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Craig Allen: Real Estate Isn’t Cheap, Despite Recent Sizable Declines

Claims of bottoming out to the contrary, economic factors should continue to put downward pressure on housing

Most real estate “experts” commenting on where the market is currently will state that, due to the significant declines since the peak in 2007 and a number of other factors, home prices are either bottoming or have already bottomed, depending on which local market they are discussing. Unfortunately for them, and for anyone who owns a home, there are powerful reasons why this is not the case.

Real estate pundits point to the recent price declines, improving unemployment, home price affordability statistics, gross-domestic product, growth, stock market performance, low interest rates, improving bank balance sheets and lending activity, improving foreclosure rates and a host of other data that they claim suggests home prices are in the process of bottoming. I have even seen some reports make the case that some markets have bottomed and are already rebounding. On a month by month basis, we do, in fact, see some markets — even in California, including Santa Barbara — where median home prices have increased.

According to the California Association of Realtors, the median home price for Santa Barbara County increased to $405,000 in April from $345,000 in March. This represents a 17 percent jump and looks really encouraging, especially if one is a homeowner here in Santa Barbara, and even more so to someone looking to sell. The problem with drawing any conclusions from this monthly data is that smaller markets such as ours tend to fluctuate quite wildly due to the sometimes limited number of sales in a given month, and the dispersion of the sales — the wide gaps between the sale prices of the most expensive to least expensive properties that are sold in the period.

In fact, back in October, the median home price fell to $330,000 and then bounced up to $429,410 in December, before falling back down to $345,000 in March. This is very typical, so we do not want to draw any conclusions about the direction of prices by looking simply at month to month changes. Over a longer period of time, we will be able to look back and see a definitive change in market direction, but we will have to make a bottom and then get well into a rebound before it will be possible to identify where exactly the bottom occurred.

The larger issue with the real estate market in general is the macro-economic landscape. We find ourselves in a very peculiar set of circumstances regarding the economic factors that influence real estate prices. Locally we have seen a more than 50 percent retracement of prices from the peak of $878,124 set in July 2007. This price decline has occurred at a time when interest rates are now, and have been for an extended period of time, at historic lows. Just this past week, the 30-year fixed-rate mortgage set a fresh all-time low of 3.83 percent. In contrast, the last real estate recession occurred in the early 1990s when 30-year fixed-rate mortgage rates were in the 8 percent to 9 percent range.

A homebuyer today, borrowing $500,000 at 3.83 percent for a 30-year mortgage would have a monthly payment of $2,338. This same mortgage would cost the homebuyer $3,669 a month at 8 percent. That is $1,331 more each month, or an increase in monthly mortgage payment of 57 percent.

The problem I see with those who believe the real estate market is bottoming is that they fail to acknowledge the very real fact that interest rates will increase in the short term, including mortgage rates. As mortgage rates increase, home prices must adjust down to maintain the same level of affordability. I would challenge anyone to find a time in history when rates were increasing that home prices held firm or decreased. It just doesn’t happen.

When mortgage rates rise, home affordability decreases, just as in our example above. This means that for a given price-point, fewer buyers can afford the home. Fewer buyers mean less demand and anyone who has taken Economics 101 will tell you that if supply is held constant and demand decreases, price must decrease.

If mortgage rates increase, those with adjustable-rate mortgages experience a dramatic increase in monthly mortgage payments, forcing some to sell and others into default and eventually foreclosure. As a result, more inventory hits the market. Again, Economics 101 tells us that increasing supply with constant (or declining demand) means prices must come down.

Higher mortgage rates also means that fewer newly built homes will be bought, since fewer buyers will be able to afford a home at any given price-point. Homebuilders will continue to build because they make decisions many months, and sometimes even years, in advance. They have capital invested in the land, and have employees they need to keep busy. If demand for new homes decreases, more new home inventory will enter the market. Again, increasing supply with constant or declining demand leads to lower prices.

I do not see any signs that definitely tell me that prices have stopped declining at this point, and this is in the lowest mortgage rate environment in history. I think the best homeowners could hope for would be that interest rates rise slowly enough that home prices don’t decline any further, meaning that prices would remain flat for the foreseeable future. To me, this is the best-case scenario (although in my opinion it is not realistic).

Keep in mind that the Federal Reserve has been conducting a “twist” operation in the financial markets — borrowing money by selling short-term notes and then buying long-term bonds to artificially force longer interest rates down. This, in part, explains why mortgage rates are so low today. The Fed cannot continue to do this forever. When it stops, rates will immediately jump back to where they would have been without the twist operation. From there, the Fed has already stated that by 2014, it expects to be raising rates. I do not expect the Fed to be able to wait that long.

I expect rates to begin to rise via Fed increases for the Federal Funds Rate and the Discount Rate, by the second half of 2013. The combination of the rebound from the twist operation concluding and initial rate increases could put the 30-year fixed-rate mortgage rate above 5 percent by the end of 2013, if not higher. I expect to see the 30-year fixed above 7 percent by the end of 2014, if not before.

Homeowners looking to sell their properties, and who are waiting for a quick rebound in prices, should rethink their strategy, and should consider these very strong economic factors influencing the real estate market. Given the current market and economic conditions, especially interest rates, I find it highly unlikely that prices will increase significantly over the coming few years, and feel much more confident in saying that they will likely fall by a considerable amount from current levels before we see a true bottom.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.

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