Posted on Monday, October 13th, 2008
The short answer is that it won't. People talk about markets moving
in cycles. And that is true up to a point: Sometimes economic
conditions push markets down, and then when the conditions change the
market rebounds. But what kind of conditions would we need to justify
the kind of prices that homes were selling for just 2 years ago?
Let's look back at where the real estate market was 6 or 7 years ago.
I felt that home prices were already irrationally high in 2002, and
that they couldn't possibly keep going up. I list a lot of homes, but I
also work with a lot of young first time home buyers. Working with
people who have never owned a home forces you to look at our economy
and real estate market through a different lens. Six or seven years
ago, I was already noticing that the "average" buyer couldn't afford
the "average" house. For example here is a West St. Paul rambler that I
sold in 1998 to a young couple for $115,000.
They were making about $38,000 between the two of them and they were
buying a home for approximately 3 times their annual income. It seemed
like a lot of money at the time. The Ramsey County tax record showed
that this home had sold for under $100,000 just a few years before. It
seemed like a stretch, but they really wanted to be in a home. I told
them not to expect it to go up much in price. Incomes didn't seem to be
rising very fast, and I didn't see how the typical entry level buyer
could afford much more.
Of course I was happy to be proved wrong when they called me in 2002
to sell their home. After one day on the market they got 4 offers and
they sold it for $167,500, about $8000 more than they were asking.
Their buyer was making about $38,000, the same amount my buyers were
making when they bought the home for $115,000. But this buyer had to
pay more than 4 times her annual income to buy the same home. I was
seeing this throughout the Twin Cities in 2002: Houses were selling for
much more than a few years before to buyers who weren't making any more
money than people did in 1998. I remember telling people in 2002 that
the Saint Paul area real estate market was near the top, especially for
entry level homes. We were reaching a point that moderate income first time buyers
simply wouldn't be qualified to buy even an entry level home. There were lots of families making between $35,000 and
$45,000, and even "starter" homes were becoming unaffordable to them. I
cautioned buyers that they shouldn't buy a home expecting to see large
increases in value. For most people annual net income increases were
very small, and I couldn't imagine any way for buyers to drive prices
much higher than they already were.
We all know that prices continued to go up, sometimes quite
dramatically, for about three more years. A lot of people made fun of
me, and how wrong I was. I like to say that I was right 3 years early,
but that doesn't really impress people.
So, how did prices continue to rise at a rate that was totally independent of what buyers could actually afford?
The answer is mind blowing in its simplicity. Banks simply stopped
worrying about whether buyers could actually afford homes. They made
loans to everybody who had a pulse. A lot of very experienced, well
educated investors were investing in mortgage backed securities as fast
as they were originated. So mortgage originators saw no reason not to
originate as many loans as they could. I remember seeing banks loan
money to people I wouldn't lend a dollar to, but I assumed that the
investors were smarter and more knowledgeable than I was. And they do
know some things that I don't know, but I'm beginning to see that I
know some things that they don?t know.
The main flaw in their thinking was that they assumed prices would
continue to go up, allowing buyers to sell their homes if they couldn't
make their payments. It's important to remember that these mistakes
were made by people who are smarter and better educated than I am. And
they had mathematical models that seemed to legitimize what they were
doing. But they were looking at the wrong data. Or maybe more
accurately, they were looking at the right data from the wrong
I spend a lot of time getting to know buyers, and trying to
understand their financial situation. Anybody who looks at the Saint
Paul real estate market through the eyes of a buyer will see a
different picture than they will if they look through the eyes of a
seller. I believe the buyer's perspective is more important because
they are the ones who drive real estate prices up, or down. By 2002 I
could see that the average buyer couldn't buy the average house. The
market really should have stopped going up at that point. There were no
fundamental reasons for it to go much higher. People weren't making
more money. Interest rates were already excellent in 2002, so there
wasn't much room for improvement.
The force that drove prices higher was the sudden availability of
loans to people who shouldn't get loans. Also the availability of no
money down loans brought a lot of buyers into the market--some of these
zero down buyers were actually qualified, so at least some of these
loans made some sense. But it was really unfair to buyers who had done
everything the "right way." The buyers who had jobs, solid credit
scores, and a down payment had to compete against all of the other
buyers who had none of these things. Many of these "quasi qualified"
buyers were willing to pay ridiculous prices for homes. After all they
were putting nothing down and they had nothing at risk. Of course this
couldn't go on forever, or even for very long. Even with my limited
intelligence, it was clear to me that a large percentage of these loans
were going to end up in foreclosure. Ironically, the banks were
counting on home values to continue to rise, but the only reason home
values were rising is because they were making loans to unqualified
What happens next?
My clients keep asking me when the market is going to "bounce back."
By this they mean: "When will homes sell for as much as they did in
2005 and 2006?" It is my opinion that the only reason real estate
market values went as high as they did is because we were selling homes
to people who had no business buying homes. Those buyers, and the
stated income loans that they used to buy houses, aren't going to
return to the market. Everybody knows that. But for some reason they
want home prices to "rebound" to values that were never supported by
the incomes of qualified buyers.
