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August 16, 2006

Today's Housing Bubble Post - How Far Can Prices Fall?

-- by Dave Johnson

Kevin Drum says he thinks housing prices in Southern California will drop 10-20%, bottoming out in 2008.

Here in Northern California housing prices have more than tripled during the housing bubble. They average around $750K for a 3BR in my area. So how much might we expect them to fall now that the bubble is popping? Let me try a calculation based on getting a return on investment for a rental property.

Suppose rents are $2000 a month for a 3-bedroom house. Subtract from that repairs, maintenance, etc., and let's say you are clearing $1800. Instead of trying to calculate property taxes let's just say $400 per month - which is lower than what they would be ($650) if purchased now but you'll get my point in a minute.

So you're clearing about $16,800 a year from your investment. Let's say you are shooting for a 7% return. That means the house SHOULD be priced at about $240K, approx 1/3 of current pricing. (Except that those property taxes are now too high for this purchase price, but you're starting to get my point.) This happens to be about what prices were before the bubble, plus a bit for inflation. EXCEPT for a few things -- the bubble provided incentive for a LOT of new homes to be built, so demand will be weaker. AND a lot of people are going to be wiped out financially so overall ability to purchase will be lower. AND, with all those houses on the market, rents are likely to fall. So these are some of the factors that could contribute to prices going lower than about $240K around here. But you get my point.

Prices have a LONG way to fall, and when they do there are a lot of factors which could make them take much longer than usual to recover.

Posted by Dave Johnson at August 16, 2006 11:25 AM

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This is the beginning of the housing crash. It is JUST starting to hit the news that sales are slowing. You're still hearing that buyers are "waiting on the sidelines to jump in." These are people who still think that... [Read More]

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Comments

Well, maybe. The thing is, AFAIK, housing prices are sticky, because people won't sell at a loss. They'd rather suck it up and wait the downturn out.

What's going to be really interesting for me is seeing what happens when all those folks with ARMs and interest-only mortgages do when the rates float upward. That's going to change their cash flow more than a little.

Of course, just the not-feeling-rich as appreciation stops will also stop the consumer expenditures based on that feeling, which will cause a downturn, which in turn will affect incomes, ability to buy, ability to manage the huge payments, which will increase inventory, etc. etc. So the ARM problem might not even be the primary driver.

Posted by: paperwight [TypeKey Profile Page] at August 16, 2006 11:37 AM

"people won't sell at a loss. They'd rather suck it up and wait the downturn out."

Then those people can hold on as long as they can. But some will be forced to sell, others bought a long time ago and will make a big profit, even at $240K.

But if you are BUYING there is no reason beyond psychology to be paying more than $240K. It's like the price of a stock. Sure it can go way, way up but in the end a stock is worth a certain price-to-earnings-ratio. No more and sometimes less. The rest is all psychology, and the psychology is about to turn seriously against buying real estate.

Posted by: Dave Johnson [TypeKey Profile Page] at August 16, 2006 12:02 PM

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