Will Home Prices Continue to Fall?

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Home prices are down, but not out (Larry Downing/Reuters)

The news today is that the value of your most valuable asset is in trouble again. A report from website Zillow, which lets you look up what your house is worth, says that home prices in the US fell 3% in the first quarter. Worse, Zillow says housing prices could fall as much as 9% more by the end of 2011. And this was the year that real estate market was supposed to rebound. Instead, it looks like we are at the start of housing bust, part deux.

Not quite. Houses are more affordable than they have been in decades. That’s what has lead many to call the bottom in housing earlier than they should have. Indeed, the emphasis on affordability might be slightly misplaced. If you can’t get a loan, it doesn’t matter how cheap houses get. You still can’t buy. But that’s changing. And factors that do matter a lot to the housing market, like jobs, are improving. So while housing bulls were perhaps too earlier, the recent resurgence of housing bears are probably arriving too late. Here’s why:

To be sure, housing prices have fallen this year. But the Zillow numbers out today make the housing market look worse than it is. The problem is with how Zillow tracks home prices. Unlike other measures of the housing market, Zillow’s numbers are not based on actual sales, but on estimates of what its model thinks your house, along with every other house in America is worth. Zillow’s model is similar to how an appraiser figures out what your house is worth. It looks at past sales of houses that are similar to yours and then guesses what your house is worth. But by the time those sales are fed into Zillow’s system they are months old. Buyers and sellers agree on a price two to three months before the sale takes place. And then it can take another month or so before that sale is recorded and makes its way into Zillow’s system. To be sure, other housing price measures have similar problems. But in using its backward looking model to predict the future, Zillow’s is amplifying the problems with its methodology. If the housing market is turning, Zillow is going to miss it.

And the chances of a turn in the housing market are looking more and more likely. One of the biggest drivers of the record rise in housing affordability is the drop in mortgage rates. Indeed a report out from HSH Associates which tracks mortgage rates, shows that the rate on the average 30-year fixed mortgage at 4.99% is the lowest is has been all year.

So why hasn’t that lead to more buying? As I have pointed out before, interest rates don’t drive housing prices in the way people think they will. Nin-Hai Tseng is good to make this point on Fortune.com today:

In fact, contrary to what most people think, interest rates have historically had limited effects on home prices, according to a 2010 reportby Harvard University. The study looked at the 1.3% drop in real interest rates between 2000 and 2006 and found that it was attributable to only a 10% rise in home prices. At most housing markets across the country, prices experienced much bigger increases. Nationally, prices shot up about 30% during the period, with Boston seeing some of the biggest rise with a 54% increase.

“Interest rates are only a small ripple in the giant tsunami of the housing crash,” says Harvard University professor Edward Glaeser, one of the authors of the study.

The problem with housing prices has been affordability, it has been access to credit. But that appears to be changing. The latest bank lending report from the Fed shows that banks are willing to lend. Tseng is good to point out that despite that change demand for loans is not there yet from buyers. But that may be changing as well.

Studies show that far more than interest rates or affordability, the best indicator for housing prices is the jobs market. People buy houses when they are either optimistic about their own finances or optimistic that the prices of housing will continue to rise. We haven’t had either of those factor for a while. With the growing strength in the jobs market that looks to be changing.

David Berson, who is the chief economist at PMI Group, says his model shows the that chance of further housing prices declines has fallen rapidly in most places in the U.S. He says underlying strength in the housing market is being hidden by the number of foreclosures on the market. He says if you remove foreclosure sales from the data, housing prices for non-distressed homes have actually been flat for the past year.

Along with Zillow, Moody’s and Fiserv are out with their predictions of what will happen with housing prices this year. Those services are predicting that housing prices will fall 3% this year, not 12%. So if Zillow’s numbers are correct, we have already hit a bottom.