What's Next for Home Prices

If you're a homeowner who pays attention to news reports about the housing market, you should be in a cold sweat. Recent headlines announced the first year-over-year drop in existing home prices in 11 years. A report from Moody's Economy.com predicted that home prices would decline in 2007 for the first time since the Great Depression.

Our advice to those who are worried about falling home prices: Relax. In 2006, the housing market continued a search for equilibrium -- the balancing of demand with supply -- and that will continue into the new year. In many cities where home prices reached the limits of affordability, prices have dropped from their peaks and have a bit more room to fall. But in many other cities, prices continue to climb.

Our home prices tool shows price changes for existing homes in 360 metro areas as of the end of 2006. As sellers become less stubborn and lower their asking prices, median sale prices for existing homes nationwide will continue to settle down. Expect an increase of about 2% for all of 2006 but a slight decrease -- as much as 3% -- for 2007, skewed by more precipitous declines in once-hot markets.

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But look at it this way: On average, the annualized increase in existing-home prices over the past five years is 5.4% -- and more than twice that in hot markets in California, Nevada and Florida. The rate of home-price appreciation in the U.S. over the past 20 years is about 4.8%, according to the National Association of Realtors. Assuming you didn't buy at the market peak, your recent returns have been ahead of the historical average.

Sales take a hit

According to the NAR, the number of home sales peaked early in 2006 and then began a gradual slide. Prices peaked a couple of months later. Buyers have been cautious because of uncertainty about mortgage rates and because they were worried that they might be buying at the top of the market. And sellers have been reluctant to trim asking prices. By September, sales of existing homes had fallen 14% from a year earlier, with a 24% drop in the West. The number of homes on the market gradually rose to one-third more than in 2005 but appeared to plateau this summer. And by September, prices finally fell -- by 2% nationwide. Single-family-home prices took the biggest hit in the Northeast, where they were off 7% from a year ago.

Homebuilders also started cutting prices aggressively in early fall and offering incentives, such as flat-screen TVs and granite countertops, to move their homes. The average incentive package is now about 5% of the purchase price. Overall, new-home prices decreased slightly in 2006 but should stabilize in 2007. Sales of condos fell even harder because of overbuilding, fleeing speculators and first-time buyers waiting for price cuts on single-family homes -- their preferred choice. In September, "months' supply" -- how long it would take to sell all the condos on the market -- had risen from 5 months to 8.6 months from the year before, and prices were off 3%.

The decline in prices nationally may seem small given the slowing market, but low mortgage rates eased the slowdown, says Bill Hampel, chief economist of the Credit Union National Association. Eventually, as many sellers decide to wait for a better environment, the number of For Sale signs will decline and the market will reach a balance between buyers and sellers.

Ups as well as downs

Often ignored amid the boom-and-bust areas on the coasts are cities where price increases keep chugging along. Charlotte, N.C., is a good example. The metro area has enjoyed a modest 18% appreciation over the past five years, or 3.4% a year, and there's no evidence of a slowdown. The median home price, at $152,000, is still below the national median and has room to rise. A growing number of affluent home buyers are relocating to this thriving financial center from higher-priced areas. Irv Schwebel, an agent with Prudential Carolinas Realty, says he was busier in 2006 than in 2005.

Among his clients are Jeff and Marnie Sagraves. Eager to buy a newly built home, they were confident that they could sell their home in Weddington, an area of former horse farms and wooded byways 15 miles south of Charlotte. Because the area is growing rapidly and has highly regarded public schools, they believed their four-bedroom, three-bath home was realistically priced at $420,000. Sure enough, after ten days on the market, their house got a bid of $410,000.

The Sagraveses have since moved into a new, 4,350-square-foot French-country-style home several miles away, with a home office for Jeff and room to accommodate their growing family. To get it, they had to pay $3,000 more than the list price.

It's different in the Virginia Beach, Va., metro area, where prices rose 89% over the past five years, or 13.6% a year. Sales in September were down 15%, inventory was up 76%, and prices were down 9%. On a driving tour, local Long Foster agent Vicky Schiano points homes for sale and says, emphatically, "A year and a half ago, that would have sold in a minute."

One client of Schiano's firm, Amy Jones, a newly remarried mother of two, listed her home for sale in October, after trying to sell it herself since last spring. It's priced at $395,900, about $4,000 less than comparable homes in her neighborhood. Currently carrying two mortgages, Jones says she's willing to take $380,000. "I'll still be making money because I've had it for so long," she says. Schiano says her current challenge as a broker is to help buyers winnow down "almost overwhelming" choices and to help sellers differentiate their home from the forest of competition.

What's ahead

In 2006, the bottom 50 metro areas in terms of price appreciation were midwestern cities that had taken a hit on jobs -- many related to the auto industry. In 2007, the bottom-50 list will be overrun by formerly booming metro areas in Florida, California and other parts of the Southwest, predicts Global Insight, the Boston-based firm that supplies our home-price data.

Global Insight forecasts that more than 60 cities across the nation will see falling prices in 2007. Of the nearly 300 cities expected to have price increases, the highest will be a modest 7% in Bend, Ore., which is seeing an influx of new residents from neighboring California. Other cities on the healthy list include Brunswick, Ga., Hot Springs, Ark., Florence, S.C., and El Paso, Tex., all of which saw only moderate appreciation over the past five years.

Jim Diffley, a managing director of Global Insight, says that his firm's forecast of stabilizing home prices in the coming year is a middle-of-the-road approach. "There could be an overreaction downward just as there was one upward," he says. "But the market shows no signs of falling off a cliff." Prices in some cities have gotten ahead of incomes and economic growth, and this is the year to play catch-up.

Rates edge up

Interest rates on 30-year fixed-rate mortgages peaked at 6.8% in July 2006 and closed the year at about 6.4%, according to Freddie Mac. ThatÕs the highest rate since 2002, but itÕs still near historic lows. The Mortgage Bankers Association forecasts that rates will work their way up to 6.7% by the end of 2007.

Adjustable-rate mortgages offer a slim advantage over 30-year fixed rates: just three-fourths of a percentage point on the average one-year ARM and one-fourth point on a five-year hybrid ARM, which has a fixed rate for five years and then reverts to a one-year ARM. Even so, ARMs account for over one-fourth of all mortgages. Interest-only fixed-rate loans and option ARMs, which allow you to choose how much you pay each month, havenÕt lost popularity, either.

The prime rate is stuck at more than 8%, pushing up the cost of home-equity loans and lines of credit. Because first mortgages remain well under 7%, many refinancers who need extra funds are taking cash-out mortgages, according to Freddie Mac.