Editor’s note: This is the second part of a two-part story looking at housing market conditions for 2006. To read the first part, “Best-case scenario for housing next year,” click here.

The scene opens on a devastated landscape, with the voices of a thousand wannabe homeowners crying out in pain. Congress has enacted limitations on mortgage-interest deductions; interest rates have hit 8 percent; creative loan products have been curtailed; investors have fled to the stock market and first-time buyers can’t afford a house.

At least, that’s the worst-case scenario for 2006, according to various possibilities suggested by experts and industry observers consulted by Inman News.

Though different folks painted the future with different strokes, one theme was consistent: interest rates will be the most important factor affecting the industry in 2006. And, though the sign of the beast is 666 in the Bible, the bad-luck number for mortgage interest rates is 8 percent, a number of experts said.

“If the (long-term) interest rate went over 8 percent it would impact the market,” said James Wright, president/principal broker of Century 21 All Islands in Honolulu.

“You tick the price up and make the monthly payment another $300, $400, and people who were marginal to begin with will be priced right out. The pool you’ll hurt the worst will be the first-time buyers,” Wright said.

A real estate analyst also evoked the 8 percent figure.

“At 6 and 7 percent we still see upward movement or, at worst, sideways-moving price projections,” said Michael Sklarz, chief valuation officer for Fidelity National Financial. “But at 8 percent, some markets have prices falling.”

Christopher Cagan, director of research and analytics at First American Real Estate Solutions, agreed with Sklarz. “Prices would start to decline. But I don’t expect that to happen.”

Indeed, not one member of the group expected interest rates to jump to 8 percent. Generally, the pundits expected rates to remain historically low in 2006, going no higher than 6 or 7 percent at most.

Exotic loan products such as interest-only loans also figured prominently in many experts’ worst-case scenarios. Some were worried about whether individual homeowners could handle the loans; others focused on investors.

“People with adjustable-rate mortgages, as long as their mortgage payment doesn’t go up too fast, they will probably do everything they can to hold on to their house,” said Delores Conway, director of the Casden Forecast at the University of Southern California Lusk Center for Real Estate.

“But if you have a speculator who took out an interest-only loan, planning to flip the property for profit in a short time, and the prices go down, they might just walk away from it,” said Conway.

“There’s a lot of homes and condos being built around the United States,” said Mark Dotzour, chief economist at Texas A&M University’s Real Estate Center. “The danger is that a large percentage of that demand is from speculators and investors. Those people can decide to start investing in Wall Street again, and demand can vaporize.

“In a town where demand from them is between 20 and 40 percent, you could end up with a massive amount of overbuilding,” Dotzour said. That could leave builders in a bad position, the economist said.

“Subprime loans to individuals with impaired credit histories opened up the market to help them afford homes, but at the same time if interest rates rise and their mortgage payments go up faster than their incomes, they will encounter difficulties,” said James Barth, senior fellow at the Milken Institute and finance professor at Auburn University.

One industry veteran predicted that exotic loans would be curtailed in 2006.

“The secondary market is tired of creative financing products and is starting to price against them,” said Pat Stone, vice chairman for Metrocities Mortgage, based in Southern California.

Another worst-case possibility for 2006: tampering with the mortgage-interest deduction, Wright said.

Wright was referring to the fact that the President’s Advisory Panel on Federal Tax Reform presented a plan to President Bush on Nov. 1, calling for replacing the mortgage-interest deduction with a more limited 15 percent tax credit, among other things.

The proposed change isn’t seen as a serious threat by many, thanks at least in part to the spirited defense mounted against it by entities including the National Association of Realtors and the National Association of Home Builders.

During the final months of 2006, as inventory grew and some parts of the country witnessed a slowdown, the question on everyone’s mind was, What about house-price appreciation? Are the days of mind-boggling price jumps over?

“The worst case scenario for home prices would be what everyone is screaming about – the so-called bubble would pop,” said Cagan. “I don’t think we’re in a bubble, though.” Cagan predicted a healthy normal market going up about 6-8 percent.

Folks used to the double-digit price growth seen in parts of states such as Florida, California and Nevada might see the experts’ home-price growth predictions as a worst-case scenario. “I would think price appreciation will be in the lower single digits in the United States in 2006,” said Sklarz. Industry veteran Steve Ozonian, CEO of Global Mobility, pegged home price growth at 5 to 7 percent.

Most of the experts said the moderating of house prices was a good sign, “a correction, not a catastrophe,” as Cagan put it. Even the overheated markets in Florida, California and Nevada aren’t in for a rude surprise, according to the experts, just a softening.

“The market is going to slow down,” said Stone. “Ten to 30 percent fewer homes will be sold. The best case is 10 percent fewer; the worst case is 30 percent fewer.”

***

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

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