Catching Our Breath

Catching Our Breath by David Lereah, Chief Economist

For the past five years (2001 to 2005) the real estate boom gave us as much as we asked for – and more. Home sales registered record numbers for four consecutive years. Inventories were lean and price appreciation was running at high levels. The collective wealth of property owners grew by over $4 trillion during this period. Those in the real estate industry also fared well: REALTORS®, homebuilders and mortgage lenders all shared in a growing revenue pie. You could say that “everything was coming our way” during the boom. But I remember what my father said to me when he taught me how to drive a car. He said: "When everything is coming your way, you are probably in the wrong lane!"

We can apply my dad’s lesson to today’s real estate markets. We got fat and some of us got too confident. With housing markets running wild, discipline was in short supply. Some of us moved away from the fundamentals that keep housing on track. The hot housing market attracted a high number of speculators; flipping became a fad; and pre-construction deals were in high demand. Overconfidence also led to loose credit standards, as lenders offered a heavy dose of interest only mortgages, option adjustable-rate mortgages (negative amortization) and low down payment and low documentation mortgage loans to virtually anyone who wanted to purchase property. Boomers purchased second homes without a second thought and condominium conversions were in vogue.

Everything Has Limits

Almost everything has limits, even real estate markets. You cannot sustain a record-setting sales pace forever. Double-digit price appreciation may be a boon for sellers, but eventually a market becomes unaffordable. So the party is now over, and the punch bowl is empty. Officially, I would say the boom ended in August 2005, and real estate markets have been cooling ever since. Price appreciation, which was 13 percent in 2005, has slowed to a 7 percent pace as of this writing. The - metros of the past several years are now experiencing 5 to 10 to 20 percent declines in home sales during the first half of this year. Days-on-market has been lengthening and housing inventories building.

The Bright Side

But there is a silver lining to the new real estate marketplace. Not all local markets are cooling, just markets that boomed in the past. The non-boom markets, like Houston and Cincinnati are gaining momentum, having registered double-digit home sales gains during the past several months. The non-boom markets are also losing inventory, not adding to it. Another positive outcome is that the cooling boom markets are shedding themselves of speculators. Both investors and speculators are exiting local markets, permitting basic fundamental investing to come back. Once-hot real estate markets are undergoing a cleansing and becoming more affordable.Looking forward, my best guess is that the non-boom housing markets will continue to grow for the remainder of this year, while the boom housing markets will continue to cool, but under a soft landing scenario – sales will fall and price appreciation will remain positive but slow. The U.S. economy promises to provide a favorable backdrop for housing activity, generating both job gains and income gains. Under an optimistic but likely scenario, home sales bounce back in 2007 with most metro markets across the nation posting modest increases.

Depends on the Fed

There is another influence to watch, and that is the Federal Reserve Board. The health of the housing sector is more dependent on Federal Reserve monetary policy than it was a year ago. Some metro housing markets are now vulnerable to rising interest rates due to the high concentration of interest-only loans in those mortgage markets and a relatively high number of interest-sensitive investors holding properties. Thirty-year mortgage rates are approaching 6.75 percent and if rates go beyond 7 percent, some metros could experience some price softening. Higher rates could also result in higher delinquency and foreclosure rates.So, except for a few local markets softening, the rest of the nation’s real estate markets are expected to survive this year of contraction rather nicely. By early 2007,we could actually be in a healthier market environment compared with 2005. All it takes is some time to correct and catch our breath in 2006.