The housing market: How bad will it get?

Part 1: Midyear housing update

Monday, July 23, 2007

By Glenn Roberts Jr.
Inman News

Editor's note: How bad will the real estate market get before it gets better? Inman News compiles the facts and analysis in this five-part series.

Speculation, rampant building, risky loans, over borrowing and escalating prices propelled the housing market to an unprecedented peak -- and are now counted among its greatest failings.

The "soft landing" that so many analysts and economists had predicted has given way to a record number of foreclosures, an implosion in the sub-prime lending market, an oversupply of housing, and home-price declines in many market areas. The dreamy days of the housing boom have received a cold slap of reality.

Real estate markets are historically cyclical -- that's nothing new. But in this case, the nation is in the midst of a downturn following a long-lasting and massive real estate run-up, and it remains to be seen whether this period will become known as one of the greatest real estate slumps in history.

How bad will the real estate market get before it gets better? Many experts have said they don't expect a quick return from these doldrums, and this outlook could turn dire if the overall U.S. economy hits a snag. While there is not a nationwide epidemic of job loss, there are worries about rising inflation and energy prices, and declining consumer spending.

David Shulman, of the Anderson Forecast at the University of California, Los Angeles, said in his latest report that he expects a 10 percent peak-to-trough home-price decline that could extend into 2009, with the swell of foreclosures growing "well into 2008." His forecast report bears a one-word title: "Turbulence."

Real estate industry consultant John Burns said during a housing conference in May that the buyer's market will continue for at least two more years, and "we're heading into a year with more price declines," with builders dropping prices by about 20 percent in some markets.

The National Association of Home Builders expects a 21 percent drop in total housing starts and an 18 percent drop in new-home sales this year compared to last year, and the National Association of Realtors expects a 4.6 percent drop in existing-home sales, a 1.3 percent drop in median existing-home prices and a 2.3 percent drop in new-home prices this year compared to 2006.

'Market-fed downturn'

The sensational rise of the housing boom may be a key factor in its demise.

"This was sort of a market-fed downturn," said Jay Q. Butler, director of Realty Studies at Arizona State University's Morrison School of Management and Agribusiness. The rapid upswing in home sales and pricing was not sustainable, he said.

"A lot of the system was being stretched, both legally and illegally to some degree, with the idea that this was going to continue. So people got in over their heads. It really sort of turned in on itself. You usually find a (real estate) downturn associated with a downturn in the economy -- we really haven't seen the downturn in the economy."

Likewise, the latest annual housing market report by Harvard University's Joint Center for Housing Studies stated that the housing downturn "has been driven largely by the market's own excesses," including an oversupply of new homes that was artificially inflated by activity among investors and speculators.

Some familiarities exist now from past cycles, Butler said. For example, in a real estate boom there are always people who overextend themselves financially to purchase homes during a real estate boom, perhaps thinking that they will be able to sell the home for a profit based on the appreciation trends.

"I don't think we really ever learn. The lenders and real estate agents and everybody else is more than willing to help people achieve this goal (of home ownership) because they make a commission for you to achieve this goal," Butler said.

But the housing market's stellar performance leading up to the downturn was unique, he said, in featuring historically low interest rates, a massive subprime market, and the Wall Street concept of packaging mortgages and selling them off.

It may take awhile for the market to return to the bustling days of the boom, Butler said, and he expects a gradual recovery. The home-price bubble that took on air in some markets has gone away, he said, and more normal conditions seem to be prevailing.

In Arizona, "all the markets that were well above normal are returning to more of what would be expected of the housing market," he said, noting that the state is home to a high tide of foreclosures in comparison to other states.

The inventory of for-sale homes remains bloated, he said, and will take awhile to work off. The population centers that are farthest away from the job centers will face the toughest challenges, he said, as long commutes, inadequate transportation systems and rising energy costs are working against housing sales in those markets.

While some home builders reported that they were taking steps to avoid sales to speculators and overbuilding, the strategy wasn't 100 percent effective, Butler added. "They claimed that they were stopping the investor by multiple means -- that they were only selling to people who qualified for homes. Then it ... appeared that maybe they weren't doing what they were saying they were doing. I've seen booms and busts before, and home builders always seem surprised (by the downturn)."

Public home-building company Lennar Corp., in its latest quarterly earnings report, reported a second-quarter net loss of $244.2 million, and KB Home reported a $148.7 million loss for the same quarter. Builder Pulte Homes announced a net loss of $85.7 million and MDC Holdings announced a net loss of $94.4 million in the latest earnings reports this year, and other builders, too, have announced quarterly net losses this year to the tune of tens of millions of dollars.

Foreclosures climbing

Meanwhile, foreclosure rates are soaring, according to foreclosure data companies and the Mortgage Bankers Association. The association reported last month that the rate of loans entering the foreclosure process in first-quarter 2007 reached a record high, due mostly to increases in Florida, Nevada, California and Arizona. An estimated 1.28 percent of all loans outstanding were in a foreclosure process at the end of the first quarter, the trade group reported, and the delinquency rate jumped 43 basis points compared to last year's rate while dropping 11 basis points compared to fourth-quarter 2006.

Ohio, Indiana and Michigan accounted for 19.9 percent of the nation's loans in foreclosure during the quarter -- the region is notable for significant job losses. Foreclosures data company RealtyTrac reported a 90 percent jump in foreclosure filing sin May compared to the same month last year, for a rate of one foreclosure filing for every 656 U.S. households.

A surge in proposed condo projects and apartment-to-condo conversions has slowed, said Richard Swerdlow, CEO for Condo.com, a Web site that features information about for-sale condo properties. "You're not going to see this giant overbuild again. It's hard to image that you'd see in the next decade what we just saw," he said.

