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Why home prices are falling -- again

Is your home's price about to fall 10% further?

That's what two respected teams of analysts are predicting right now. And TrimTabs Investment Research is more pessimistic, suggesting it could be five or six years before home prices stabilize and move higher.

Of course, this is just one more problem for investors and consumers to worry about. The economy appears to be slowing again. Stocks have ambled sideways since February. The U.S. government faces the prospect of a technical default on the national debt.

Indeed, we're looking at a time of serious upheaval. We've had the Arab Spring in the Middle East. There's been a spate of natural disasters, including Japan's earthquake and nuclear plant meltdown, as well as floods and tornadoes in America's heartland. And frothy commodities markets have suffered violent setbacks, with silver in particular showing symptoms of excessive speculation. And don't forget that the dollar, after being left for dead, is rising like Lazarus, reanimated by new fears over Greece and the future of the eurozone.

In all of the tumult, it's easy to forget that the root cause of all this mess -- now entering its fourth year -- continues to fester like an untreated wound. I'm talking about the U.S. housing market, which, by some measures, has fallen to new lows. After showing signs of hope late last year in the wake of the homebuyer tax credit, it's now suffering fresh setbacks and reaccelerating price declines.

Consumers, weighed down by rising inflationary pressure and lackluster job growth, are losing confidence. At the same time, tight lending standards and efforts to reform Wall Street and Fannie Mae and Freddie Mac are restricting access to mortgage credit. Right now, housing finance survives on government largesse: Government-backed entities like Fannie Mae and Freddie Mac now account for 95% of new mortgages.

All of this is limiting economic growth by keeping pressure on the financial system. And it risks the creation of a negative feedback loop in which lower home prices result in more homeowners falling into negative equity, leading to more foreclosures, more bank losses, tighter credit and, ultimately, further price declines.

All this leads the analysts to predict another drop in prices before a solid bottom is found. For potential landlords, especially those with cash in hand, this could mean it's time to buy property. For investors, it means bargains on a lot of related equities; I'll have some names later in this column, though I wouldn't start buying just yet.

But for homeowners? More pain. Here's why.

Hopes dashed

Longtime readers will remember that last December, when the economic outlook was much brighter, I penned a column ("Why it's safe to buy homes again") encouraging buyers to jump back into real estate. And if you got a low interest rate and you planned to stay put, it was. I also wrote that barring some "unforeseen calamity, another self-perpetuating cycle of higher home prices" could be seen as early as this year.

Unfortunately, we've had a few calamities since then; Fed-induced inflation, the Portuguese bailout, unrest in Libya and Japan's quake have led to a manufacturing slowdown. Economic growth slowed dramatically in the first quarter of this year to just 1.8% from 3.1% in the fourth quarter. The team at Capital Economics noted that households had "been hit hard by surging prices for everyday necessities such as food and energy."

And now there is evidence that the job market is softening again, with the unemployment rate popping back up to 9% in April. (I covered the economic slowdown and its impact on stocks in my April 27 column, "Investors, it's time to run and hide.")

Housing activity is way down because of all this. Home sales have stagnated near recessionary lows after unwinding the temporary boost from the homebuyer tax credit. Demand for new mortgages has dropped back to levels not seen since the depths of the financial crisis in 2008. Homebuilder confidence has sunk to very low levels -- and stayed there -- for more than three years and hasn't been positive since April 2006.

As a result, home prices have started falling again. What's more, the price declines seem to be accelerating, with the 20-city Case-Shiller Home Price Index off 3.3% in February from its year-ago level -- a drop of a magnitude not seen since late 2009. That's the eighth consecutive month-over-month price decline. The homeownership rate also continued to fall as more and more distressed owners became renters.

There are still some pluses

That's the bad news. The good news is that the long-term factors I mentioned back in December are still valid. These include record affordability, thanks to low prices and low borrowing rates, and still-favorable long-term demographics, as the United States is one of the few wealthy nations set to enjoy an expanding workforce in the years to come -- unlike Japan and most of Europe.

And over the medium term, household formations are set to bounce back from 50-year lows as young adults realize that living with Mom and Dad to save on rent loses its appeal pretty quickly.

But it's the short-term picture that remains a problem as foreclosure activity ramps back up in the wake of the foreclosure paperwork scandal (banks have been found cutting corners to expedite foreclosure legal proceedings), as well as the expiration of the homebuyer tax credit. More foreclosures will push prices lower as a flood of supply hits the market just as demand weakens.

Why lower prices lie ahead

The problem is simple supply and demand. Because of the fresh economic woes, demand is anemic: Total demand for new and existing homes is running at about a 5.5 million annual rate. And supply listed for sale stands around 3.7 million units, or around eight months of supply. Economist David Rosenberg of money management firm Gluskin Sheff notes that six months of supply represents a balanced market.

