Housing Price Declines Will Overshoot Equilibrium

[TJ_98370]

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The author makes a case for housing prices to decline below long term average price-to-earnings ratio of 3.2.
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.....The Case-Shiller price index, down 17% over the last 12 months, was down only 0.6% over the last month, leading analysts to chortle that the housing market decline was coming to an end. After all, with a 20% decline in house prices and 10% rise in general prices (normally a close proxy for wages) over the last two years, the ratio of house prices to earnings must have dropped from its peak of 4.5 times to quite close to its long term average of 3.2 times.
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A moment's thought should convince us that this trajectory is unlikely. Mortgage conditions are not those in which the long term average was attained. Not only have subprime mortgages as a category disappeared, but so has much of the mortgage securitization market as a whole. The government-backed mortgage behemoths Fannie Mae and Freddie Mac have subsided effectively into bankruptcy, and will not be buying mortgages aggressively in the future. Mortgages have become very difficult indeed to obtain for anyone with a credit score of under 700 or so and generally require a down payment of a full 20% of the purchase price.
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On the other side of the equation, home buyer psychology has completely changed. No longer is it expected that house prices will continue a steady and inexorable rise, without significant downdrafts. Buyers now know that if they need to move again in a hurry, they may well be lumbered with an asset that will prove impossible to sell except at a price that wipes out of most or all of their original investment
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With mortgage markets much more difficult than their long term average, and home buyers much more nervous and pessimistic than their average, it is hardly to be expected that house prices will stabilize around their long term equilibrium level. Only interest rates, still exceptionally low in real terms, will tend to hold them up. However since interest rates will eventually need to be raised to combat inflation, that sustaining force also will be removed from the market.
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At that point, house prices will decline, not to their equilibrium level but to some much lower nadir. The further drop will itself tend to depress mortgage activity and investor sentiment. The model could be Japan, where real estate prices dropped around 60% from the 1990 high, with further drops extending to 80% in downtown Tokyo. Since Japan is an island chain of dense population and limited buildable land, real estate prices should always be high and might be thought immune to such fluctuations; the experience of 1990-2005 proved that if a deep recession took hold, there might be very little restraint on the downside. ......
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......a national price decline of 30-35% seems easily possible, taking the house price to earnings ratio below 3.2 times to a bottom in the 2.5 times range. At that point, unlike in the more crowded Japan and Britain, the availability of attractively priced real estate in outer suburbs and the heartland, where prices had remained much more affordable, will bring new buyers into the market. These new buyers will be easily able to fulfill the prevailing tighter mortgage standards and will see home ownership as a financially attractive alternative to renting, whatever the behavior of house prices.......
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[Markor]

Good article. I've said all along that we could see 80% price drops from the peak. (People will sell property for peanuts before they'll starve, the Great Depression showed.) Even holding on to cash in the bank could become tough. Hopefully it won't be that bad (and I say that as a renter currently), but the argument for significant overshooting is compelling.