come election time. Good luck American economy!

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