Housing Bust Not Over Yet

The housing slump has everyone on edge -- from home buyers to home sellers to investors. Unfortunately, it's for very good reasons.

On nine occasions since 1960, the U.S. has experienced a decline in residential construction from one year to the next. Seven of those declines were accompanied by recessions, reports James Stack, president of InvesTech Research in Whitefish, Mont.

We're now in the midst of the tenth such decline. What's more, this one is a doozy -- and it keeps getting worse. "Economists and government officials have underestimated its size and duration every step of the way," Stack warns.

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Housing starts fell 10.2% in September, hitting their lowest level in 14 years. Standard & Poor's projects the decline in home construction to register its worst reading in the first quarter of 2008 at 20.8% lower than the same period in 2007. S&P doesn't see home construction increasing from the year-earlier period until mid-2009.

By the time the housing bust ends, the median price of U.S. homes will have tumbled 11% from the 2005 peak, says David Wyss, S&P's chief economist. We're not even halfway there yet. Wyss says the bottom will come in the first half of 2008. Some economists are even more pessimistic.

Personally, I'm surprised that stocks have held up so well amid the abysmal housing news and the concerns that it will spook consumers. Even more surprising to me is that real estate investment trusts (REITs) haven't fared worse.

REITs -- commercial real estate companies that must pay out almost all their profits to investors annually -- have dipped just 4% this year through October 31. That follows prodigious, multi-year gains, not unlike those experienced by home owners. The Vanguard REIT index fund, which lost almost 3% in the first ten months of 2007, has still returned an annualized 22% over the past five years.

The commercial real estate market and the residential housing market, of course, are different animals. But they are closely related species. Both rely heavily on borrowed money -- and borrowing money has become more difficult and more expensive. And both sectors experienced booms all out of proportion to reality.

Bottom line: I'd avoid REITs and funds that invest in them until they're much cheaper.

How to tell the bottom

Usually I limit my recommendations to stocks, funds and other similar investments, but I'd like to weigh in on what, for most people, is their biggest investment -- their homes.

Given the current real-estate slump, what should you do if you're thinking about selling a home or buying one? Unless you can wait several years to sell, I'd go ahead and sell now. If you've been in your house awhile, you'll likely still end up with a tidy profit. And if I were a prospective home buyer, I'd wait.

There has never been a nationwide decline in housing prices before. But there have been 21 regional declines since 1978, according to the Federal Deposit Insurance Corp., which defines a bust as a decline of at least 15% over a five-year period.

Busts tend to play out over a number of years. So if you buy near the top of the market, it could be years before you break even. Price drops tend to be protracted because most homeowners are reluctant to sell at a loss. Thus, they wait, sometimes for years, before throwing in the towel.

There's a silver lining to this cloud -- if you happen to be a prospective home buyer. Once the market finally hits bottom, it tends to stay there quite awhile. Thus, you can usually recognize the end of a decline simply by the fact that prices stop falling and stagnate. That's the time to buy. For now, you should wait.