But Rosenberg finds that we're a long way from that, given the overhang of "shadow inventory" -- vacant homes being held off the market for "unspecified" reasons. Based on the latest quarterly U.S. Census housing data, the shadow inventory stands at more than 3.8 million units, up from 3.6 million in the same period last year.

Factoring these homes into the equation boosts the total supply picture to 16 months at current sales rates. And that doesn't even consider the supply of around 500,000 newly built homes entering the market each year. That's a lot of excess supply.

Clearly, prices will need to fall to encourage demand until the economy can do the job via wage increases, job gains and higher consumer confidence.

Leveling that supply?

Redfin CEO Glenn Kelman chimes in on the oversupply situation with an optimistic note, saying that there are "not enough pretty homes" out there, as much of the "shadow" inventory is dilapidated, low-quality stuff. Kelman, who runs an innovative online listing and brokerage service, has heard lots of complaints from buyers that there are not enough homes to buy. And in some cases, such as a recent example he told me about in the San Francisco area, bidding wars have erupted over desirable properties.

How do we reconcile all of this? With a bulldozer.

The fact is that much of the shadow inventory is probably a lost cause and will be razed. Back in December, I talked about how places like Detroit and Cleveland are leveling old, empty, unwanted homes to fight urban blight and help boost the value of existing, occupied homes. Watch for more of this as banks and local authorities realize that many properties are simply lost causes.

So maybe the supply overhang, after accounting for unsellable properties, isn't as bad as it seems. But it's still a problem.

Kelman believes that two separate markets have developed, one for bank-owned or "short sale" distressed properties and one for nondistressed units. The banks are in a race to the bottom with their units as they try to unload what they have before the ravages of nature and vandals erode whatever value is left. But for the "pretty" nondistressed units, Kelman thinks that sooner or later an absence of high-quality inventory is going to "stabilize prices in some segments of the market."

But first, it appears that the prices of these "pretty" houses are set to fall a little more, say Morgan Stanley analysts. The team, led by Oliver Chang, is looking for home prices to fall around 10% this year before finally bottoming. This is based on recent observations that much of the renewed weakness in the housing market is being driven by nondistressed homes. Their research shows that distressed property prices have largely stabilized over the past 12 to 18 months.

Analysts at Capital Economics are also predicting a 10% fall.

It appears that owners of high-quality homes are going to have to cut their prices to close the gap with bank-owned properties if they want to sell in this environment, at least until the supply of distressed properties dwindles enough that Kelman's optimistic scenario can play out.

Not bad for everyone

From the perspective of investors and landlords, the situation looks much different and much more attractive.

Cash buyers are becoming an increasingly dominant force in the market for distressed properties as financing gets harder to secure for potential owner-occupants. Not only that, but a steady drop in the homeownership rate has pushed down the rental vacancy rate as apartments and lease properties attract new tenants.

Rents are moving higher again as a result -- pushing up the earnings yield of investment properties relative to financing costs to levels not seen since the 1960s. That's creating a great profit opportunity for current and potential landlords. Paul Dales of Capital Economics wrote in a note to clients this week that over the next five years the rental market "will be a rare bright spot in the otherwise gloomy residential housing market."

As for when we could expect to see prices finally stabilize and move higher, Zillow's chief economist, Stan Humphries, believes that these cash landlords will play a critical role in getting the housing market to finally find a bottom. Next up would be second-home buyers and retirees. These are the kinds of buyers with the longest time horizons and the least sensitivity to price fluctuations.

Overall, Humphries is looking for prices to overcorrect to the downside as all the positive, bubble-era sentiment is painfully squeezed out. That, combined with improving economic fundamentals and a drop in the homeownership rate to historic norms around 64%, will be the green light indicating that the housing market is finally ready to heal.

But don't expect big home-price increases, much less a return to the heady days of 2005 and double-digit annual price rises. According to Humphries, we're not likely to see a "V"-shaped bottom where the rapid price fall is quickly reversed with a rapid rise on the other side. Instead, we're likely to prices bounce around the bottom for a few years in a "U" shape before moving higher at a more normal rate of a percentage point or two above inflation.

Mark your calendars: Zillow's brain trust, the guy behind those home price "Zestimates," is looking for home prices to start rising again as early as 2014. But clearly it's going to be a bumpy ride along the way.

For investors, obvious candidates would be the iShares FTSE NAREIT Residential Plus Capped Index Fund (REZ), which invests in residential real estate investment trusts. Individual REITs in the industry include Equity Residential (EQR) and Avalonbay Communities (AVB). I would add these to your buy list, but don't pull the trigger just yet.

As I've implored in my recent columns and blog posts, I think we're headed for a period of broad market weakness, and I've recommended that investors at the very least hold off on new purchases for now. When the time is right, I'll let you know.