One simple rule that every student of introductory economics understands is that a product that has more demand than supply will typically push the price up.  The recent stabilization in housing prices has given the impression that the housing market is correcting on its own.  Nothing can be further from the truth.  There are three primary reasons why housing seems to be stabilizing in the current market:

1.  The $8,000 tax credit

2.  Federal Reserve buying mortgage securities and keeping the overall interest rate artificially low

3.  Shadow inventory being held off market giving the appearance of a smaller inventory

Combine these three powerful forces and you can understand why there has been a slight stabilization in the housing market.  Yet this is extremely deceiving especially in a state like California. First, let us look at some data from the Case-Shiller report put out on Tuesday:

What you will notice is that yes, prices have seemed to tick up according to this chart.  Yet overall, prices are still falling.  So what gives?  You need to understand how the Case Shiller operates.  This index looks at repeat home sales.  So let us run a hypothetical example.

-Homeowner buys home in California for $200,000 in 1999.

-At one point in 2005, home is valued at $500,000

-Homeowner needs to move and sells home in 2009 for $300,000

Did the homeowner make money?  Of course.  Does the actual chart reflect this change?  It doesn’t.  The Case Shiller is the best indicator of market trends but it does have its flaws.  The recent uptick reflects the convergence of the three forces of tax credits, shadow inventory, and low mortgage rates.  All of these are artificial injections into the market and can’t be held together forever.

Consider the overall mortgage rate.  In many cases people can get mortgages for 5 to 5.25 percent.  This is much below the historical trend.  In fact, looking at 40 years of data the overall 30 year rate is closer to 9 percent:

The problem with setting up the current precedent is that it front loads the market to the short term.  Say you buy a home with a 5 percent mortgage rate.  But what happens if mortgage rates go to 8 percent in a few years?  Unless fundamentals in the actual economy change the future buyer of your home just lost a massive amount of purchasing power.  The difference between a 5 percent mortgage and an 8 percent mortgage is gigantic.  Look at the principal and interest difference between these two for a $400,000 mortgage:

$400,000 @ 5% 30 year fixed PI:                 $2,147

$400,000 @ 8% 30 year fixed PI:                 $2,935

This is a significant difference especially when many mortgages are being backed by government loans that adhere to strict debt to income ratios.  What is being missed in all this discussion of housing prices is one pivotal point regarding jobs and income.  The current increase in price is due to government subsidies and not an improvement in the economy.  What this tells us is the general move of prices is temporary and not long lasting.

If you have any doubt of this temporary move, then why would those in the real estate industry keep pushing so hard on an extension on the tax credit?  They realize that most of the movement of the current market is sponsored by the government.  But you have to look at incomes as well.  The mid tier and upper tier of the markets are still extremely over priced in California.

Here is a look at the California median home price over time:

Now this is a fascinating chart because it shows how big the bubble got during the boom.  The fact of the matter is, the median family income in California still can’t afford the median priced home.  However, much of the data is distorted because the mix of sales.  That is, many of the homes that sold over the last year happened at the lower end of the market thus misrepresenting the median price.  So although the median price is down, it is a reflection of the massive amount of foreclosure resales.  In the mid to upper tier of the market prices remain stubborn on the downside.

That will change as more and more shadow inventory makes its way to market in 2010.  There is simply no other way around it.  Many of the Alt-A loans, those made to “better income” borrowers occurred in more expensive areas.  When these hit recast dates, a new inventory surge will hit the market and a simple rule of economics will play out.  That is, more supply equals lower prices.  There is no way around this fact.

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For many prudent prospective home buyers, many who have saved diligently for years, many are licking their chops to purchase a home in California.  But let us be honest, most are looking to purchase in selective markets like Marin County or parts of the Westside here in Southern California.  They hear about the 50 percent median price drops and overlay this statewide data to niche markets.  Yet most of the sales are occurring at the lower end.  This is a given.  But how does this look if we really break the data down?  I pulled the recent DataQuick data for August of 2009 for Southern California and broke out the price segments:

Now I think this data is extremely important in helping to dissect the current home selling trends in Southern California and for the most part, other areas of the state.  The lower end of the market, homes priced under $300,000 seem to be moving at a brisk pace.  Yet once you move over that point, things change.  In fact, 53 percent of all homes sale occurred under the $300,000 point mark.  Out of 4,168 single family homes sold, over 2,000 came from the lower priced region.

There seems to be a bit of frustration by people who have sizable down payments and look at regions that have resistant price drops.  It isn’t so much that prices are resistant, it’s just that there is a number of buyers who are capitulating at a time when California will see a second leg hit in 2010.  Interestingly enough more of the problems are going to occur on the over $300,000 market.  But let us look at some affordability calculators here.  Since the government is backing most mortgages and subsidizing purchases with tax credits, let us see what a family can afford according to Ginnie Mae.  I’ll run the numbers for a family making $150,000 a year, with $200 of credit card payments per month, and a $300 auto loan:

Here is the problem.  With a $150,000 income a family can afford a home within a $350,000 to $360,000 range.  This is assuming they use a FHA backed loan which for Southern California, made up 37 percent of all loans for last month.  But notice the conventional side of the equation?  If they have a down payment of $85,000 they can buy a home up to $569,000.  But look at the total housing cost.  For this borrower they will be spending $5,300 a month on their overall home payments which include principal, interest, taxes, and insurance.  This is assuming only $500 in other expenses and the family having over $100,000 to close on the deal.  And you wonder why the higher end of the market is stagnant.

So how were buyers able to buy expensive homes in the past?  Usher in the era of the interest only, option ARMs, and other mortgage products that artificially gave the buyer massive leverage that is now putting many in trouble.  Just run a scenario.  A couple that pulls in $150,000 now loses a job in California.  Not unlikely with 12.2 percent unemployment.  They were already squeaking by if they have a $600,000 mortgage so the income might fall by half.  But the payment is actually going to go up either with a reset or more likely, a recast in more expensive areas.

But go back to the scenario above.  All someone would need to buy a $365,000 home with a FHA backed loan is about $14,000.  That is a large amount of leverage still.  You would hope that banks are at least adhering to strict underwriting guidelines required by FHA and their front end and back end ratios (31 to 38 percent).

The above also explains the stagnant mid to upper tier market.  People can still buy as long as they have the adequate income to back it up.  But don’t expect a flurry of people to jump on all these homes and certainly don’t expect prices to zoom back up.  The economy in the state is already putting a cap on that.  The amount of leverage is simply no longer in place.  We are really heading back to a more traditional market but we have years of pending foreclosures that will work their way through the system so our market won’t be “normal” probably for another 5 years or so.

So how much home can you afford?  As a rough rule about 3 times your gross annual income for a mortgage.  So someone making $100,000 can buy a $300,000 home and still have safe wiggle room.  But many of these people when I speak with them have their eyes set on $600,000 homes.  This is the same logic that went with the housing bubble.  They cannot afford these homes.  And given the troubled loans in the mid to upper tier, I won’t be surprised to see a 10 to 15 percent drop in the next few years which in many cases will wipe out 2 or 3 years of you saving up for a down payment.

You also want to assess how secure your position is.  Are you seeing hours cut?  Will you downsize from two incomes to one if you plan on having a family?  Sometimes people ignore these important questions.  So right now California is still seeing pockets of the bubble but homes that are priced right are moving.  Yet many people have beer budgets and champagne taste.

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