Are Local Home Prices Destined to Tumble?

Are California’s astronomical home prices likely to continue falling?

They are indeed, says an intriguing new report from a University of Michigan real estate expert.

In fact, says Dennis R. Capozza, a professor of finance and real estate, four of the five most over-inflated markets in the country are in California, despite recently declining prices.

“Right now, the West Coast cities are showing up as very, very risky,” he says. “I wouldn’t be buying in those cities.”

The interesting thing about Capozza is that he doesn’t just restate the obvious, which is that prices in, say, San Francisco are sky-high.

Instead he’s developed a model that predicts with reasonable accuracy what major-market real estate prices are likely to do in the years ahead. It takes account of city size, demographics, mortgage rates, construction costs, personal income, climate, amenities, growth controls and other factors to determine “normal” prices for each locale.

Capozza’s theory is that over the long term, three to five years, prices tend to move toward this norm. “We view the real estate cycle as reversion to long-run equilibrium,” he writes.

The model hasn’t done badly. Consider Capozza’s 1985 risk index, which related actual prices to “normal” ones. Four of the five cities with the highest risk rating had inflation-adjusted price declines within five years. New York, the exception, saw prices tumble a bit later.

By contrast, eight of 10 “safe” cities--those with the lowest 1985 risk index--had inflation-adjusted price increases within five years.

Capozza’s latest model, which uses figures from the second quarter of this year, finds that about two-thirds of cities fall within the index range of -1 to +1, meaning that homes in those cities are relatively close to their “normal” or expected price.

For California, the model predicts tremors. San Francisco, with a risk index of 4.0, and Orange County, at 3.9, are wildly overpriced. Prices are likely to fall in those places by 1996.

Los Angeles, also badly overpriced, ranks third at 2.9. “The risk index for Los Angeles has almost tripled since the first quarter of 1990,” Capozza said in July, when figures for the first-quarter of 1991 showed Los Angeles residential real estate to be slightly safer than it is today.

Hartford, Conn. came next, followed by San Diego at 2.4.

In many respects, Capozza’s projections are good news for California. High housing prices have been driving out business and talent. Houses themselves have become far too important as an investment vehicle compared to, say, stocks and bonds, which at least help fuel productivity.

California home prices--the median is $198,920--are already slipping and, coupled with lower mortgage rates, these have opened up the market, which is more good news. In its annual survey of second-quarter transactions, the California Assn. of Realtors said first-time buyers accounted for about 45% of sales, up from 37% in 1990.

Besides, who is this hurting? Much of the enormous run-up in California home prices is an unearned windfall existing for many homeowners only on paper. And if all prices fall, that covers the house you plan to buy as well as the one you own. Unless you just bought, you can’t lose.

But a sharp decline in home prices is no unalloyed blessing. Home equity is a source of capital--financial as well as psychological--that prompts homeowners to spend, invest and risk. This wealth effect would vanish if prices collapsed.

The state’s economy would find it that much harder to shake off its current doldrums, the worst in years. Foreclosures would probably rise and housing starts would flag. California financial institutions, many of whose loan portfolios are heavy with supposedly safe residential real estate, could be sorely tested. Some more might fail.

It needn’t happen this way, of course. Prices could decline slowly. In nominal terms--in other words, not adjusting for inflation--they might even rise, masking their true drift.

Capozza, a visiting scholar this semester at the Massachusetts Institute of Technology, says he expects that eventually the marketplace will provide a variety of financial instruments to let investors, lenders and possibly even homeowners hedge real estate investment risk in one region against real estate risk in another. Short-selling will be possible too.

Meanwhile, he says, falling prices aren’t the only way out. California’s economy could rev up and improve enough to justify its home prices. Then they needn’t fall at all.