Optimism is up, but U.S. housing market faces painful shift

It's spring, the time when Americans traditionally think about new homes-trading up for growing families, downsizing for retirees, picking up a vacation home or buying a starter home to escape renting.

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But four years after the start of the financial crisis, and six years after home prices began to collapse, the market is still shaky. Nationally, prices are about 35 percent below their peaks in 2006, according to the S&P/Case-Shiller Home Price Indices released on April 24, and in some markets homes have lost 60 percent of their value. About one in four homeowners with mortgages, some 11 million households, are “underwater”-owing more than their homes are worth. Construction and sales of new homes remain anemic, with housing starts about one-third the historical average.

Still, there have been some hopeful signs. A second home-price dip that began late in 2010 seems to have stopped this year, according to the Case-Shiller survey, and the National Association of Realtors says February’s existing-home sales were up nearly 9 percent from a year earlier.

The key question: Has the housing market hit bottom? If it has, are prices likely to climb, or will they bounce along the bottom for some time-for many months, perhaps for years?

Answers vary from one part of the country to another, says Wharton real estate professor Joseph Gyourko. “It will depend on the market. I think we are somewhere near a bottom; we are bouncing along. But it certainly would not surprise me if we went down a bit.” But for the moment, there is little reason for prices to rise, he adds. Wharton real estate professor Fernando Ferreira agrees, noting that “If we’re not at the bottom, we’re very close to the bottom.” He also cautions that it’s far from certain prices will rise significantly anytime soon.

Mark Zandi, co-founder of what is now Moody’s Economy.com, holds similar views: “There are some signs of life, but nothing to suggest that we are moving north in a definitive way.” He says the housing crash is “largely over” and points to some strengthening in sales and new-home construction, but does not believe this is enough to lift home prices. “The key is getting through more of the distressed properties that are in the foreclosure pipeline,” he notes, adding that this involves some 3.6 million of the nation’s 49.5 million homes. “Until we work through them to a greater degree, that is going to remain a pall over home prices.”

The bumping-along-the-bottom view is shared as well by Wharton real estate professor Susan M. Wachter. Despite much negative data, she believes that economic recovery, though sluggish, is helping the housing market to mend. She expects to see more improvement this spring, noting that the recent Case-Shiller figures offered a glimmer of hope: better annual returns in home prices in February compared to January. Nationally, home prices are about where they ought to be, given fundamentals like employment levels and interest rates, Wachter says.

The slow housing market does not just affect people who want to buy or sell homes; it is dampening the whole economy, Gyourko notes. When home building is down, construction workers are idle. With fewer home sales, fewer people are spending money to move and form new households, affecting everything from furniture sales to moving firms. And the low level of sales means real estate agents are not getting much work, and are therefore spending less.

Among the housing market’s key problems is an excess supply of homes due to the building binge in the late 1990s and early 2000s, Gyourko says. Because homes last so long, an oversupply does not dwindle as quickly as it does for non-durable goods. “This housing stays for decades. Once you oversupply, there’s no real way to get out of it.” Job growth helps by enabling more people to buy; however, although unemployment is ebbing, “we’re still 5.5 million shy of the pre-crisis employment peak,” he adds.

Millions of homeowners bought during the market peak in the middle of the past decade, at inflated prices before the crash. It could be years before those homes are again worth what their owners paid, and homeowners with negative equity-owing more than their homes are worth-typically cannot move. To do so, these underwater owners must come up with cash to make up the difference between their debt and proceeds from selling the home, and this often comes to tens of thousands of dollars, sometimes hundreds of thousands.

Gyourko’s research shows that a homeowner with negative equity is one-third less likely to move than a homeowner with positive equity. “So that’s going to affect the trade-up market. There are a number of reasons, in a lot of markets, that prices were not rational before the crash,” he notes. “There’s no reason to go back to irrational prices, and in a number of markets the supply is very large.”

Mounting obstacles

On the positive side, today’s extremely low mortgage rates-around 4 percent for a 30- year, fixed-rate loan-give buyers a lot of borrowing power. However, although the Federal Reserve has vowed to work to keep interest rates low through 2014, a strength- ening economy will eventually lead the Fed to lift rates to stave off inflation. Some experts think this could happen before 2014. When mortgage rates start to go up, some potential buyers may rush into the market to beat higher rates, Gyourko says, and that extra demand could push prices up. But higher rates could also slow the housing recovery by making home ownership more expensive and encouraging homeowners to stay with their current, inexpensive loans rather than move and face higher rates, he adds.

“We all realize that interest rates are unsustainably low,” Wachter says. As rates rise, we would expect that will have a fundamental negative impact on housing prices once again.” While today’s low rates would seem to make homeownership attractive, there are other obstacles in the lending process, she adds. “Despite the fact that housing is extraordinarily affordable, it is difficult to get a mortgage. There has been a ratcheting up of lending standards, which is quite significant.”

Before the housing bust, it was possible to get a loan for 100 percent of a home’s appraised value, sometimes even more. Today, driven by underwriting policies of Fannie Mae, Freddie Mac and the Federal Housing Administration, plus their own bad experiences, lenders want at least 20 percent down, a big financial hurdle for buyers. Appraisers are under pressure to be more conservative in valuing homes.

Conditions are even tougher for borrowers seeking jumbo loans-generally above $417,000, though varying around the country. In addition to the 20 percent down payment, the borrower is required to have a large cash reserve to cover payments should anything go wrong, Ferreira says. To purchase an $800,000 home, one would need $160,000 down, plus $60,000 to $80,000 in reserves- “very few people have it,” he notes.

In the past, buyers used equity in the current home to trade up, but now many people have little or no equity, or negative equity. “What that is doing is leading to very low mobility,” Wachter says. “Mobility is at historic lows, and the trade-up market is impacted.” Ferreira adds that it could take five to 10 years for underwater homeowners to build equity again, “or they may never do it again.”

