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Thursday, May 18, 2006 | Last week, I began to discuss why the San Diego housing market’s oft-foretold soft landing is something less than the shoo-in that everyone thinks.
The definition of “soft landing” is a bit of a moving target. At best, the soft landing will be a period of 5-percent-or-so appreciation before home prices really start to take off again. At worst, it is to consist of several years in which home prices remain flat until incomes grow enough to render housing affordable once more.
The entire spectrum of soft-landing predictions are predicated on the idea that past housing booms have been followed by price flatness – unless, that is, economic times got so hard that many people were forced to sell their homes.
The essence of the problem with this analysis is that it completely fails to account for the fact that we’ve just been through the mother of all housing booms.
Where do I begin? Home prices have doubled in five years, and tripled in the past 10. Even with low interest rates, affordability is dismal. And it would be understating matters to point out that the ratio of home prices to people’s incomes is at an all-time high. That ratio is, in fact, more than half again as high as it was at the loftiest peak of any prior housing bubble.
The major problem with the soft landing thesis is that home prices are so high, and affordability so poor, that it would simply take too long for incomes to catch up.
Of course, if the most optimistic soft landing advocates are right, then incomes will never catch up at all. A very common variant of the argument is that home prices will now rise at the same pace as incomes. Housing affordability would not get even a little bit better in this case – it just wouldn’t get any worse.
It is unrealistic to think that homes will remain so expensive in comparison to incomes. Affordability is so dismal that the typical San Diegan is only able to purchase a home through the use of “exotic” mortgages, and often with the aid of prior home equity windfalls. This is not a sustainable situation, especially in a low-appreciation environment.
And more generally speaking, it’s not how markets work. To my knowledge – and, since I don’t get out much, my knowledge on historical bull markets is actually kind of extensive – no asset in history has seen its valuation rise as far and fast as San Diego housing has (at least as measured by the ratio of prices to incomes) without giving back a substantial portion of those valuation gains. I doubt that San Diego is about to redefine financial market history.
Let’s just say, for the sake of argument, that we can agree that mean reversion is for real, and that the ratio of home prices to incomes needs to return to a more normal level.
Even then, and even using the most pessimistic scenario of a protracted period of flat prices, the soft landing hypothesis just doesn’t cut it.
Last year, per capita income grew by 4.6 percent nationwide (a figure for San Diego would have been nice, but we work with what we have.) If prices were to flatline right now, and incomes were to grow at 4.6 percent per year, it would take 11 years for San Diego homes to reach their average historical valuations, and 16 years to reach the valuation low point that has followed previous price booms.
Even the soft-landing boosters acknowledge that home prices would decline if a significant number of owners were forced to sell. Well, a decade is a long time to go without experiencing any economic hardship.
But we may not need to wait that long. There are some potential economic problems right around the corner, both of which I have written about before.
First, there is the issue of all those mortgage resets headed our way over the next two or three years. There is a very real possibility that, lacking their hoped-for home price appreciation, many borrowers will not have the financial wherewithal to keep making their payments.
On top of that is the fact that our local economy has become quite dependent on a robust housing market. As the effects of manic housing activity and home equity cashouts continue to be removed, local economic activity is likely to slow. More forced home sales could be the result.
The picture would change if incomes were to start growing a lot faster than they are now, because such a rise would enable home “expensiveness” to revert to normal levels more quickly. However, such rapid wage inflation would likely be accompanied by higher interest rates, causing problems both for holders of adjustable mortgages and for buyers looking to get into the market with reasonable monthly payments.
Home prices are so extreme right now that, barring a fairly serious bout of rate-increasing inflation, it would take around decade for them to get back into normal territory. Meanwhile we’ve got two near-term risks to the economy as exotic mortgages reset and housing-related economic stimulus is removed.
This all makes for a real estate market landing. But the odds don’t favor it being very soft.
*(Investment advisory services and securities offered through Girard Securities, Inc., member SIPC/NASD.)