The Good News In Housing’s Bad News

In the first quarter of this year, home values fell 3 percent, the largest quarter to quarter drop since 2008.(1) That’s bad news for homeowners who want to sell, but for the market as a whole, the renewed spate of falling prices is a sign that things may soon be on their way up.

On the surface, the current drop in prices looks like a new down cycle, since prices rose from April 2009 until last summer. It seemed we had already reached the bottom of the trough and were on the rebound. However, that rise was an artificial one, spurred by the first-time homebuyer’s credit.

The credit, which aimed to create demand, in fact simply shifted it, causing those who would have bought homes anyway to do so earlier. The acceleration of home-buying activity temporarily raised prices but did nothing to correct the underlying imbalance between supply and demand. More details please

Meanwhile the Obama administration did everything in its power to distort the supply side of the equation by stalling foreclosures. Like the first-time homebuyer’s credit, this temporarily kept prices from falling. But while policy wrangling may have kept some people in homes they could not afford a little longer, it did not change the fact that those homes would eventually need to be put on the market.

As I have written before, the key to restoring the housing market to health is to let the sickness run its course. People who moved into houses that they couldn’t afford during the easy-money boom period now need to move to homes that they can afford. The recent spate of falling prices is a sign that these people are finally moving on with their lives, allowing the housing market to move on as well.

While house prices are down, activity is up, showing that the market’s process of realignment is moving forward. Existing home sales increased 3.7 percent in March to a seasonally adjusted annual rate of 5.10 million, from 4.92 million in February.(2) The Pending Home Sales Index, which measures sales under contract, increased even more, rising 5.1 percent on a month-to-month basis. Since home sales typically close 45 to 60 days after a contract is signed, the Pending Home Sales Index provides a better indication of the current level of activity.

The fact that real estate sales take time to close also means that we may be closer to a rebound in prices than the first quarter numbers seem to show. The sales recorded in the first quarter were largely the completions of contracts signed near the end of last year. Therefore the low average prices were likely, at least in part, a product of the heavy load of foreclosures that hit the market then after being previously held up by paperwork issues. Fannie Mae and Freddie Mac saw a 23 percent increase in the number of foreclosed homes they sold in the first quarter of 2011, compared to in the fourth quarter of 2010, according to The Wall Street Journal.

The lousy weather that affected much the country last winter played a role as well. After all, most people like to see a house before they buy it, and that can be hard to do when it is buried in several feet of snow.

Still, even as the increased activity eats into the supply of homes on the market, demand is likely to remain suppressed, at least for the time being. A full recovery in prices will take time. The unemployment rate remains high, at 9 percent for April. And even those who have enough income to consider buying may not be able to qualify for a mortgage. Banks, still wary of any remotely risky lending, are pickier now about prospective borrowers than they were before the boom. The government continues to provide critical life support to the mortgage market, with some 90 percent of new mortgages receiving government backing.

The low prices, however, are drawing in more investors who often pay cash, adding a strong source of demand. Investors accounted for 22 percent of sales activity in March, according to the National Association of Realtors. The risk of inflation has made real estate more attractive for domestic investors looking to add hard assets to their portfolios as a hedge. Meanwhile, the weak dollar has made U.S. properties particularly cheap for foreigners.

In the longer term, the real boost to the housing market will probably come from demographic shifts. The segment of the population now in their 20s is particularly large as a result of the baby boom echo. In the next five to 10 years, these boomers’ children are going to start raising children of their own, and many of them will want to buy homes to do it. In time, their families and incomes will grow, leading them to seek larger homes, creating a steady source of demand that will carry us into the next decade.

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