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Forecasting the bottom of market is unrealistic. There are many factors which cannot be modeled reliably. Principal among these is consumer and institutional confidence. However, we will present a simple analysis to bracket a timeframe for recovery.
On the short end, we evaluate market prices vs. the economics of investing in properties. Our models show that 88% of US markets are nominally “affordable”, meaning that an investor who can borrow at prevailing interest rates can potentially break even on an annual basis because local rents cover operating and financing costs. Under this analysis, pricing has dropped as far as it needs to attract investors back into the market and thus support pricing. Obviously this isn’t happening, and there are several reasons for this: fear of further losses, ambiguity about the effectiveness of TARP in supporting home ownership, and tightening credit (both availability and real cost of borrowing).
Assuming these issues are ironed out in the coming year, housing may already be priced rationally. If it continues to fall, we need to ask: what is the next lower floor for price decline?
For this, we look at pricing trends. We assume that the bubble of the last 7 years inflated prices above historical norms, and that the air has yet to be let fully out of that bubble. First we try to determine an estimate of a “historically normal” rate of property value appreciation. In the following chart, we identify a real estate price cycle that occurs during the period of 1987 to 2001, based on peak-to-peak returns that appear to suggest a cycle that is repeating in 2001. The nominal rate of increase in national property prices during this cycle is 4.06% annually. For simplicity we are not accounting for inflation and other factors.
When we extrapolate this rate of value growth (4.06%) into the period of the bubble (2003-2005) we find that the bubble over-inflated prices by an amount that exceeds the “normal” rate by 16% as of last quarter. Projecting the current rate of 8%/year in price collapse, combined with an anticipated normal growth of 4.06% suggests that this gap should close in November of 2009, or about a year from now. During this time, nominal prices will have fallen another 8% from today’s prices.
Do we really believe that the market is still significantly overpriced and that it will take another year to complete the correction? If the market was already poised for a cyclical downturn in 2003, then prices should have been significantly lower by now anyway. The bubble not only exceeded cyclical highs, but may have overshadowed a cyclical decline. In addition, pessimism and ambiguity in the market today will further suppress prices. So, yes, we believe that the market will continue to weaken well into 2009.
On the other hand, falling prices offer opportunities for investors, particularly those with cash or convertible assets who do not depend on institutional sources of credit.
