A bit over a year ago, I wrote an article for the E-Commerce Times entitled "Is the Real Estate Bubble About to Burst?" The article was written during a long run-up of real estate prices. At that time, it seemed that prices would continue to rise indefinitely.
In the article, I wasn't so foolish as to predict when the bubble would burst, or even that it would burst. I merely put forth what I felt were the major factors influencing real estate prices.
I received much e-mail 
regarding my article, some complimentary and some accusing me of being an alarmist for even writing on the subject. But, as of this writing, real estate prices, particularly residential real estate, have gone down a considerable amount -- 15 percent from their peak values and about 10 percent from last year, the largest drop since 1970.
Factors Influencing Prices
In my previous article, I mentioned that low interest rates coupled with high employment are major contributors to increasing real estate values. But a key factor limiting ever-increasing values is that personal income must keep up with rising real estate prices in order for the phenomenon to continue.
Listen to Ted di Stefano (7:53 minutes)Now, rising real estate prices have bumped up against the reality that many family incomes just do not support the higher prices. As a result, prices have gone down.
Granted, employment numbers are still good. And, though interest rates have certainly gone up over the last year or so, they haven't gone up too steeply.
So, what's happening to dampen the real estate craze? Mainly, prices have gone too high for existing incomes to support them. Family income has come nowhere near to rising as quickly as real estate values. Therefore, values had to come down.
The Variable Rate Trap
Many homeowners who took advantage of mortgage promotions were lured into the variable rate trap. They were given low introductory rates to begin with. These rates were subsequently adjusted as interest rates changed. Unfortunately, interest rates have gone up from a year ago, thus substantially increasing some borrowers' monthly payments.
This interest rate trap is squeezing many borrowers. What they thought was a good deal a year or so ago, has turned into a nightmare when their monthly payments increased beyond their payment abilities. Some borrowers have been able to make do by cutting expenses such as vacations, new cars, and other luxuries.
Unfortunately, this phenomenon tends to feed upon itself -- less money available to homeowners means less spending, which means a softer economy, which ultimately means less employment.
How Far Will Prices Decline?
Actually, no one knows that answer. But let's take a look at what elements could encourage prices to fall even further.
I'm sure you remember that a year ago, many lenders were fighting for your business. In fact, someone came up with the bright idea of the so-called "smart mortgage." This mortgage required no down payment with little or no interest payable for the first few years. Some mortgages actually called for no principal payments and no interest payments for the earlier years of a mortgage.
My fear has been that since so many people have taken advantage of these so-called "smart mortgages," they were particularly at risk if values started to fall. That put them in a position that bankers call "upside down" -- meaning that they owed more money on their mortgage than the house was worth.
This situation of being "upside down" puts tremendous pressure on the borrowers to not default on their mortgages. The fact is, if someone in that position were to sell his/her mortgage to pay off the debt, the proceeds would not be sufficient, thus requiring the borrower to come up with money at the closing of the sale in order to satisfy the bank.
Needless to say, many borrowers have not been repaying their mortgages because they feel that they are in a no-win situation. Consequently, defaults on residential real estate debt have gone up accordingly.
To add insult to injury, real estate prices have been coming down, thus creating more borrowers who are likely to default on their debts. This could become a spiral of defaults where many borrowers are put into the position of owing more on their houses than they are worth -- thus inviting a default.
Using Home Equity
Actually, the increase in mortgage delinquencies has been compounded by the fact that since home values seemed to be going nowhere but up, many homeowners started to use the equity in their homes for non-real estate purposes like buying a car, taking a vacation, etc.
This certainly helped our economy by pumping more money into it. But it eroded the wealth of many Americans -- the wealth that resided, excuse the pun, mostly in their homes.
Now the collective wealth of many Americans has decreased because they have squandered their major asset, their home.
What Will Fix It?
Actually the best we can hope for, in my opinion, is relatively low interest rates coupled with high employment. If this happens, the situation will correct itself faster than many have expected. If it doesn't, the situation will continue to deteriorate until a major correction occurs.
The fact is, there have been major corrections in real estate in the past. The most recent one occurred in the northeast in the late '80s and early '90s when real estate prices fell so steeply that many banks were put out of business because too many borrowers defaulted.
The bright side is that the values in the northeast have risen substantially since that crisis. Therefore, I feel that, like anything else, this correction in real estate values will be relatively short-lived before prices stabilize and even start to rise again.
Good luck!
Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at Ted@capitalsourcepartners.com.
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