Housing Market Revealed 2006 – Is The Party Over For Real Estate?

Prior to 2000, the real estate market and the economy were always cyclical. For instance, the US housing prices tended to weaken as the GDP and employment prospects declined, particularly during the recessions of 1980 and 1990. The economic downturn of 2000-01 defied many predictions by having the opposite impact on real estate prices. Over the past five years, real estate prices have increased approximately 10%, outperforming equities by a wide margin.

Historically, real estate has been viewed by many as a good hedge against inflation. During the last five years however, real estate prices have exceeded the rate of inflation by a gross margin.

Given the significance and size of the U.S. real estate market, our analysis will focus on U.S. real estate, which is currently quite representative of markets around the world.

U.S. Real Estate

In 2005, America’s real estate boom was strong, with prices up by 13%. But there were signs that the market was weakening. Sales of existing homes fell this January to the lowest in nearly two years. Meanwhile, the number of unsold homes rose to the highest level since 1998. In addition, new homes continue to be built at the fastest pace since 1973. In other words, while the supply of housing is at the highest level, demand for homes has fallen dramatically, rendering a downward price adjustment inevitable.

Due to the low interest rate environment, affordability ratios are still within historical ranges, although they’re approaching a 14-year low. On the other hand, other ratios that disregard the interest rate level (e.g., home price to rent, home price to disposable income) appear to have escalated.

The Supply / Demand Imbalance

In general, we see no evidence that the supply factors are positively affecting the prices. For example, the rate of population growth has not increased significantly and the supply of land available for housing remains largely unchanged. In fact, research by Goldman Sachs reveals that U.S. residential investing is at the highest level in 40 years, yet new household formation is growing at its slowest rate.

Based on the experience of the last few years, we may see a fundamental shift in sentiment, favoring home ownership. Up to now, most of the baby boomers nearing retirement have decided against downsizing their homes and opted for the financial security of their current houses instead.

Other Asset Classes

Financial exposure to real estate is generally a good thing as long as it is a reasonable proportion of one’s assets, and the investment environment is favorable (e.g., not in the midst of a bubble or heading into a decline). In a diversified portfolio, real estate investments can be a very good diversifier due to relatively low correlations with other asset classes.

Contrary to popular belief, holding a diversified portfolio of various asset classes (with a large equity exposure) has been a much better investment than buying a house during the last 30 years. For instance, a dollar invested in real estate in 1975 would grow to $6.07 while it would turn into $36.14 if invested in the S&P 500. However, in calculating the exact returns one must factor in taxation and deductibility of interest rates.

The Failure of Risk Management

As rising house prices lift the market value of collateral on banks’ existing loans, banks are willing to lend more, pushing prices higher. In effect, banks have an incentive to lend when property prices are rising, and to pull out when prices fall, leading to extended boom and bust cycles.

For the past few years a number of researchers have pointed to the non-sustainability of the housing market, comparing it to the high-tech bubble of 2000. Barring any fundamental change, the primary question remains why real estate prices have defied this historical market relationship for so long, and whether will they will ever reach the tipping point.

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The Wisdom of Hindsight in the Real Estate Market

“Consider the following observations about the Metropolitan Washington, D.C. real estate market:

  • A home in Silver Spring, Maryland comes on the market and sells in one day. That’s no big deal. But the real estate agent received forty-one offers. I’ll repeat: Forty-one offers in only a few hours.
  • A home in the city of Alexandria sells in one day at a price $100,000 over the asking price. I’ll repeat: The house sold for $100,000 more than the seller’s asking price.
  • More than 30 people camped out for 7 days in order purchase units in a new urban townhouse development. I’ll repeat: Thirty people living on the streets with sleeping bags and tents in order to buy in a new townhouse development.

A dream come true you say? These are excerpts from the article “One Word For Metro Washington Real Estate: Insane, written by Henry Savage for RealtyTimes.com…in March 2004.

Almost five years ago Mr. Savage painted a picture of a thriving sellers market that had gained so much momentum that home buyers were waiving financing and home inspections to make their offers more attractive to home sellers. As we have all witnessed, any market, whether stocks or real estate, cannot sustain this level of exuberance before something has to give.

Home prices increasing 20% per year eventually results in fewer buyers for these over priced homes. Add to this mix, greedy money lenders offering low introductory interest rates (only to spike in a few years), and resulting in too many people owning homes they can’t afford. The demand for real estate begins to decrease, inventory rises, and eventually home prices drop. Sound familiar?

The increase in interest rates, would also have a devastating effect on all of those buyers who purchased homes with little or no deposit and are faced with the expiration of the attractive introductory rates. Foreclosures and housing gluts would be a natural result of this market.

Mr. Savage predicted this outcome in his article; stating “the bigger the boom, the bigger the bust”. Real estate, as do all markets, runs in cycles. The plight of our current market is the fall out from the golden age of real estate we experienced a few years ago.

Currently, in the Metro D.C. market, the average Sold price is just under $550; a 12% increase from the same time last year. It’s not 20%, but definitely a more realistic increase one would expect. Perhaps we are entering a new cycle in real estate; one that reflects adjusted home prices, sensible lending practices, and smarter buyers.

Recession, Inflation & Housing – Home Prices Fluctuate, Real Estate Market Responds to the Economy

Amazingly, financial reporters still are reluctant to say the American economy is in recession (which it most obviously is). Hence when inflation fully shows its ugly face, expect housing prices to catch up with oil which already accounts for the dying dollar (a currency no longer carrying much weight with OPEC as a basket of currencies is being embraced and the Euro and yen are taking preeminence).

Undoubtedly inflation and the recession caused by it shall weigh heavily on the Fed and we the American people. Since it seems financial reporters are usually about a year or two behind the actual occurrences in the market (that is reporting them honestly to the general public), always choosing to use colorful and positive language, it may be another year or two until we see the true signs of inflation in the real estate market. A big spending, pro-inflation government however will always prove inflationary when it comes to U.S. currency (since this sneakily reduces their repayments).

The U.S. economic forecast remains bleak to say the least. Latest reports released show that consumer-level inflation remains steady, while the housing slump shows no signs of improvement.

The U.S. consumer price index (CPI) rose 0.3% in March while the core rate, which excludes food and energy prices, was up 0.2%, following flat readings in February.

Energy prices are rising at a 17.0% year-over-year pace. Gasoline prices rose 5.2% and are up 26.0% from a year earlier.

Recent inflation reports underscore and highlight the the Federal Reserve’s ongoing challenges. “Ongoing hefty gains in headline prices will continue to needle (policymakers) despite the Fed’s near-term focus on economic risk, as the Fed faces an inflation problem that may have greater shelf life than the problems in the financial industry,” says Action Economics.

U.S. housing starts plunged 11.9% to a 0.947 million annualized rate in March, though after an upwardly revised 1.075 million pace in February (1.065 million before). Markets expected a more modest fall to 1.003 million. Starts are down 36.5% over last year. Permits fell 5.8% to a 0.927 million pace, and are down 40.9% over last year.

Contracts for housing will remain dismal as the recession deepens and the media hype dies down to the tune of reality.