The rush to build condos led to speculation and oversupply in some markets. Swerdlow noted that in some markets prospective buyers camped in front of a development site for the chance to buy units.

"Real estate brokers and the developers were in almost a ticket-collecting mode. They were processing orders because there was so much business to go around. Now that sort of investor phenomenon has gone away," he said. "That phenomenon has stopped."

Some investors who bought multiple units hoping for a profitable sale are now returning them to the market as rental units, he said, and some projects never got off the ground or have converted to apartment buildings. In hindsight, some apartment-to-condo conversion projects may have been better off as apartment buildings, Swerdlow said.

There are still projects that are being built, he said, though far fewer new development proposals these days. "In the next six to 12 months we'll see a lot of the projects being completed. We don't have a sense of what the market will look like until those projects (are completed), as it's uncertain whether all of the condo sales of units in those developments will successfully close.

Lending rules for condo buyers have tightened in an effort to screen out speculators from end-user occupants, he said, and international interest in U.S. condos may help to work off any oversupply.

Steve Jacobson, president for Fairway Independent Mortgage Corp., a brokerage with 105 branch offices that handled $1.6 billion in loan volume last year, said that there is definitely fear in the industry, as a wave of loans are scheduled for a reset in rates in the next six to 12 months.

The variety of high-risk loan products "got away from a make-sense standpoint," and contributed to the current market problems, he said. "As long as inflation stays low and unemployment stays low we should be able to come back," he said of the down market. "I don't see us going down to a deep depression."

Lessons learned?

The lesson to be learned from this market cycle is that there was "way too much flexibility" in the loan products offered to consumers, which ultimately led some consumers to buy homes that they couldn't afford, Jacobson said. "Sometimes that's not the right house ... they may not like what they hear but that's the right answer."

What makes this market cycle different than previous cycles, he said, is that the economy is far more globally dependent today.

Author and mortgage banker Richard Cohen, said that a contributor to the market's problems is that too many people have shopped for a house like it's a commodity, and he said it's up to the industry to remind consumers that there can be disastrous consequences for home purchases that do not pencil out financially. "It's part of our culture to buy stuff, and it's even more part of our culture to own your own home. How do you tell someone, 'You are not supposed to buy a home because you can't afford it and it's going to hurt you, potentially'?"

He said he would support a giant banner with a statement to consumers: "Stop going out and shopping like it's a bottle of catsup." He added, "There are a lot of people who are encouraging people not to do the right thing. During those boom years there were a lot of people getting into programs that were risky for them as well as the lender (and) were putting people really on the margin," he said.

While the rising foreclosure rate has been making headlines, Cohen said the story that is less told is about all of the people who are forced to sell to avoid foreclosure and end up as renters again.

Bill Lyons, founder and CEO for LEI Financial, a mortgage and real estate company based in San Diego, Calif., said he expects that prices must stabilize and the interest rates for short-term and adjustable loans must drop or there could be a "major blow up in early to mid-'08" in the real estate market. If one of the two does not happen there will be a blow up that will make the subprime blow up look like a firecracker compared to a scud missile," he said, as option-ARM loan sales peaked in mid-2005 and borrowers may find themselves upside down in the coming year.

Easy credit days over

This real estate cycle will certainly be remembered for its abundance of unconventional mortgage products, said Neil B. Garfinkel, a real estate and banking lawyer who serves as a lawyer for the Real Estate Board of New York, a real estate trade association for New York City's building industry. "We probably saw more creativity in mortgage products than we ever have before," he said.

While Garfinkel said the Manhattan real estate market is "always a strong marketplace," some of the Outer Burroughs are seeing properties sit longer on the market. "There is less of an urgency in the marketplace. Two years ago, the marketplace was crazy."

In those days, for-sale properties were moving almost immediately, but that has changed. "The mortgage market is certainly not helping them right now," he said, as credit restrictions have made it more difficult for people to qualify for a home purchase." Garfinkel, like some other industry officials, said he blames the media, in part, for instilling fears about the real estate marketplace. "I think it does affect people -- it's almost like a self-fulfilling prophecy."

While people had been using their home equity as a piggy bank, that scenario is less likely now, Garfinkel said. And rising interest rates could be "really problematic" when coupled with credit tightening -- if interest rates rise up to 9 percent, for example, it "would really push people over the top," he said.

The "easy credit" environment that preceded the downturn makes this housing cycle unique, said Joseph Ventura, president of William Tell Financial Services in Latham, N.Y., which offers mortgage, insurance and other financial services.

The problems stemming from this easy credit "should last about another 12 months until everything is 'washed' out of the cycle, allowing common sense to return to the lending market," Ventura said.

If unsold home inventory levels off for several months in a row that may be the first sign of a market recovery, he said. "Any interest rate rise will delay this phenomenon."

He shies away from labeling the housing market's boom and decline as a bubble. He said it's "more of a turning point in American personal finance history as the economy is relatively strong and unemployment and interest rates are at historically low levels -- this will keep things percolating."

Will any lessons be learned from this latest housing market cycle? "People unfortunately will always be attracted to bargains that are too good to be true, which in a nutshell has been what's happened with the latest mortgage debacle," he said. "Tighter lending laws may help but others will argue that easy credit has enabled many borrowers to successfully invest in home ownership."

While Ventura said that some fallout in the sub-prime market may be inevitable because it is by nature a high-risk business, he also stated that mortgage lenders that pass loans on to Wall Street firms "are often less responsible to whom they lend," as they may "operate in a virtually risk-free environment since they generally do not 'hold' the loan for a long period."

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