The Twin Cities are filled with home owners who can't come to grips
with today's market. They can't understand why their little 3 bedroom
rambler is worth "only" $180,000 when they could have sold it for more
than $200,000 a few years ago. They see the 2006 prices as "normal" and
today's prices as unbelievably low. I would encourage them to look at
things through the eyes of a first time home buyer. Not the kind who
was buying up homes 3 years ago. I'm talking about the kind of buyer
who has a job, a down payment, and a strong credit history. These
buyers are carefully considering how their monthly mortgage payment is
going to fit in with all of the other payments they have to make. To
people who are actually planning on making their payments, today's home
prices don't look low at all. In fact we are still at a point where
modest starter homes are barely affordable to people with average
For a young teacher with an income of $35,000, a typical Dakota County starter home sells for about 5 times his/her annual income. This is
high by historical standards. I always like to use teacher salaries for
this kind of comparison because their salaries have always been
considered middle class, and because their salaries are a matter of
public record and are easy to look up. When I was about 8 years old my
father, a teacher, bought our family our first home. He was making
$8000 a year, and the home sold for $17,000. It looked a lot like the West Saint Paul rambler pictured above. My dad was nervous about
spending more than two years salary on a home, and he didn't feel like
there was a lot of discretionary income left over after paying the
mortgage and other bills. My dad would be amazed to have been told that
within my lifetime, starter homes would be selling for 5 times what a
young teacher makes. What's more amazing is that people are complaining
that home prices are too low.
My best advice.
Today's home prices aren't low. They are barely affordable to people with average incomes.
Incomes are not expected to increase much in the near future, so don't expect home prices to increase much in the near future.
There are more current home owners than prospective home owners, and
current home owners vote more often. So expect politicians to continue
to wring their hands about our "depressed" real estate market. Some of
them will actually try to do things to prop up the market, but they are
trying to defy gravity. They can't go back to letting unqualified
buyers get loans. They gave us a tax credit, but they took away the Nehemiah Program that enabled qualified buyers
to get into homes without a down payment. The tax break will entice
fewer buyers than the market will lose due to the loss of the Nehemiah
Program. But the tax credit and the Nehemiah Program are small
potatoes. Unless politicians can find a magical way to radically change
the economic situation of typical buyers, intelligent buyers will
continue to see today's home prices as barely affordable. Also, they will understand that there are more homes for sale than there are of them (buyers.) The only market force that could raise prices is to suddenly have more qualified buyers than we have. Keep in mind we didn't have that many qualified buyers in 2005 or 2006, we just sold homes to unqualified buyers so we could all pretend that the market was healthy.
Even if politicians could make home prices go back up they probably
shouldn't. It is painful for owners to watch home prices fall, but I
don't understand why it would be desirable to artificially inflate
prices to a point that people with middle class incomes can't buy homes.
Intelligent sellers will realize that they have to come to terms
with reality, and price their homes to sell in the current market. In
Dakota County alone, 130 homes have sold in the first 11 days of
October. That's more than 10 homes a day. Of course many sellers are
failing to sell their homes. The common theme is price. The sellers who
are able to offer their homes at a price that makes sense in today's
rational market are successfully selling their homes.
Many people are blaming our economic woes on the real estate market.
But our economy is based on consumers going out and buying stuff, and
nobody has any money. About 4 years ago it became apparent to me that
none of my clients had any money in the form of actual savings in the
bank. They had been spending all of the money they made and then using
credit cards to buy more stuff. The only money any of them had was
equity in their homes and retirement savings in their 401k accounts.
None of them were going to be able to keep buying things on credit
indefinitely. I expected a recession 3 or 4 years ago. The only thing
that delayed the inevitable is the sub prime loans that created buyers
out of nowhere. This made people think the real estate market was on
solid ground. Even people who weren't buying or selling used their
homes as an ATM. Taking out a long term loan on your house for day to
day purchases is never a good idea, but it is a particularly bad idea
when your home isn't worth what you think it is. The sub prime mess
didn't really cause our economy to tumble. Our economy was in trouble 4
years ago. The sub prime loans allowed us to pretend that real estate
was booming and that therefore we didn't need to worry about all of the
other problems in our economy. The underlying problems with our economy
are not going to be fixed soon. Don't expect real estate prices to go
If you have a real estate appraisal that was done in 2005 or 2006,
use it to wrap a dead fish. The dead fish is worth more than the
appraisal, and the fish probably has a better idea of what your home is
worth today than you will get from the appraisal.
Is there any good news at all?
Home ownership is still a central component of achieving the
American Dream. There are buyers who want to buy your home. They just
don't see any reason to pay 2005 prices for it. If you list your home
at a price that reflects today's market you can sell it. Using a full service discount broker is one way to price your home competitively while protecting your bottom line.
For home buyers there is lots of good news. Interest rates are
great, and prices are lower than at any time in the last 3 or 4 years.
The phasing out of the Nehemiah Program means that buyers need to have
a down payment. But the new tax credit will entice some buyers. A few agents, myself included, are offering additional cash back to their buyers.