During the past six months, the most common questions posed to Real Estate Economics are ‘has the market bottomed’ and ‘when does market recovery begin’.

Traditionally, the best leading indicator to new home market absorption and price stability has been a careful examination of levels of employment relative to levels of housing supply in California. This relationship, however, only covers half of the equation to market health. The other half deals with the long-term relationship between housing costs and incomes. This newsletter presents both relationships, and translates them to an index that leads changes in market direction by 12 to 18 months and, in effect, describes the timetable associated with risks and opportunities for California’s housing market.

The total number of jobs in a given region relative to the total number of homes in that region is known as the jobs-to-housing ratio, and it lends special insight to the economic foundation that supports housing sales and prices. When presented in index form where an index of 100.0 equals equilibrium, a jobs-to-housing index above 100.0 results in pent-up demand, while an index below 100.0 describes over supply. During recent months, the jobs-to-housing index has fallen slightly below equilibrium, as job growth has slowed in California in the face of high housing supply.

Though the jobs-to-housing index is important, it presents only half of the overall equation contributing toward market stability. In and of itself, the jobs-to-housing index is not sufficiently weak to describe the current housing market disruption. The other half of the equation deals with price support (or more specifically, mortgage cost support) relative to household incomes. When the actual mortgage cost-to-income index falls below the equilibrium line, housing values are considered overstated. When the mortgage cost-to-income index rises above the equilibrium line, housing values are understated. In recent months, the mortgage cost-to-income index has improved, but still suggests significant over pricing for housing throughout California.

By combining the jobs-to-housing and mortgage cost-to-income indexes, a Composite Index of Leading Indicators is created. As with the individual indexes, a composite index of 100.0 equals equilibrium. Anything above equilibrium represents relatively strong market opportunity, and any number below equilibrium represents market risk. The resultant Composite Index of Leading Indicators is summarized below:

Currently, the Composite Index resides below the equilibrium line, but the trend is toward the equilibrium line. By September 2008, the index will approach the equilibrium line, but will still remain marginally below it. As it approaches equilibrium, increasing opportunity will be evident for land purchases and housing construction. In effect, the window for land purchases is becoming increasingly evident in California, as long as land prices correspond with prices associated with the Composite Index at equilibrium.

This Composite Index implies that current housing prices must fall by a total of 13.8% from 4th quarter 2007 net price levels in order to fully reach equilibrium. This is a higher level of drop than our previous method of forecasting, but this composite index-based estimated is considered much more reliable than other measures. This continued drop may take more than 12 months, but if builders negotiate this drop into current land deals that correspond with current housing price levels, land purchase should be considered.

It should be noted that the above composite index leads market changes by 12 to 18 months. For example, the Composite Index in July 2006 effectively describes market conditions from the mid- to latter part of Year 2007. It should be noted that the Composite Index reached its lowest point during July 2006, and not surprisingly, we are now feeling the ‘pit’ of the market. It should also be noted that, once equilibrium is reached (projected to occur during 3rd/4th quarter 2008), equilibrium may not actually be felt until late 2009 or early 2010.

The Composite Index proved to be an excellent leading indicator to the massive real estate disruption that is currently being experienced in California. This index fell below the equilibrium line in 2nd quarter 2004, then approached equilibrium during the latter part of 2004, then began to trend steeply downward beginning in January 2005. Had builders and financial institutions heeded the index, many of the challenges associated with the current market disruption could have been avoided, as land positions should have been sold during Year 2005 (instead of purchased at top dollar) and price appreciation should have been avoided in order to enhance absorption levels before the disruption began.

The purpose of this Composite Index is to provide adequate warning of increasing risk, but also to provide strong indications regarding market improvements. Based upon the index above, the upward trend toward equilibrium suggests that, if land can be purchased at a price justified by home values that are 13.8% below the present level, the land purchase and housing development plans should be strongly considered. If homes are currently being sold at current market price levels, chances are that an 13.8% discount will be needed to begin to move inventory at an acceptable rate.

Reaching this supportable pricing structure via concession activity is considered ineffective, and reduces consumer confidence. The market will eventually be forced down to the supportable median value via actual price cuts as opposed to concessions.

During Year 2008 to 2009 relief from the current market situation will take place, and a move toward stabilization will develop. This stabilization will be due to the lower pricing structure that will be available to consumers (as prices continue to fall during the balance of Year 2007 and 2008), and due to the anticipated reductions in inventory as an abundance of builders carry out ‘fire sales’, and delay construction of new housing. Severe gaps in housing supply may become evident in select markets once the overhang in inventory is depleted, and as the market moves toward equilibrium.

This newsletter presents findings for the State of California as a whole. Various markets within California will react differently than the State level forecast. Real Estate Economics is pleased to announce the introduction of our Opportunity / Risk Report, available at the county level anywhere in California and Arizona, and available at the Metropolitan Statistical Area (MSA) level for anywhere in the United States. A sample of this report is attached to this email. This report is updated monthly, and is available now, by visiting our website, at www.realestateeconomics.com, or by contacting one of our sales associates below:

If you need assistance or technical training on how to analyze your specific market areas, please contact Jennifer Banks at (949) 502-5151 ext. 108 or at Jennifer.Banks@RealEstateEconomics.com.