Why the Housing Bottom Might Be Here

It might be time for reluctant buyers to tiptoe off the sidelines.

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Predictions can be risky, and downright foolish if you're trying to guess the direction of the wayward housing market. Yet thousands of potential home buyers are making bets every day on whether the housing bust is over, or only at an intermission.

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More and more, they're gambling that the worst is past. And it is in fact a gamble, because there's still some evidence that the rout in housing continues. The latest data on home prices, for instance, shows that prices have turned south again after an encouraging but brief rebound in 2010. Some economists even predict a "double-dip" in housing prices. Foreclosures are still near record highs, and they could get worse before they get better, thanks to the recent controversy over bank improprieties and a stall in foreclosure proceedings. Unemployment remains stubbornly high, meanwhile, and unrest in the Middle East is yet another reminder of the many things that can unexpectedly rattle the global economy.

Yet home buyers are tiptoeing back into the market, amid an increasing number of signs that the fifth year of the housing bust might be the last. Economists are watching closely for an inflection point at which the housing market turns upward for good. But for buyers planning to live in a home for years, precise timing matters less because they also need to take into account the direction of interest rates and their own personal need for housing. With flippers and speculators largely out of business, most buyers simply want to know that the home they buy won't plunge in value once they own it. In many U.S. cities, that now looks to be the case. Here are four reasons home buyers can feel increasingly confident that it's safe to step off the sidelines:

In some markets, homes are now undervalued. According to the Case-Shiller home-price index, overall prices nationwide have fallen 30.3 percent since peaking in 2006. In a few markets, like some Midwestern cities, prices have fallen only slightly, while in hard-hit areas like southern California, Nevada, Arizona, and south Florida, prices have fallen more than 50 percent. The question, of course, is how much further they're likely to fall. Moody's Analytics predicts a further national decline of about 5 percent in 2011, with a small overall increase possible in 2012.

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But locally, some areas are starting to look like a buyer's market. Moody's, for instance, says that homes are undervalued in many cities, based on the ratio of home prices to median income. That includes many Midwestern cities where unemployment is better than the national average of 9.4 percent, and even some of the biggest bust areas, where home values have fallen the most. Buying an undervalued home doesn't mean you'll cash in overnight, since prices often overshoot their natural trend levels and can take years to careen back toward equilibrium. But it does mean the fundamentals are lining up for a recovery and the end of the bust is in sight.

In a handful of cities, meanwhile, average prices could actually rise this year. Research firm Fiserv predicts that median home values will go up modestly in Rochester, N.Y., Spokane, Wash., Memphis, and about 20 other cities in 2011. In 2012, Fiserv expects prices to rise in more than 300 metro areas, with further declines in only 60 or so. If those predictions hold, most buyers in 2011 would see a bit of appreciation within a year or two—not enough to get rich on, but enough to make the purchase seem like a decent investment.

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Affordability is excellent. Falling prices, plus falling interest rates, have made homes more affordable than they've been in decades. The National Association of Realtors' affordability index, which goes back to 1970, is at the highest level it's ever been. The typical family today needs to spend just 13 percent of its monthly income to pay the mortgage on a median-priced home, compared with nearly 25 percent at the peak of the housing bubble, 20 percent in 2000, and 23 percent in 1990. The catch, of course, is that tight credit means a lot of people can't get loans, and if they can, the terms might require a bigger down payment than they can afford.

Lenders say they expect credit to loosen gradually over the next several years. But as that happens, interest rates, which are now near historic lows, will probably start to tick upward; economist Mark Zandi of Moody's says 30-year fixed rates could rise from about 4.8 percent now to 6 percent or so by 2012. Rising rates would make homes less affordable, but they could also be a catalyst that spurs ready buyers into action, lest they miss out on a deal that might not last. It would be ideal for buyers, of course, if rates and prices bottomed out at the same time. But that probably won't happen. And once it seems clear that rates are going up, smart buyers might be content to lock in a low rate even if they think prices could fall a bit more.

[See why low inflation seems high.]

Economic factors that affect housing are improving. Most economists believe the recession is over for good, with the risk of a double-dip fading rapidly. Consumers are spending again, and the economy is growing. Big companies have lots of cash and are in a good position to hire once business picks up. A rally in the financial markets is helping many Americans recover some of the wealth they've lost through falling home values. Household formation is returning to normal levels, after a period in which young workers doubled up, adult children moved back in with their parents, and divorcing couples put off the day of reckoning because they couldn't afford it.

Those trends all support increased higher demand for homes and new levels of home-building activity. In some areas, a huge inventory of foreclosed or low-priced bank-owned homes will prolong a housing recovery. But the foreclosure rate—which is closely linked to unemployment—should start to decline soon, since many of the riskiest subprime mortgages dating to 2005 and 2006 have already cratered. Since lending standards got much tougher over the last few years, mortgages issued since 2008 are far less likely to end up in default.

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The government will continue to support housing. With Republicans in charge of the House of Representatives, there's likely to be a lot of vitriol directed at two of their favorite targets: Fannie Mae and Freddie Mac, the wrecked housing agencies now operating under government control. Fannie and Freddie have turned out to be the biggest bailouts of all, costing taxpayers about $150 billion so far, a point critics are likely to make repeatedly during upcoming hearings on Capitol Hill. Many Republicans and other critics would like to completely dissolve the two agencies and end the government's controversial role in the housing market. Problem is, the government now dominates the market for housing finance, backing or supporting more than 90 percent of all new mortgages. So without Fannie and Freddie, most buyers would lack financing and the whole market would collapse.

Even the toughest critics of Fannie and Freddie know this, so despite their public calls for a private system to finance housing, it's likely the government will remain a key player in the mortgage market until at least 2013, after the next presidential election. And once policymakers figure out how to replace Fannie and Freddie, it will probably happen slowly, so as not to upset a delicate market recovering from trauma. So the sturm und drang over housing will probably continue, even as the storm itself finally passes.

Twitter: @rickjnewman