October 12, 2007

The US housing bust is like a leaking ship. You may still be able to stay afloat, depending upon where and how bad the holes are.

Will the home market continue to sink, or is it just bobbing around, waiting for buyers to rescue it? With odds almost favoring a recession due to the housing and mortgage meltdown, it’s a good time to examine what makes local markets weak or robust.

There was no single cause that burst the housing bubble. Demographics, economics, and mass psychology - what I call demoeconology - merged to create a buying frenzy that was like a meme, a contagious mass information pattern that infects minds with new ideas.

If you understand the dynamics of these powerful forces, you can then begin to see which markets will have more painful price declines and which will experience appreciation.

For now, it’s fairly easy to conclude that most home markets are in a funk and won’t pull out of it soon.

In August, housing prices posted their biggest drop in almost 40 years, and pending sales fell the most on record. New-home sales declined to a seven-year low. There are more than 5 million homes sitting unsold. The behavioral economics of this market are tugging buyers to the sidelines, for now. And with the possibility of 2 million more homes coming on the market due to foreclosures, the supply is outpacing demand.

Mass psychology anchored home buyers to the myth that homes were endlessly appreciating wealth vehicles. Now the sentiment has shifted.

As Yale University economist Robert Shiller wrote, home buyers fell prey to a “social epidemic” and a “widespread perception that houses are a great investment.”

Shiller found that “residential investment as a percentage of gross domestic product has had a prominent peak before almost every recession since 1950.”

In the last quarter of 2005, he notes, home investment rose to 6.3 percent of GDP, “the highest level since 1950.”

Will this downturn be like the 15 percent decline between the third quarter of 1989 and to the fourth quarter of 1996, or the 42 percent rout in Los Angeles between December 1989 and March 1997? Since real estate is a conglomeration of local markets, it depends what area you are considering. Location is everything in surveying this moribund market.

To get an idea of how overpriced a market may be, you need to compare it with some benchmarks. Until the recent decline, Florida had been well ahead of the pack in terms of price appreciation - up more than 95 percent over past five years. The US average over the same period was almost half that at about 51 percent.

Now six of the 20 worst markets are in Florida, and all of them are located in desirable areas on the coasts. Fort Pierce, for instance, is feeling the pullback with a 21 percent drop in its condo market.

The most important truth is that buyer sentiment, rising population, demographic changes, and supply/demand ratios all need to be weighed when you try to divine which housing markets are headed for more pain and which may be good investments.

Will the markets that are benefiting from demoeconology continue to grow if the United States enters a recession? Probably not, unless they continue to expand their labor pool, find new buyers, or see an influx of brain-burb residents or retirees.

Markets glutted with housing may sink further. Like too much water in a ship, excess inventory doesn’t contribute to buoyancy.