Pacific Northwest Real Estate

Home prices in the Greater Seattle Metro Region decelerated to a single-digit rate of appreciation in the second quarter of 2007. Though still considered strong, the local market has lost its momentum. With job gains continuing at a robust pace, home prices likely will continue to be in the positive territory. A sharp reduction in new home construction will help control the overall inventory situation. Resetting loans and the rising number of foreclosures related to the subprime fallout are clearly negative factors, but the impact will be offset by the fundamentals of the healthy local economy.

Despite some media reports of the worst housing market conditions since the early 1990s or since the Great Depression, the recent home price declines have been negligible at the local level. Unlike past local housing downturns, which were accompanied with severe job cuts, the local economy continues to add jobs. Apartment rents have been rising at the highest pace in five years, which will begin to encourage some renters to seriously consider ownership. Mortgage rates have also been falling recently and stood near a historic low of 6.5% for prime borrowers. Rates could be even more favorable in upcoming months as the Federal Reserve cuts the federal funds rate in late 2007 and in 2008 as there are clear signs of contained inflation. A revival in FHA loans, which had lost substantial market share to the risky subprime market, will provide funding for low-tomoderate income households at much more attractive mortgage rates. If a modernization of FHA loans is implemented including lower initial payment requirements, higher loan limits, and risk-based pricing then there could be a surge in FHA loan usage.

The outlook is positive. Homebuilders having drastically cut production will help minimize prolonged oversupply conditions. Further production cuts by builders, which is encouraged, will help the market to more quickly return to a healthy state. On the demand side, job gains have added to the number of potential homebuyers. Historical relationship imply roughly one additional homeowner for every two additional new jobs. Since the peak of the housing market two years ago, the local market added 109,000 net new jobs (August 2007 vs August 2005). A rise in home sales and a strengthening in home prices appear immiment.

The home price forecast in the local region will vary depending upon alternative assumptions regarding

mortgage rates and the sustainability of mortgage debt levels. Prices could climb 7.4% in 2008 (Path 1) if mortgage rates remain relatively stable at around the current 6.4% in 2008. The price increase largely comes due to the rise in income (assumed to rise at the same pace as in 2006) while mortgage rates remain stable. The current mortgage debt servicing capacity is assumed to remain at the current manageable level given continued job gains. If jobs are cut, then one assumptions to consider would be falling mortgage debt servicing capacity - but this case is not considered here.

If debt servicing capacity steadily returns to the historic average level then prices are expected to rise at a slower pace (Path 2). The next two scenarios show outcomes based on whether mortgage rates turn more or less favorable. Prices will likely decline in 2008 if mortgage rates rise to 7.5% next year from the current 6.5%. With the Federal Reserve ready to cut the federal funds rates, it is difficult to foresee such a rise in mortgage rates, however.

The above mortgage rate forecasts are well within the range of credible Wall Street and government economic forecasts. As to the mortgage debt capacity, it would be unreasonably pessimistic to say that local households have already stretched to the maximum in the past year - and now need to fall greatly from the historic average levels.

There is always a possibility, however small, that the economy could suddenly turn for the worse. Oil prices - assumed to remain at around $70 per barrel for most of the next two years - are always a wild card. The weakening of the dollar or changes in foreigners' appetite for holding onto dollar-backed assets, including mortgage-backed securities, could suddenly and measurably push interest rates much higher. Also, homebuyers' confidence could remain weak despite solid gains in jobs, income, and wealth. In such cases, home prices could weaken measurably from what is assumed in the above cases.

Many analysts who have called for a major housing market correction often point to the disconnect between income and home price growth in recent years. This local market is one where home price growth outpaced income growth.

However, such a reliance solely on price and income growth is inapproriate. For a homebuyer, what is relevant is not home price in relation to income, but rather the mortgage payment in relation to income. Since 1990, interest rates have generally trended down, thereby permitting more purchasing power with the same level of income. Furthermore, the fees associated with taking out a mortgage have fallen from about 2% to less than 0.5%. As such, any home price analysis needs to taken into account the lower overall mortgage borrowing costs.

A more important factor for assessing the risk of a home price bubble is the median mortgage servicing cost relative to median income. As shown below, mortgage servicing costs have been trending only slightly above the historic average. Such a condition implies a manageable financial mortgage debt load for homeowners in the region on average.

Another key question for the Seattle market is whether or not the current debt servicing cost can be sustained or if it will trend higher over time. Perhaps, due to the fast changing nature of the local market, in terms of job growth, land prices, the dwindling supply of developable land, international buyers, or even the less tangible "vibrancy" factor, the mortgage servicing cost now should be higher than the historic average. The local area is active in cultural performance and is close to many outdoor recreational activities. The sustainable debt servicing cost could, over time, reach to a level comparable to that of San Francisco, for instance. In such a case, prices could make a significant gain over the next decade.

Price differentials among local markets can exist for prolonged periods due to many factors (including those difficult to measure). Measurable factors like income, housing shortage, job growth, and foreclosures certainly play a role. But, intangible (non-measurable) factors like the quality of life, water views, city vibrancy or quietness, cultural amenities and zoning laws also impact home prices. San Francisco has always been one of the priciest markets in the country. As such, it also has a higher debt servicing cost capacity. It would be naive, therefore, to categorize San Francisco as overvalued based solely on side-by-side comparisons with other markets. It is more appropriate, in our view, to take higher-than-average debt capacity for markets like San Francisco as a fact of life. What matters is how that debt capacity changes in relation to its historic average and not in relation to other markets. Though not shown here, top international cities like London, Paris, and Tokyo have cost burdens higher than nearly any U.S. city.

The question for the local market is whether or not the city should be commanding a higher premium for the higher debt capacity than in the past. If so, then home prices could increase strongly. If not, then the local debt service cost could just revert back to its historic norm, in which case, home price growth will still be solid over the next few years.

The local job market is very important in supporting housing demand. At the same time, changes in housing supply can quickly upset the market balance. It is, therefore, critical to monitor the housing demand and housing supply factors to assess if the local market is trending to a tighter or looser condition.

Fortunately, job gains have continued. In the past 12 months, 57,600 payroll jobs were added to the local economy. Such a job growth gains should provide underlying support for housing in the local area.

On the supply side, there has been a marked reduction in new home construction in the past year. A drop in new housing supply helps prevent prolonged oversupply conditions.

Zooming-in on construction activity from January 2006 to current shows a significant supply reduction. More jobs were added than new single-family homes were constructed in the past 12 months. Such conditions are favorable for future home price growth. A similar picture emerges if viewing on a longer 3-year basis. Because of the job losses at the early part of the decade, the trend is less strong if viewing over a 5-year cycle.

Sales activity has been down significantly, but home prices have largely held on in the Seattle market. The local economy is quite strong and is generating jobs at a respectable pace. The national economy is also fundamentally sound due to rising exports and business spending. Consumer spending will be a bit weaker because of stagnant home price and its accompanying wealth impact. One interesting observation is that the continuing low mortgage rates have not led to more buyers - implying that there is an issue of confidence, or lack thereof - in the homebuying decision. Also, the recent subprime fallout is a concern, though the shakeout will be good for the housing market over the long-run as the market eliminates bad mortgage lenders.

Inflation appears to be contained. Both the headline and the core consumer p