Editor’s note: The real estate industry is heading for big change in 2005. Experts once again are predicting slower home sales and easing price appreciation due to an anticipated rise in interest rates. In this Inman News forecast series, we attempt to get a clear picture of the industry next year, including what we can expect from housing numbers, who the industry should be watching and what the best and worst-case scenarios might be for housing in 2005. (See Part 1: The interest rate roller coaster ride; Part 2: Best-case scenario for housing next year; Part 4: What will happen in 2005? Part 5: 15 people to watch in 2005; and Part 6: Inman News Readers 2005 Real Estate Forecast.)

Real estate’s worst nightmare for 2005: The country would slip into a recession and the number of home loan defaults would spike, putting downward pressure on home prices overall. The U.S. also would over-commit itself abroad, leading to foreign investors no longer viewing the country as a safe place to buy real estate. Those investors would then choose to put their money elsewhere, having a “dramatic impact” on the real estate industry.

That was the scenario HomeGain CEO Richard Sommer painted when challenged to come up with a “what’s the worst that could happen” image.

In imagining a worst-case scenario for housing next year, experts and industry observers came up with a range of possibilities. Everything from politics to oil prices could impact the industry’s success, but the most recurring worry centered on a sharp rise in interest rates.

“The worst thing that can happen is a sudden shock in rates where they jump 100 basis points in the course of a couple months,” said Doug Duncan, chief economist for the Mortgage Bankers Association.

Some households would be priced out of the market altogether and others would need months to adjust their finances before being able to buy a house.

If rates were to reach 8 percent or 9 percent, the volume of home sales would be cut in half, said Pat Stone, vice chairman of Metrocities Mortgage. Stone doesn’t believe that scenario will come true and instead believes the housing industry will see another strong year in 2005. But he worries about the impact foreign debt may have on the market.

Under a worst-case scenario, the budget and trade deficits would continue to swell and the dollar would lose even more value against foreign currencies. Foreign investors would then pressure the market for higher rates on bonds. That in turn would push mortgage rates higher.

In the worst-case scenario, the value of the U.S. dollar would drop another 10 percent against the euro, pound, yen and gold, pushing mortgage rates up to about 7.5 to 8 percent, said Christopher Cagan, director of research and analytics at First American Real Estate Solutions.

Oil prices also would go through the roof. Such a drastic increase would raise inflation overall, and longer-term interest rates, such as those for mortgages, would rise, said James Barth, senior fellow at the Milken Institute and finance professor at Auburn University.

Not only would high oil prices drive up inflation, but it also would cause people to reconsider buying a bigger house, said Stephen Thode, director of Lehigh University’s Murray H. Goodman Center for Real Estate Studies. Instead, they might think about installing new home insulation.

Combine rising interest rates and a significant decline in job growth and you have Steve Ozonian’s view of the industry’s worst-case scenario. “Those two events would definitely slow everybody down,” said Ozonian, Bank of America’s home ownership executive.

Add inflation and a sluggish economy and that’s Mark Dotzour’s worst-case view of the housing industry next year. Dotzour is chief economist with the Real Estate Center at Texas A&M University.

Political risks also could bring about bad situations for the real estate industry.

The Bush administration appears poised to push for reform of the government-sponsored entities, including Fannie Mae and Freddie Mac. Several past attempts have stalled for one reason or another, but with more Republican support in Congress, the administration may have the will and support to make it happen, said David Lereah, NAR’s chief economist.

“We don’t know how that’s going to impact housing,” he said.

Experts have said any reform efforts of the two mortgage giants now are likely to be tougher than previous proposals because the Bush administration now appears ready to aggressively pursue GSE reform. Recent accounting problems and looming federal investigations at Fannie Mae also may spur more aggressive action.

Past reform efforts have included moving supervision of Fannie Mae and Freddie Mac under the authority of the Treasury Department, and forcing the companies to be subject to more of the same disclosure requirements other publicly traded companies must follow.

Another piece to a worst-case scenario for real estate next year involves the Bush administration’s commitment to a tax overhaul, which would include simplifying the tax code. Favorable real estate tax treatments could be changed, which could have a negative impact on housing.

“We worry about that because housing has been a favored sector when it comes to taxes,” Lereah said.

Bruce Norman worries about potential changes to the Real Estate Settlement Procedures Act, which governs industry kickbacks and payoffs. The real estate industry in the last decade has pushed the limits of the law in order to capture revenues from affiliated businesses with lending and title companies.

The Department of Housing and Urban Development, which polices RESPA, has tried to reform the loophole-ridden rules, but with no success. The department earlier this year withdrew its proposed changes after the industry responded in outrage. But Norman, president of First Mortgage Corp. in Diamond Bar, Calif., believes reform efforts will be back on the table next year.

“That’s sort of scary because people don’t fully understand it,” Norman said. “That could have a very serious impact.”

The original RESPA reform proposal would’ve changed the disclosure requirements for mortgage broker fees, including the controversial yield spread premiums. It also would’ve simplified the good faith estimate form and permitted the sale of guaranteed-price bundled packages of mortgages and mortgage-related services. The industry argued that such changes could seriously impact the competitive dynamics of the industry and cooperation among companies, and ultimately hurt the industry as a whole.

The original HUD proposal netted an unprecedented 45,000 comments, many from industry professionals in opposition to the proposed changes.

In another worst-case scenario, other political risks to the real estate industry could play out on more of a local level as city and county governments look to fill their coffers after a tough economic stretch. They could turn to property tax raises as a source of income, increasing the overall cost of home ownership, Thode said.

Beyond strictly political risks, a worst-case scenario would involve mortgage giants Fannie Mae and Freddie Mac revealing they have no money, Cagan said. Such a turn of events would surely impact the market since the companies enable a constant flow of funds for home loan borrowers, but it likely wouldn’t cause a collapse, he said. Instead, the government would bail out the two government-chartered corporations.

In the end, however, thinking up worst-case scenarios simply comes down to not worrying – too much – about factors beyond control.

“You just close your eyes and cross your toes and fingers and hope for the best,” Lereah said.

Send tips or a Letter to the Editor to samantha@inman.com or call (510) 658-9252, ext. 140.

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