Research Facts & Figures > Economic Forecasts & Updates > January 2009 Quarterly Forecast > Housing Update, Levan Efremidze, Economist, UCLA Anderson Forecast

Housing Update

Our previous report saw indications that the housing downturn in the East Bay was coming to an end and if so, it would no longer be a drag on East Bay economic growth. We now re-examine this analysis, since the economic environment has changed drastically over the last three months. To ascertain to what extent we should modify our previous forecast, we look at several factors characterizing supply and demand conditions in the East Bay housing market.

On the supply side, the market is in the process of burning off excess inventory. The latest home price estimates using the OFHEO Price Index for the 3rd Quarter show East Bay home prices have continued to fall and are down -26% from the peak of June 2006. Even more telling is the fact that the average increase in home prices in the East Bay over the last five years is only 14% percent. After adjusting for inflation, home values have not increased since the 3rd Quarter of 2003. Therefore, the excess appreciation of homes in the East Bay has for the most part been burned off and home prices are relatively close to their long run trend. To be sure, these declines are related to the record number of foreclosures in the eastern portion of Contra Costa and Alameda counties and neighborhoods in the western part of the region with less expensive housing, and though foreclosure activity fell sharply in October and November due to SB-1137’s increased foreclosure waiting period, they still dominate the supply in the market. Nevertheless, sales in the East Bay are up 65% from last December² indicating the pricing mechanism is working to reduce inventory.

In addition to foreclosures and owner occupied inventory, builders add inventory to the market by increasing the overall stock of homes. Residential permits have now fallen across the state as home builders are unsure at what price they will be selling their product. Builders are now building a minimum number of homes to stay in business. Or as John Walsh, MDA DataQuick President put it, “builders are in a holding pattern; staying alive until the market recovers .” ³ Large builders such as KB Homes and Ryland are building to a different market. They are taking orders and building to consumer means rather than building on spec ⁴. So on the supply side, the only factor on the horizon which might delay the end of the housing downturn in East Bay is the increased inventory due to newly unemployed workers being unable to meet their mortgage payments.

On the demand side are households who are both investing and obtaining housing services and investors who are buying for the return they can earn on their investment. Households are nervous about the economy, and do not want to buy too soon, lest they lose out on the benefits of further price declines. While investors are nervous as well, they look to the rental streams they can earn to support their investment and as home prices fall, their incentive to get into the market increases. This component of demand could stabilize prices in the market in the near term and help induce owner-occupier buyers to come back into the market. The key for both types of buyers is the value they expect to obtain by entering the market.

One measure of the value of a home for investor-buyers is the P/R (Price/Rental) ratio. Rents, of course, are correlated with earnings and therefore the higher the P/R ratio the lower the rate of return to be earned from purchasing the home. If it is expected that rental rates will rise in the future and home appreciation rates remain the same or increase and costs of ownership are unchanged, investors today would be willing to pay more for the higher expected stream of rental income. While not a perfect measure, when the P/R ratio deviates substantially from their mean there tends to be a correction. For the aggregate of homes in the East Bay an estimate of the P/R ratio is calculated as the ratio of the median price of homes divided by the shelter component of the CPI. Shelter CPI is used as a proxy for annual rental values. In the East Bay the P/R ratio began to increase with the easy money, housing bubble period in 2003. After hitting the peak in 2006, the ratio began to decrease. Were the current trend to continue the P/R ratio will be at its 1975-2001 mean in the first quarter of 2009.

For potential owner-occupier buyers the P/R ratio is only one factor. As important is the ability to qualify and carry the mortgage. The graph of “Affordable and Actual Median Home Prices” illustrates a comparison of estimated affordable home prices and actual median home prices in the East Bay for the years 2002-2008. We used median family income from U.S. Census’ American Community Survey ⁵, a 30% ratio of mortgage interest and principle payments to income, an 80% loan-to-value ratio (which implies that the family has a 20% down-payment) and a conventional 30 year fixed mortgage rate from Federal Housing Finance Board survey to calculate hypothetical affordable home prices.

There is a striking difference between the home prices at which median income families could afford to purchase according to our model and actual median home prices for the years of 2004-2007. Why such a difference? Loans such as the ones used to calculate the “affordable home” were not used to purchase the median home in 2004-2006. Rather, stated income, sub-prime credit, 100% finance, adjustable-rate, interest only, or negative amortization loans provided the funds to purchase these homes. So as long as homes were appreciating, the appreciation and subsequent re-financing would support the price. The interesting fact is that with lenders reverting to more traditional mortgage loan practices, affordability has improved substantially and median home buyer’s borrowing power is very close to the actual median home prices.

In our re-examination of the forecast of an early 2009 stabilization of the housing market, we have looked at both demand and supply factors. On the supply side the stock of housing is increasing at a low rate and the rate of foreclosures is beginning to fall. The job loss associated with the recession, expected to continue well into 2009, should add additional supply in the coming months and slow the decline in foreclosures. On the demand side, the financial fundamentals for investor-buyer and owner-occupier buyers suggest the market has adjusted from the imbalance of 2006. Again, the fly in the ointment is job loss due to the recession. The UCLA Anderson Forecast for the East Bay economy is for the recovery to begin in the 2nd half of the year. This is consistent with a stabilization of the East Bay housing market by the 4th quarter of 2009, two quarters later than our previous forecast.

Next: "Commercial Real Estate Survey Results"

2 http://www.dqnews.com/News/California/Bay-Area/RRBay090121.aspx

3 http://www.dqnews.com/News/California/Southern-CA/RRSCA090119.aspx

4 Daniel Miller, Still Building, Believe It or Not, Los Angeles Business Journal, January 26, 2009

5 http://factfinder.census.gov