by Calculated Risk on 5/12/2006 08:10:00 PM

Writing in the East Bay Quarterly, Dr. Thornberg on California housing:

"... there were some legitimate reasons for the increases in prices. The late nineties saw a sharp rise in rental rates around the state, caused by a growing gap between production and demand. The late nineties saw the removal of tax liability on the sale of a home within a certain amount. Then there was the large drop in mortgage rates between 2001 and 2003. But since 2003 there has been little reason to believe the price increases we have seen are legitimate. Mortgage rates are rising slowly, rents are just now starting to recover and with the state permitting over 200,000 units over the last two years those housing shortages seem to be a thing of the past.

A bubble is when the market price of an asset becomes misaligned with what the fundamentals say the asset should be worth. Bubbles form because of buyers who concentrate on trends, not fundamentals. Property prices may have risen for legitimate reasons in the past, but this past performance is being taken as a sign of things to come, even though the drivers of the market point in a different direction. But the force of people rushing into the market to collect what they see as ‘free money’ may be enough to drive up prices all on their own. This self-fulfilling prophesy cannot last forever though. Eventually the harsh reality will settle in, and the markets will come to a halt. It is just a matter of time. The irrationality of the market makes it tough to predict the when, only the eventual direction is known for sure.

The best leading indicator of a cooling real estate bubble is unit sales. The frenzy that characterizes the rush to get some of that free money is best characterized by a run up in units being bought and sold. Unit sales of existing homes in the state have fallen from 140,000 to 110,000 (seasonally adjusted). In the East Bay monthly sales have fallen to about 1900 units, still high but the downtrend continues. New permits for residential structures have also fallen to below 200,000 units for the state, although they remain solid in the East Bay at slightly over 10,000 new units annually. Inventory levels are on the rise in all the major markets according to data from the California Association of Realtors. Make no mistake, all the numbers still reflect a hot market, and are considerably above where they were as recently as 3 years ago. But these markets are very trend sensitive. The slowing of the market feeds on itself, not unlike the acceleration did. When the market was hot, it caused people to rush in to get a piece of the action, causing it to get hotter. Now as it cools, it will cause more people to think twice before buying, causing it to cool more. Going by past trends this slow decline will continue for the first half of this year, and then the bottom will truly begin to drop out.

As for prices, they are still rising. Much has been made of this, and discussions about how unusual it is are common in the press. The real estate community claims it is indicative of a ‘soft-landing’ scenario. Let me be perfectly clear, there is absolutely nothing unusual about the current pattern of slowing in the market. Prices always lag sales activity on the order of six months to a year. With the markets starting to slow as of late 2005 we would expect price appreciation to slow and come to a halt somewhere towards the end of 2006. This is exactly what we are starting to see. From the 25% pace, appreciation has fallen below 10% as of March of this year. Expect it to continue downward.

So is this the time to sell your house and move in with your parents? Only if you happen to be a masochist, and even then it might end up being too painful. Housing bubbles do not pop on the price side, unless there is a substantial loss of employment in the local economy—the kind of employment losses typically associated with a wider recession. And even under those circumstances the price declines tend to be slow. If you need a good example to go by, the breaking of the late seventies bubble would be a good start. While the US economy was dramatically hurt by the deep recession in 1983 and the shallow one in 1981, only in one year—1982, did California actually see a decline in its workforce. As a result prices stayed relatively stable, falling in value only slightly.

Given the current momentum in the general economy, the forecast for real estate is general cooling. Appreciation will slow to a mere 6% (nominal) by the end of this year and will be flat in 2007. Yet the ‘soft landing’ scenario being predicted by the industry is clearly overly optimistic. We predict that sales of existing homes at the state level will fall from 530,000 units sold in 2005 to 390,000 in 2007 and even lower in 2008. New units being built will drop below 150,000 units by 2008. The impact on the real estate and mortgage industries will be substantial.

What risk does the State have? In 2005 brokerage commission fees nationally tallied in at something close to $100 billion. California’s share of this is probably at least 15%, or $15 billion or more. If the average broker pays 7.5% state income tax on this, this suggests that the drop in sales of homes will cause a $1 billion hit to the state in proprietors income alone. Throw in taxes paid by mortgage brokers and residential developers and you can see the revenue problems that will start to accumulate in the latter part of this year. The spillover to the rest of the economy will be noticeable. State employment growth will slow to 1%, and taxable sales growth will slow to 4%. With taxable sales slowing along with income, the state will start feeling the pinch. Do not expect the dramatic collapse we saw in 2001, but then again we have less room to spare.

Of course the industry that has the greatest degree of risk is construction. Is seems doubtful that non-residential construction will be able to pick up the slack in the wake of the slowdown in residential units. We expect residential permits in the state to fall by over a third in the next few years. The decline will be larger in the places that have been building at an incredibly high pace, namely Sacramento, Contra Costa and of course the Inland Empire. Expect new permits to fall by close to 40% in these areas. There will also be a distinct shift in the type of construction, away from pricey higher end units towards entry level units. Local governments interested in promoting the development of affordable housing will find it much easier to get builders to buy into various programs when demand is slack.

The value of non-residential permits have been growing over the past two years, but only due to the increasing cost of construction. In real terms the amount being built has been flat since bottoming out in 2003. Commercial space still has a high vacancy rate, and demand for new space will remain tepid there for a number of years. Retail and industrial space are tight, but these are being driven in part by the high degree of consumer spending on imports. Weaker spending growth will cool demand for these sectors as well. Construction employment will lose 200,000 jobs statewide over the next three years, with an additional unknown number of jobs lost in the informal sector. In the East Bay this will likely translate into the loss of 17,000 construction jobs in three years.

Is there a possibility of a worse outcome? Certainly. Other shocks to the economy, or a rapid closing of the current account deficit could cause a major recession. This would worsen the outlook substantially. But there is no evidence of this secondary possibility at this point in time. So we see the housing crunch as a force that will slow growth, not stop it. Look for weak growth starting beginning the end of this year or early next year and lasting for up to two years. What is clear is that the downside risks are larger than the upside."