I continue to be amazed by Americans who buy houses in this environment.  Supply and demand have yet to be revoked by Congress or the US Treasury, so as house prices fall prospective buyers step up and purchase newly discounted homes.  This is inevitable, the nature of free markets and a necessity for price discovery.  Caveat emptor!  The concept of purchasing a house, given current market conditions and economic trends which invariably influence housing prices, is so foreign that I am unable to fluently discuss the motivations which result in this outcome.

Since 2006 local and national media sources have produced a steady stream of stories about buyers purchasing houses at “bargain prices”, via short sales and through foreclosure transactions.  Sadly, only a small number of people in this country have an adequate understanding of economics sufficient to fully appreciate the forces at work within the housing industry, but it is still confounding that so many people are willing to put their capital, credit and financial futures at stake in an environment where every fundamental determinant of housing value points to further price declines.

There are a large number of forces driving these decisions and individuals are undoubtedly making rational decisions given their specific situations and expectations.  Each market and every house represents a unique situation and defies generalization.  But virtually every person who has purchased a home since 2006, when the cracks in the housing market began to materialize, has or will come to regret the decision.  Yet there continue to be a steady stream of optimists who are willing to take such a risk in the worst housing collapse since the Great Depression.  I am confident that these buyers will also come to regret these transactions.

I offer an incomplete framework for determining an attractive entry point for purchasing a house.

Structural Impediments to Housing Price Stabilization

Inventories – House Supply
It makes no sense to buy a home while the inventory of housing units for sale is at historical highs.  House prices will continue to fall and are unlikely to stabilize while inventories are high, increasing or materially above sustainable norms.  The United States presently has the largest number of uninhabited housing units in our history.

When to buy:
Home purchases should be avoided until the inventory of houses for sale is consistently falling and is approaching historical norms.  There is no reason to try to guess the bottom and assume the risk of buying into a falling market.  It will take months if not quarters of inventory consistently falling for supply to return to sustainable levels.  This process will be easy to verify and widely reported by the media.

Foreclosures – House Supply
As long as there is a material number of foreclosures in the market prices will not rise.  House prices are unlikely to stabilize unless values become so cheap relative to fundamentals that people are willing to buy regardless of price.  We are not near this dynamic.  Median home prices have reverted to 2004 levels whereas the Housing Bubble and excessive appreciation rates began around 1996. 

At present we are experiencing an all-time record number of foreclosures.  There is a large source of highly visible foreclosures looming for the next several years in the form of adjustable rate mortgages.  These mortgages will continue to reset through 2012 and result in a large numbers of defaults.

When to buy:
As long as foreclosures are at record levels or increasing there is no reason to buy a house.  Until adjustable rate mortgages are permanently defused there is a large supply of looming foreclosures.  It is possible that some pending government action may defuse these economic time bombs, but be wary.  If government intervention simply delays inevitable foreclosures, the market’s pace of decent may slow, but this will be a false positive.  Housing prices will not stabilize or begin to rise on an inflation adjusted basis if there are millions of government delayed foreclosures that will eventually hit the market.

Unemployment – Supply and Demand
Home prices won’t stabilize or rise while unemployment is high or increasing.  We are experiencing a rapid increase in unemployment which is unlikely to reverse for the foreseeable future.  Unemployment leads to greater foreclosures, fewer home purchases and falling prices.

When to buy:
Unemployment is also a slow moving phenomenon.  There is no reason to try to front-run the peak of unemployment.  Wait until the trend has reversed itself for a meaningful period of time based on sustainable, non-government sources of growth.

Mortgage Availability and Credit Terms - Demand
When lenders are tightening credit terms there is no reason to purchase a home.  Prices rose to unsustainable heights based on and supported by the ability of buyers to access loose credit, on favorable terms, with no-down payments and adjustable rate mortgages.  Banks are presently unwilling to lend on overvalued housing purchases, require good credit, down payments and market interest rates.

While credit terms are tightening and credit availability is falling there is no reason to believe that prices will stabilize.

