Thursday, February 23, 2006 | Forecasting home prices is a bad idea.

This doesn’t really seem to stop anyone, though. Bulls and bears alike are all very eager to weigh in on exactly how much they feel San Diego home prices will rise or fall. Some pundits are not content merely to predict an exact housing price tag, but insist on specifying a timeline as well. “The median home price in California will increase 10 percent to $575,500 in 2006,” the California Association of Realtors Web site proclaims with unwavering confidence. Not $575,000 or $576,000, mind you – the median price of every home sold in California in 2006 will be exactly $575,500.

Now that’s forecasting.

The problem is that nobody can predict where housing prices will be one year from now.

In more normal times, we could look at projected income, population growth, housing supply and other economic factors in order to formulate a decent guess as to how much prices would change within the year.

But these are not normal times. California is experiencing a late-stage speculative bubble in residential real estate, with San Diego as its standard-bearer. And while broad economic trends can be measured and forecast, the speculative fervor required to keep a bubble going cannot.

In predicting where home prices will be in a year, one has to predict whether homebuyer enthusiasm will increase, decrease, or, in the worst case, be replaced by pessimism. The unpredictable nature of investor emotion makes this a dangerous game.

Things become a little more clear-cut further down the timeline. But even looking out several years, we can’t forecast with any authority what will happen to home prices.

To understand why, have a look at the accompanying graph, which very clearly demonstrates that the “expensiveness” of San Diego housing (as measured by the ratio of home prices to income) ebbs and flows. Homes get too expensive, adjust downward until they are not expensive enough, and then start to rise again.

The cycle continues.

Given that there are really no fundamental underpinnings to the latest multi-year spike in home expense, there is one thing that can be predicted with utter certainty: the ratio of San Diego home prices to incomes will decrease by an awful lot.

What isn’t quite so clear is how much of this adjustment will take place due to falling home prices versus rising incomes.

If we assume that incomes continue to grow at their current subdued rates, the bulk of the work will clearly have to be done by falling home prices. But because the Federal Reserve will likely act to stimulate wages if times get tough, that’s not necessarily an assumption that we can make.

It is similarly difficult to predict the timing of San Diego housing’s return to Earth. While prior housing market corrections have taken around five years, the housing booms that they followed were absolutely dwarfed by the current home price run up.

We can make some educated guesses, of course. Given that the much smaller prior booms begat five year busts, it seems likely that the upcoming downturn will itself last at least five years. And given the extent to which home prices are out of line with incomes, it’s likely that a substantial portion of the adjustment will be caused by declining home prices.

But as I said, these are just guesses.

All we can really do is watch, wait, and use the proper framework to analyze events as they take place. And the proper framework is this: San Diego housing is in an enormous speculative bubble, and just about the only thing we can accurately predict about bubbles is that they will eventually burst.

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. Or submit a letter to the editor here.

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