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As '07 realty clouds gather, so do silver linings

Americans are increasingly nervous about the real estate market in 2007. They have good reason to be. But the news isn't all bad: Interest rates will remain at historically low levels, home buyers will see more opportunities, and best of all, for those planning for the long term, 2009 could be primed for a comeback.
/ Source: BusinessWeek Online

Americans are increasingly nervous about the real estate market in 2007. They have good reason to be. But the news isn't all bad: Interest rates will remain at historically low levels, home buyers will see more opportunities, and best of all, for those planning for the long term, 2009 could be primed for a comeback.

To gauge what the next 12 months might look like, though, asked economists at leading real estate research firms to provide their outlooks for the housing market in 2007. The less-than-festive consensus: Home prices will continue to fall in some markets, and the rate of price appreciation will slow in most places. Declines in homes sales, which directly influence price trends, will set the stage for another year of price decreases in 2008. Foreclosures will continue to increase. For those struggling to hold onto their homes, their net worth will shrink as these homes lose value. Long-term mortgage rates will rise. Housing starts will see double-digit depreciation, the sharpest decline since 1991, the worst year for housing starts on record.

Grim as that might sound, there are some bright spots. Nationwide, home prices will be flat to up slightly in 2007, with many large markets seeing small increases. While new home sales will be down for the year, existing home sales will also be flat. And housing starts won't see as sharp a decline as they did in the early '90s or early '80s.

Another reason for optimism (keeping in mind that expectations are somewhat lower this year): For many, the ongoing market correction will make the dream of buying a home a reality.

“In so many of these markets, housing became extremely unaffordable,” says David Stiff, chief economist at Brookfield, Wis.-based financial data processor Fiserv Lending Solutions, who expects average U.S. home prices to appreciate only 0.1 percent overall in 2007. “Prices moving back in line with household income sets the stage for price appreciation in the future.”

Blame the rapid run-up in prices on speculation. Taking advantage of low interest rates and good economic conditions, investors drove prices to new heights in the first half of the decade, so they could flip purchases for profit. Some markets saw price appreciation rates of as much as 50 percent, versus the average annual rate of about 10 percent.

But as interest rates rose and the gap between income and housing costs widened, home buyers never materialized as expected. Investors have now been forced to dump their property on the market, flooding many places with homes for sale and forcing prices to a more realistic level.

“The market was in a frenzy in 2005,” says Lawrence Yun, senior economist at the National Association of Realtors. “The current transition is just cleansing away the speculators.” Yun expects existing home sales to slip just 0.6 percent in 2007, with a pickup in the fourth quarter continuing into 2008.

Home price trends tend to lag nine to 12 months behind sales trends, said Stiff, who predicts prices will be weakest in 2008 and rebound in 2009.

The researchers at Fiserv arrive at their price forecasts by first estimating what home prices would be if housing supply and demand were in balance — that is, if price levels were consistent with local demographic trends and household-income levels. They then look at the difference between the estimated “equilibrium” price and the actual price level. If prices are too high relative to the affordable, equilibrium level, the forecast is weaker price appreciation. If prices are much higher than equilibrium, the model forecasts price declines.

This explains why former red-hot markets like Southern California, Florida and Las Vegas, which saw the most rapid run-up in prices between 2001 and 2005, will see the sharpest declines in prices in 2007. The Miami area, with an estimated decline of 9.16 percent, will have the second-worst 2007 price drop out of all the country's metro areas. Las Vegas comes in third-worst overall, with a 9.15 percent forecast decline, and Los Angeles, with a 7.1 percent decline, isn't far behind.

Texas didn't experience dramatic price appreciation until more recently. Consequently, the Dallas and Houston metro areas are expected to have 2007 price increases of 4 percent and 3.3 percent.

Since trends in housing starts echo price movement, it goes without saying that new home construction is headed for a major slump in 2007. Nationally, total housing starts will slide 13.2 percent to 1.576 million, according to the National Association of Home Builders in Washington. The last time the nation saw a downturn of this magnitude was in 1991, when starts dropped 15 percent year-over-year.

“It isn't as bad, but it's a very big decline, and one of the big reasons is because of all the investors and speculators,” says Gopal Ahluwalia, vice president of research at the homebuilders association. In the fourth quarter, the seasonally adjusted annual rate will pick up to 1.635 million. At this point, the surplus in inventory will be gone, and prices will start to stabilize, Ahluwalia adds.

As with prices and sales, trends in new home construction can vary dramatically from market to market. Housing starts in the Detroit area will be among the lowest in the country in 2007, plummeting 18.3 percent due to continuing economic woes. Interestingly, prices will not decline, but this is largely because they cannot go any lower. Seattle is the only area that will see a rise (4.7 percent) in housing starts, primarily because of a strong job market with companies like Microsoft and Boeing based in the area.

Ironically, even record-low new home construction numbers can be interpreted as good news for the overall housing market. With fewer homes being built, the market will be forced to absorb its current oversupply, bringing about the supply-demand balance that, once again, leads to more realistic prices.

“It's important to note that the value of homes isn't dropping,” says Santo Rizzo, chief executive of Rizzo Realty Group, a Chicago-based national real estate investment firm.

The normalizing market is causing “unnecessary fear” and creating a favorable market for real estate investors, says Rizzo, who recommends investing for the long term in 2007 “losers” Phoenix, Las Vegas and Orlando, Fla., for their stable economies, high resale marketability, vacation market statuses, low vacancy rates and favorable price-to-income ratios.

Interest rates are, of course, the wild card here. The Mortgage Bankers Association of America expects the Federal Funds Rate — the interest rate on overnight loans between banks — to remain at 5.3 percent throughout 2007, with the average 30-year fixed mortgage rate climbing to 6.6 percent from 6 percent and the one-year adjustable mortgage rate average staying about the same at 5.8 percent. According to the National Association of Realtors, the Fed Funds Rate will fall to 4.8 percent by the end of 2007, the 30-year fixed rate will hit 6.7 percent, and the one-year adjustable rate will decline to 5.5 percent.

But no matter how you spin it, interest and mortgage rates are and will remain at historically low levels. The rest of the economy isn't in terrible shape either — the unemployment rate hovers around a relatively low 5 percent, and the stock market is in the midst of an encouraging rally.

“The law of supply and demand, more than anything, is going to be the driving force that keeps the market relatively ‘flat,’ throughout the year,” says Rizzo. “Since we expect the economy to continue to improve, rents to continue to rise, interest rates to remain relatively low, and investor supplies to be absorbed, the 2007 ‘flat’ market will set the stage for brighter predictions in 2008.”

So while 2007 won't be an outstanding year for real estate, it's unlikely to go down in history as one of the worst. At the very least, it will create an investment opportunity — and a great lesson in basic economics.