For most parts of the U.S., the housing bubble peaked in 2006 and prices have steadily declined ever since. The amount of decline has varied by city and state, driven by several factors such as job losses, demographics and the magnitude of run-up in prices. The worst hit states have been California, Florida, Nevada and Arizona where overbuilding and shrinking demand have driven prices down significantly. (To learn more about the price of realestate, check out The Truth About Real Estate Prices.)
TUTORIAL: Buying A Home
A frequently asked question is whether or not housing has hit bottom and if it's a good time to buy. The answer depends on many factors that will be addressed in this article.
The government has implemented several policies to shore up home prices. These include a huge stimulus package, a one-time tax deduction for new home buyers, a continuation of the "Bush tax cuts," foreclosure assistance and mortgage modifications. In addition, the Federal Reserve has embarked on a program of "quantitative easing" (QE) and holding interest rates at their lowest level in decades.
Quantitative easing has the effect of increasing the money supply with the potential of causing inflation, or minimizing deflation. The first round of QE announced in November 2008 was originally pegged at $600 billion but was later raised to $1.8 trillion of mortgage backed securities, bank debt and Treasury bills. By June 2010, it had peaked at about $2.1 trillion and was followed by another $600 billion in November 2010 (QE2).
There was a time in the U.S. when banks only granted mortgages to people who had jobs and a sufficient income stream. The average loan was about three times annual gross income, so if you made $25K per year you could afford a $75K loan.
In recent years, those lending guidelines went out the window as easy money flowed fast and furiously. In some areas of the country such as coastal California, the debt/income ratio climbed to over 10, resulting in an unsustainable level of personal debt. "No-Doc" loans were all the rage, requiring no proof of income, assets or employment when applying for a loan. This attracted investors and gamblers who flipped homes for quick profits until the bottom fell out of the market.
The environment today is decidedly different and is putting more downward pressure on prices. Lending institutions are requiring complete documentation, stellar credit reports, proof of income and sizable down payments. They have also adopted debt/income ratios that are comparable to historical norms. Foreclosures, short sales and delinquent mortgages have damaged the credit ratings of many homeowners and they won't be able to reenter the market for many years. As a result, fewer people can qualify for mortgages which equates to lower buyer demand. (For more on how interest rate affect housing, read How Interest Rates Affect The Housing Market.)
In spite of unprecedented government intervention, home prices have continued to fall. Through its policies, the government has attempted to artificially inflate the bubble to avoid having more homeowners go into default, further depressing prices. While these actions may have prevented even bigger price declines, they have added significantly to the national debt.
Although the government continues to call the current economic environment a recession, the precipitous decline in home prices closely mirrors that of the Great Depression. By the first quarter of 2011, prices had dropped 33% below the peak of the bubble. This compares to the 31% drop experienced during the 1930s. It wasn't until the mid-1950s that prices had recovered that loss.
The Case-Shiller Home Price Index for April 2011 indicates that prices nationwide have dropped 4% so far this year, although they were up 0.7% in the month of April. During that month, 13 of 20 cities experienced rising prices, but only Washington, DC has had a positive change for the year. (To help you understand the importance of housing prices, see House Price Vs. Interest Rate: Which Is More Important?)
In addition to tighter lending standards and bad credit ratings, there are a number of economic forces that continue to weaken the housing market:
- Hesitant buyers still expect prices to go lower
- Concern about future job security for those who currently have jobs
- Weekly unemployment claims have consistently exceeded 400,000, reflecting very weak job creation
- "Flippers" have left the market, so the fictional demand has evaporated
- CoreLogic estimates the shadow inventory of bank-owned homes that have not been put on the market at 1.7 million units (either seriously delinquent or in foreclosure)
- CoreLogic estimates 2 million more homes that have negative equity of at least 50% or $150,000
- Total unsold inventory (including shadow) as of April 2011 was 5.7 million units according to CoreLogic
- Surfacing of a shadow inventory of underwater homes with second mortgages and home equity loans
- Over the next five years, Amherst Securities Group estimates that 11 million of the 55 million mortgaged homes are at risk for default
- New home construction exceeds an annual rate of 500,000, adding to the glut of unsold inventory
- Rumors of eliminating the home mortgage interest rate deduction have scared off some potential buyers
- Any price rises will be met with more sellers who have been waiting for higher prices before putting their homes on the market
- If the U.S. credit rating is downgraded by companies like S&P and Moody's, higher interest rates will eliminate some potential buyers
- The maximum conforming loan limit will be reduced on October 1, 2011, increasing borrowing costs
- A continuing trend of strategic defaults, where homeowners who can afford their mortgage payments walk away because the loan is underwater
These factors may provide an impetus for prices to rise:
- Continuation of the low interest rate environment by the Fed
- Inflation caused by the Fed's monetary policies, with a possible QE3 on the horizon
- While new homes are being constructed, the rate is half the historical norm. Eventually the demand will catch up with the supply
- At some point the foreclosures and short sales will work their way through the system, reducing their severe drag on prices
- In the hardest hit areas, homes are now selling near or below replacement cost, preventing prices from going much lower
The Bottom Line
Home prices will stabilize when supply matches demand. As long as unemployment and the risk of further job loss remain high, it will be difficult for housing to make a sustainable recovery.
The argument has been made that the quickest way to recovery is to let market forces work without further government intervention. Once a real bottom has been reached, demand would pick up and prices would rise. While this would be painful in the short term for those currently underwater on their mortgages, it would put housing on a solid footing for the future. (To find out more on the housing bubble, check out Why Housing Market Bubbles Pop.)