Seattle Bubble

One of the topics we touched on during yesterday’s Rain City Radio conversation was when and how to catch the bottom of falling house prices.

I’m not personally obsessed with catching the very bottom, but I also am not interested in buying something less than ideal that I can barely afford based solely on a false notion that prices will keep rising, only to have them drop another 10-20%. I outlined one possible strategy in this post, where one would wait for three years or 6 consecutive months of price increases, whichever comes first.

Reader Sniglet pointed out a possible flaw with this strategy in yesterday’s comments:

Personally, I would suggest waiting for more than 6 months of consecutive price increases before buying, as Tim suggested (if you are trying to time the market, and buy at the bottom). If you look at Japan’s price decline in the ’90s there were some periods where prices seemed to have stopped dropping for about a year, but yet the decline continued anyway.

One thing that is consistent at all housing downturns is that it takes years for prices to really pick up significantly. My advice would be to wait until it looks as if prices haven’t declined anymore for a couple years. There is certainly no rush to jump in once a market has hit bottom, so patience is the best policy.

There certainly exists the possibility that there will be “false bottoms” that last longer than six months. How long you set the horizon is really a matter of your personal assessment of the risk.

What it really comes down to for me is this: “can I afford a decent house that I will be happy with long-term at today’s price?” If the answer to that is yes and I am comfortable paying today’s price knowing that I could possibly get a better deal by waiting, then I’ll probably buy anyway—bottom or not.  For my family, I expect that time will probably come around 2010, even if prices are still declining.

So what is your strategy? Are you waiting for a specific price point, or are you more interested the overall direction of prices? Or perhaps something else entirely? Let’s hear your suggestions.

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I thought it would be fun to check back in with an update on the San Diego / King County home price comparison I made back in March.

As of the latest Case-Shiller data (February) home prices San Diego have fallen 24% from their November 2006 peak. The Seattle area has dropped 6.5% from its July 2007 peak.

April median price for all homes sold (single-family + condos):

• San Diego County: $400,000 (source: San Diego Union-Tribune)
• King County: $410,000 (source: NWMLS)

Both counties had an anemic spring bounce of sorts, but that didn’t stop aggregate home prices in San Diego County from falling below King County, thanks to a huge drop in March. Here’s an update of the graph from March, based on the following two supposedly realistic assumptions:

1. King County home prices will remain flat through December.
2. San Diego County home prices will continue to decline, at roughly half the rate they have dropped in the last six months.

Click to enlarge

The gap has widened since March, and those assumptions now lead to an 11% price difference by the end of the year. But of course San Diego doesn’t have any tech jobs, and their economy is basically in the toilet, so that makes perfect sense. Wait, neither of those statements is true at all.

Now that prices are undeniably dropping in Seattle, a common refrain from real estate salespeople is that “you can’t time the bottom,” or “you can’t predict the future,” implying that you should go ahead and just buy now, because we’re probably at or near the bottom already, and if you wait you’ll be sorry.

This is an interesting line of reasoning, but while it is true that no one can know with certainty what the future holds, blindly making a gut decision based on our lack of knowledge would be foolish. Instead, we can and should consider the different possibilities and base our decision on a rational analysis of what we do know.

So let’s look at three different possibilities for where prices might go from here, and look at what it would mean if you buy now versus if you continue to rent a while longer, waiting for either two years, or six consecutive months of price increases before you decide to buy, whichever comes first.

Scenario A: We’re not at the bottom yet. Prices continue to decline, eventually bottoming out at summer 2005 levels in the summer of 2010. Prices begin to inch up slightly through the end of 2010.
Scenario B: We’re at the bottom, but we’ll be here for a while. Prices stay more or less flat through 2010, increasing no more than about 1% per year.
Scenario C: We’re at the bottom. Prices begin to increase again, rising 5-7% YOY through 2010 and beyond.