In addition, buyers’ tastes have changed, apparently reducing demand for some homes that were the rage before the bust. Housing industry observers note that today’s buyers are turning away from the “McMansions” of the 1990s and early 2000s in favor of smaller, less-expensive homes- ones both cheaper to buy and maintain. This can make it harder to sell a big home with all the trimmings. Part of this shift in demand is certainly due to the obstacles to getting big loans. Another factor: The ideal buyer today is a renter who does not have to sell a previous home, and renters tend to be young people buying their first home, which is usually modest. Whether the taste for somewhat smaller, more affordable homes will persist is anyone’s guess. Fashions can change quickly, and the urge to live in a spacious, showy home-to keep up with the Joneses-could swell again when people feel more prosperous.

In the shadows

For any housing recovery to gather steam, the backlog of foreclosures, and distressed homeowners who could end up in foreclosure, must be reduced, Wachter says. “The concern is this overhang of shadow supply,” she points out. While there is also a shadow demand composed of people who would like to buy, many potential buyers stay away for fear they could buy and then lose money if economic troubles turn the shadow supply into real supply. “The concern is that a fire-sale is coming to a market near you,” Wachter explains. “And it’s a very valid concern.”

Just how many homeowners will end up in foreclosure is impossible to predict. Falling unemployment reduces the problem, but the 25 percent of mortgage holders who are underwater could produce a new wave of defaults if the economy takes a jolt. “That’s the shadow supply of homes that could become available if something happens to the owner-because of a health shock or an employment shock,” Gyourko says. Another spike in foreclosures would depress home prices by increasing supply with homes offered at fire-sale prices, since lenders are better off minimizing losses by getting what they can quickly rather than carrying empty homes while awaiting higher prices.

Wachter notes that about half of the borrowers who took out subprime loans between 2005 and 2008 are in default-typically 30 to 60 days behind on payments. In many markets, 30 percent of home sales involve distressed properties, she adds, noting that an economic downturn could push this to 40 percent or 50 percent, which would seriously undermine prices.

The Obama Administration’s efforts to help people avoid foreclosure have had only limited success. Generally, these have focused on reducing the borrower’s payments relative to income, and making it easier to refinance at today’s low loan rates, which reduces monthly payments. Unfortunately, about half of borrowers who have gone through some type of loan modification default again afterward, Wachter says. Also, while these efforts have helped several million homeowners, they do not tackle the underwater-home problem that is such a dominant factor in today’s market. Studies have shown that homeowners are much more likely to default when they are underwater, even if they can afford the payments, because it seems pointless to make payments on a money-losing investment.

Various proposals have been made to assist underwater owners by reducing the loan balance. But lenders cannot be forced to do this, and they have been reluctant to participate in voluntary programs because they don’t want to book the losses or encourage other borrowers to default to get a portion of their loan forgiven. “There are a lot of problems with principal reduction,” says Zandi. The first issue is moral hazard- the risk of encouraging more defaults. “Second is the straight-up fairness issue. Is it fair?” After all, most homeowners continue making payments even if they are underwater or wrestling with other financial troubles. “I don’t think there is political will for a program that will do principal reductions right now,” Ferreira adds. Zandi suggests that principal forbearance can work just as well as forgiveness. Rather than reducing the outstanding debt, forbearance allows the borrower to temporarily make smaller payments, as if the debt were smaller, while in the long run still owing the full amount.

A better approach, Gyourko says, might be a program that makes it easier for troubled homeowners to become renters, perhaps by helping with security deposits, to ease landlords’ concerns about renting to people who have defaulted on their mortgages. “But I’m not holding my breath,” he notes. According to Wachter, there’s some hope for programs, now in the pilot stage, which would make it easier for investors to buy distressed homes and turn them into rentals. With this approach, lenders would take smaller losses than with foreclosures. Since homes would probably sell for more than they do in foreclosure, this would minimize damage to prices of nearby homes, she says.

Still, millions of homes are likely to go into foreclosure in coming years. A year or two ago, the economy was too fragile to handle a large number of foreclosures, notes Zandi. Now he believes it is strong enough that the best course is to “get these problems behind us.”

No longer in investment

While most experts believe that will happen eventually, and the housing market will improve, it is far from clear whether the housing market of the future will ever look like that of the bubble years. American have long viewed the home as a key step to prosperity, a major “investment.” While this never was completely true, as home appreciation barely beats inflation over the long run, the housing bust has demonstrated that homeownership has its downside, too.

“People no longer believe ownership is a way to get rich,” Gyourko says, noting that the homeownership rate has fallen and demand for rentals has jumped. According to the census bureau, 66.4 percent of households owned homes at the end of 2011, down from a peak of 69.1 percent in 2005.

Ferreira teaches a real estate course to graduate students in their late 20s, traditionally a time when people buy their first homes, sometimes the second. Each year, he asks his 70-odd students how many intend to buy when they return to the working world. Before the housing bust, nearly half would raise their hands. Recently, only two did. “There is a hesitancy to get back into the housing market,” Wachter says, describing former owners who have become renters. “Therefore we see rentership increasing. We see doubling up. Household formation is at historic lows.”

While experts have long advised against buying unless one planned to remain in the home for at least four or five years-time for appreciation to cover buying and selling costs-that message is even more important today, Ferreira notes. Young people typically face too many changes, such as new jobs, marriage and children, to make a home purchase more practical than renting. Older people should also think twice about the merits of renting rather than owning, he adds, as people change jobs more often than in the past.

“When you buy a house you buy it for consumption value, because you need it or your family needs it,” he advises. “Don’t buy it to speculate, or because you think a house is an investment. Everything is much easier once you realize that.”