Question from one of Matt’s readers:      “When should I start buying real estate again?  When will the market rebound?”

Matt’s Answer:          No one can tell you when the real estate market will rebound.  There is not one expert who knows for sure.  No one can accurately say that it will happen in early 2009, late this year or 18 months from now.  There are millions of variables, and no one can truly predict the future. 

However, I can tell you what will precede increases in market prices.   It is actually quite easy, and a trained eyed or observant student will know when things are getting better. 

If you have never studied economics, this article might not help you.  If you have never studied economics, do so.  Buy a book- Economics for Idiots or something akin to that.  Take an adult continuing education class.  Get your MBA.  I do not care how you learn about economics, but learn it.  Economics is that important.  There is a reason why micro-economics is a first semester class in virtually every business school and business program in this country.  If you are in business, you better understand economics.

Here is where economic study begins, with the supply and demand curves:

Supply has outpaced demand.  Cheap land.  Cheap credit.  Questionable lending practices.  Low unemployment.  Low inflation.  These and other factors contributed to irrational exuberance in home construction a few years ago.  As the supply curve for homes shifted (to the right from S0 to S1), the price of homes dropped and the quantity increased.  It is, frankly, that simple.  We have a huge number of homes on the market.  There are more homes than people.  Central Indiana, where I live, is no exception.  In Marion County, Indiana, the number of new building permits in the past few years far exceeded Census data showing population growth during the same period.  Literally, builders built more homes than people to live in those homes.

Kaboom!  The bubble burst, and credit for home buyers became more difficult to acquire and more expensive.  All of a sudden, that excess inventory of homes became a big problem.  But, you cannot shift the supply curve for houses without purchasers or fires or floods or something else to shift the curve (to the left).  There are only two ways to increase prices.  Either demand increases, or supply decreases.  So, existing homes must be destroyed somehow, or someone buys some of them.  The former would shift the curve, while the latter might only constitute an increase in the quantity demanded.  Prices would remain low, below the original equilibrium price, until demand increased significantly.  In either event, prices would increase, and the excess inventory would be absorbed to some degree.

What would shift the demand curve to maintain high quantities and higher prices?  The only thing I can think of is more immigration.  If we changed immigration policies and allowed millions to move here (assuming they had cash or credit to buy homes), the demand curve would shift such that high quantities and prices would result.  As that is not likely to happen any time soon, this is going to be a slow recovery.  And, the only way for prices to increase without maintaining high inventories is for supply to shrink.

There is another way, of course.  We could return to the days of really cheap credit, low loan standards, high appraisals (based on the theory that real estate prices always rise), etc.  That’s what got us in this mess, but it may be the only solution.  We need more buyers in the market, and we need to create incentives for buyers to reduce existing inventories, before we encourage more new home construction.  The stimulus bill that Congress just passed does not create the right incentives for buyers to take up existing home inventories.

So, how will you know when prices have reached the bottom and will start to rise?  That’s easy- when the excess inventory starts to drop for one or more reasons.  Let’s not hope for a flood.  Rather, let’s hope that more buyers enter the market.  If interest rates stay low, and unemployment levels, the inventory will start to be absorbed.  That is, unless builders start saturating the market with more house again.

So, watch the inventory.  Traditionally, prices follow reductions in inventory six months later.  In other words, when inventory consistently and significantly drops for periods of six to nine months, prices rise six months in arrears to that trend.  So far, inventories across the nation and in Indiana especially remain at historical highs.  Many economists believe we have 11 months of inventory right now, without another home being built.  This assumes no dramatic changes in market conditions- interest rates, employment rates, etc.

Again, keep watching the inventory numbers.  I personally plan to start buying when I see consistent drops in inventories over a period of months.  That is when I will know that price increases will follow.  If home builders react by flooding the market with inventory, we will be right back here again.  The perfect solution is slow building growth for 12 to 18 months with a modest rise in interest rates to discourage builders from saturating the market.  That will be a slow process, however.  Until then, consider buying rentals.