How to Think about Real Estate Prices

I'm not very interested in predictions about how long the
current economic downturn is going to last. What I'm
interested is in the thinking behind the predictions.
Here's
what I think about the segment that started the downturn:
real estate.

My basic formula is that we'll see the bottom when
foreclosures have brought prices down enough so that it costs
as much to own as it does to rent.
That sweet spot gives
investors the incentive to buy rental property.

The first caveat is that, in a particular area, if there is a
lot of property in foreclosure, the prices can fall below the
formula
. The banks that own the foreclosed property might
just want to unload it, driving prices lower and lower.
However, if the foreclosures run through the system in a
fairly orderly fashion, the prices will go down until it's a
good time for landlords to buy property. Similarly, in some
areas that are very desirable right now or have very little
rental property, the prices may stay higher than the formula.

The second caveat: this formula works if there are no big bad
unexpected events.
Big bad events usually include a lot of
people dying, losing their jobs, or losing a lot of property.
GM going bankrupt was big and bad but not unexpected; people
knew that it might happen. The events that could affect the
recovery are events, like natural disasters, that are a
surprise.

With formula and caveats in mind, let's look at Chicago.
Readers in other real estate markets can follow the logic and
apply it to their own. In Chicago, we don't have some of the
factors that make the housing crisis so severe in other parts
of the country. We aren't suffering huge population loss
because of industry moves, like in Michigan. Also, people
don't tend to buy second homes, which have a higher risk of
abandonment and foreclosure than principal residences, in
Chicago. That's Florida and Las Vegas.

But the real estate market isn't a monolith here. The types
of buildings matter a lot right now. A recent story in the
Chicago Tribune details how Chicago two-flats (two story
buildings where you live on one floor and rent out the other)
have come down in price.
According to the Trib, now it's
worth it to buy with the intent to rent:
http://www.chicagotribune.com/classified/realestate/advice/chi-0628-two-flatsjun28,0,7127635.story

I wasn't sure if I believed it until a friend called and told
me about a two-flat she has her eye on. She's planning on
living upstairs and renting out the first floor. Financially,
it sounded like a great deal. So, using my formula, pricing
for two-flats could be at their low.

Condos are still facing problems right now, especially new
construction.
It's more difficult to get mortgages on condos
than it used to be. Lenders are more skittish about condo
associations and have tightened their standards considerably.
This American Life ran an episode with one Chicago condo
horror story.
http://www.thisamericanlife.org/Radio_Episode.aspx?episode=377

So, using my formula and caveats, it may take a while for the
condo market to get back to normal. The issue isn't price,
however, as much as availability of mortgages.

On the single-family home front, I was talking to my local
building inspector a few weeks ago in the near-western
suburbs. According to him, there are a lot of properties in
foreclosure in my suburb and even more in pre-foreclosure.
The foreclosure situation is worse than in many parts of the
metro area. This sounded like bad news. But when he told me
about a how much a neighbor of ours is renting his house for,
I did the math in my head. A light went off. Ah! The
magic formula was approaching. What the neighbor could rent
it for and the market price are coming together. If nothing
catastrophic happens, once the foreclosures move through the
system, things will probably turn around in this segment of
the market, too.

Does this mean I am suggesting you buy now? No. Don't buy
because you suspect that the real estate market may be around
the bottom. Buy if now is a good time for you to buy for
other reasons. And buy with your eyes open. While the
economic news has settled down for the time being, we are
still financially vulnerable. We need a lot of good news
before the recovery is really on its way.

Does this mean that the housing market in other parts of the
country have hit bottom? I have no idea, but I'm interested
in your thoughts! Enter a comment and let me know what you think.

by Bridget Sullivan Mermel
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