Click to enlarge

In our hypothetical scenario, let’s say that you are looking at a $450,000 house, you have the 20% down ($90,000), can afford a fixed-rate 30-year loan, and your alternative is to rent for a monthly cost of $1,500 (increasing 5% per year). There are comparable houses for sale and rent right now in Ballard that fall within these specifications, so I think they’re reasonable.

Scenario A
Buy now: Your total monthly costs are around $3,000. The value of your home decreases around 15% by 2010. If you have to sell, agent fees and excise taxes will eat up most of the $30,000 that remains of your down payment. If you don’t have to sell, who cares what it’s worth—enjoy your house and the (mostly) fixed payments.

Rent for now: Your rent increases to $1,650 per month by 2010, and if you save the extra money you would have put into the mortgage every month, and invest your $90,000 down payment at 5%, your savings has increased to $125,000 by that time. You see the prices start to increase again, and after six months of steady increases, you decide that now is the time to buy. Houses that would have formerly sold for $450,000 are now $380,000, allowing you to put down over 30%. Your total monthly costs are around $2,300 at 6% interest, $2,500 at 7%.

Advantage: Rent for now

Scenario B
Buy now: Monthly costs are $3,000. The value of your home stays more or less flat through 2010. If you have to sell, you’ll get back about $70,000 of your down payment after agent fees and excise taxes. If you don’t have to sell, who cares?

Rent for now: Rent goes up to $1,650, savings to $125,000. You decide to finally take the plunge on that house, and you can get one for $455,000 that is just like the one you were considering before. Your total monthly costs are around $2,750 at 6% interest, $2,900 at 7% interest.

Advantage: We’ll call it a wash (depends on future interest rate)

Scenario C
Buy now: Monthly costs are $3,000. The value of your home increases around 12% by 2010. If you have to sell, you get to pocket over $115,000. If you don’t have to sell—well, you know the drill.

Rent for now: You save six month’s worth of payments before realizing that prices are already going up again. Homes that were $450,000 are now $465,000. Your down payment investment has gone up slightly to $99,000. Your monthly costs are around $3,000 at 6% interest, $3,150 at 7%.

Advantage: Again, more or less a wash (also depends on your interest rate)

Of course, I don’t personally believe that all three of those scenarios are equally likely, but even if they were, there still is no real benefit to buying now. Even if we’re currently at the bottom and prices start climbing relatively quickly starting now, you’re really no worse off for waiting six months to find that out.

The biggest factor that makes this a feasible strategy is the continued large discrepancy between rents and home payments. I’m sure a skilled real estate salesperson could concoct some scenario in which waiting out the market right now is a foolish financial move, but based on this analysis of three fairly reasonable possibilities, I’m comfortable recommending that course of action for the time being.

Here’s an interesting comparison.

As of December’s Case-Shiller data, prices in San Diego County have fallen nearly 20% from their November 2005 peak. As of last month, their median price for all homes sold (single-family and condos) was $415,000 (source: San Diego Union-Tribune).

In the Seattle area, December’s Case-Shiller put prices off 4% from their July 2007 peak. Last month the median price for all homes sold in King County was $395,000 (source: NWMLS).

Now, if you listen to the so-called real estate “experts” around here, they will tell you that prices here in Seattle are just going to “plateau” and stay flat for a while, before continuing their ever-upward journey to the stars. On the other hand, no one in their right mind believes that San Diego’s price drops are over yet, given the continued severity of the foreclosure problem down there.

So let’s project the rest of this year for King County and San Diego County based on two allegedly reasonable assumptions:

1. King County home prices will remain flat through December.
2. San Diego County home prices will continue to decline, at roughly half the rate they have dropped in the last six months.

Here’s what that would look like:

Click to enlarge

If those two predictions were to hold true, homes in sunny San Diego will be seven percent cheaper than here in King County by the end of the year. I’m probably just ignorant of how super-great-awesome the Seattle area truly is, but to me, that doesn’t seem very likely. I predict that if such a turnaround does take place, it won’t last long once people realize that they can move back to California and buy a home for less money than in Seattle.

Please vote in this poll using the sidebar.