Housing Will Fall 25%, Assuming...

PRINT     E-MAIL STORY    SHARE

FACEBOOK

REDDIT

NEWSVINE

DIGG

DEL.ICIO.US

BLINKLIST

Thursday, June 8, 2006 | So let’s just say, for the sake of argument, that San Diego is going to experience a housing downturn.

If you don’t want to grant that assumption right off the bat, you could read part one and part two of the series dedicated entirely to the idea that a soft landing is unlikely. Another alternative would be to skip all that reading and start crafting a vitriolic letter to the editor right now.

Rich Toscano

Either way, in order to get on with this article, we need to allow the assumption that there will be a housing bust. Because our task today is to try to figure out what past housing downturns say about how our hypothetical bust might play out.

All things being equal, the best way to model an impending downturn is to look to past down cycles for repeating patterns of market behavior. All things are, of course, not equal. The duration of the price run-up, the tremendous growth in real estate employment, the prevalence of negative-amortization and other "exotic" mortgages, the low levels of home equity, the sheer magnitude of the price increases, and the resultant crushing lack of home affordability -- all of these elements are unique to this unprecedented housing boom. Muddying the waters further, we have a new Fed chairman who was talking like an inflation hawk on Monday but who in 2002, when financial market prospects seemed a little bleaker, proposed monetary policies that he likened to dropping cash from helicopters.

All in all, much is different this time. But much is similar as well, and the past is all we've got. The forecasting game, whether its practitioners admit it or not, requires loads of assumptions. So, just for fun, let's proceed with trying to figure out what will happen in the housing market if we make that giant assumption that the next downturn is similar to those prior.

First, let's figure out what the past tells us about the duration of the next downturn. But before we even do that, we must figure out exactly what a downturn is. For the purposes of this article, I am choosing to define a "downturn" as "a period in which home prices are falling in comparison to incomes." A less nerdy-sounding but equivalent definition would be "a period in which homes are getting less expensive."

It turns out that the past two cycles (which is as far back as my data goes) are quite helpful in suggesting a duration for post-boom housing slumps. The accompanying graph shows that the prior two busts were very similar in duration, and that in each case, the bulk of the valuation decline took about six years.

So if our assumption that the future mirrors the past holds true, the upcoming housing downturn will take about six years, more or less.

Taking the game a step further, if we assume that the downturn will last six years, what will be the effect on nominal prices? This question requires us to make even more assumptions (I told you; all forecasts are lousy with them).

First, we have to figure out where the price-to-income ratio will bottom out. Again, the past two cycles are fairly consistent here. In both cases, as the graph shows, home prices found a "floor" at about seven times incomes. That seems as good an assumption as any.

If we know how far home prices have to drop in comparison to incomes, and we know how long it has to take, all that's needed is to figure out how fast incomes will grow. This is a tough one because it depends more on the actions of the Central Bank than it does on the outcomes of the comparatively predictable free market. To start with, though, and because San Diego-specific data isn't available, let's pick the 2005 nationwide income growth rate of 4.6 percent.

If 2005 marked the end of the housing boom and 2006 the first year of the downturn -- another assumption, yes, but one I believe will be borne out by history -- we end up with the housing market bottoming out in 2011. In order for the price-to-income ratio to get down to the level of prior market lows, and assuming the 4.6 percent income growth rate, San Diego home prices will have to drop by 36 percent.

Well, that seems a little dire. More to the point, such a drop in home prices could cause enough problems to warrant Professor Bernanke's well-meaning attentions. So we should probably also run the calculation under the assumption that our Fed head does indeed fire up the chopper fleet, drop some bundles of cash and manages to goose inflation such that incomes rise faster than they would have. Let's say he is able to foster wage growth at a rather alarmingly high 8 percent.

Even still, keeping all our other assumptions the same, we find that home prices would have to decline by 23 percent within the allotted time period. (Inflation at this level would likely cause interest rates to rise to levels that would be problematic for the housing market. For simplicity's sake, though, let's just leave that aside for now).

So, the Ghost of Housing Busts Past says that home prices will drop roughly between 25 percent and 35 percent from their 2005 levels, and that they will take around six years to do so. Will he be right? To answer that question, look back at the painfully long string of assumptions we had to make just to get this far. Put another way: who knows?

There are certainly an awful lot of cross-currents that could cause this post-boom housing market to behave quite differently than those that came before it. But if the past does end up repeating itself, it has at least given us an idea of what we are in for.

Rich Toscano is an independent real estate analyst residing in Hillcrest and working in La Jolla. He writes extensively about San Diego housing at Piggington’s Econo-Almanac.