When to buy:
Wait for credit availability to stabilize at minimum.  A few quarters of stable or loosening credit will at least provide a framework for analyzing what housing valuations are supportable given sustainable mortgage terms.  Until then the bogey of what a house is worth is a moving target.


Things to Ignore as a Prospective Home Buyer

The Psychology of “The Deal”
Individuals and investors fall prey to the psychology of the deal, discounts, sales, price reductions and incentives.  Just because you can buy a house at a 30% discount to what it sold for in 2005 does not make it a good deal.

Were WebVan and Pets.com a good deal when they were selling at a 30% discount?  Were Enron and WorldCom savvy investments when they were down 50%?  How about IndyMac, Countrywide, New Century, Lehman Brothers, AIG, Fannie Mae and Freddie Mac?  Just because something is on sale doesn’t make it a good deal. 

Housing prices will be attractive when they make sense based on fundamentals.  They will make sense when they have stopped falling and are unlikely to resume their decline.  A home purchase will make sense when prices are appreciating at a pace at least equal to the rate of inflation.  
 
The Temptation to Purchase Discounted Foreclosed Properties
Many people have resisted the temptation of buying houses that have declined in prices but have fallen victim to the allure of foreclosures.  These distressed purchases are available at below current market prices.  The important concept to understand is that the price of foreclosures is collapsing just like the price of new homes and non-distressed existing homes.

People who bought foreclosures in 2007 aren’t particularly thrilled by their “deals” especially if the properties were purchased in Florida, Nevada or California.  Price declines have more than offset the discounts possible in foreclosure transactions.  These people are underwater just like recent buyers of non-distressed houses.

Foreclosures will persist for many years as a contracting economy, rising unemployment and adjustable rate mortgages trigger defaults.  Home prices will continue to fall.  And years from now foreclosures will still be occurring.  If you find yourself interested in buying a foreclosed property, consider how much better of a deal will be available on distressed properties in 2012.

Social and Cultural Pressures
The social pressure to own a home has traditionally been strong.  The economic incentives, created by congress, have been effective at reinforcing this phenomenon.  These cultural values have been and will continue to erode as the damage from buying overvalued houses with excessive leverage deepens.

Mortgage Rate Swings
It makes no difference if mortgage rates drop next month or next year. 

It is true that all things being equal mortgage rates have an impact on the value of homes and determines their affordability.  But these are not normal times and all things are not equal.

House prices are falling and will continue to fall.  It doesn’t matter if mortgage rates get cheaper.  Why would rational people borrow money at any price to buy a house (or anything else for that matter) that is going to be worth much less in the future?

Two observations about mortgage rates:

1)  Marginal mortgage interest rates are actually much higher than they were during the bubble.  In 2005 a buyer could access an ARM or Option ARM that functionally allowed the borrower to pay interest rates as low as 2%.  These hybrids are now gone.  As such, a 30 year mortgage with a 6% interest rate represents a much higher rate than that which was determining and supporting prices during the mania.

2)  What if mortgage rates were 3% or even 0%?  If you could go buy a house with a zero percent interest rate would you do it?  In Kansas maybe but not in Miami, Tampa, San Diego, San Francisco, Las Vegas, New York, Boston, etc…  Low interest rates are great, but if prices fall you lose any equity that you may have had in the purchase at a pace magnified by the leverage of your mortgage. 

It was irresponsible for people to borrow money to buy overvalued houses but at least it was done with the expectation of rising prices.  It is absolutely insane to borrow money to buy a house that is falling in value and likely to continue to fall for years to come. 

Concerns About Missing the Bottom
You don’t want to buy a house and hope for the best.  You are much better off buying a home after the market stabilizes or begins to rise than you are trying to predict the bottom.  This isn’t the stock market.  You can't dollar-cost average.  A home purchase is a highly leveraged transaction.  The housing market won’t reverse on a dime or rise dramatically over a period of a few months or even quarters.  The bottom of the housing decline may take years to find and there is no guarantee that we will see any real home price appreciation in the next decade.  Either way, missing the bottom by a few percentage points is infinitely more appealing that entering into a highly leveraged asset purchase while prices are collapsing.