I think Mick Jagger might actually know a bit more about the housing market than our politicians. In case you can’t already see where this is going let me spell it out for you: “You can’t always get what you want but if you try sometimes you just might find you get what you need.” In this case what we need is for the housing market to clear and, unfortunately, that is not consistent with stabilized home prices, which is what everyone wants. And in this highly charged political season politicians want to give people what they want, not what they need. So we hear endless lamentation about how we are not going to solve our economic problems until we stop the decline of home prices and everyone is floating ideas about how to prop up the housing market.

No surprise that the NAR is also getting in on the action with their 4 point plan for government handouts to the real estate industry. More on that another day.

Unfortunately, all this is a bit like trying to build a city below sea level in the path of numerous hurricanes. Wait a second…don’t we do that also? The fact of the matter is that sooner or later nature has to take its course. Home prices have to seek their natural level. They expanded at above-trend rates and now they need to return to the trend line, which is a bit below where they are now. Driving this was an unnatural growth in home ownership levels above the norm of the last 40 years as demonstrated in the chart below from the Federal Reserve Bank of St. Louis.

It should be no surprise that during this period the affordability of homes declined.

Now, as the real estate market attempts to cope with these imbalances, we find buyers and sellers at a stalemate and transaction volume has dried up. Politicians can pull all the rabbits out of the hat that they want: tax credits for homebuyers, Fannie and Freddie support for the mortgage market, government purchases of mortgages, etc… However, they can’t stop the ocean from seeking the lowest level. Nothing will return to normal until prices return to normal. And normal prices will be a good thing. For instance, homes can once again be affordable for people with good paying jobs.

During the last 10 years or so the country made poor financial decisions to put too many people in their own homes and to build bigger homes than people really needed. Instead of investing in our infrastructure we invested in granite countertops and marble showers. So today we find ourselves with vacant homes, collapsing bridges, and roads full of potholes. If the government wants to stimulate our economy they would be better off investing in our infrastructure than in more homes.

Speaking Of Potholes

While perusing David Dalka’s Internet Marketing Blog the other day I noticed several links to sites for reporting potholes and even filing a claim for vehicle damage from potholes. Sounds like a great idea. However, I attempted to file a claim about 6 months ago using the process outlined on one of those sites after my car was nearly swallowed by a giant sinkhole. OK, maybe I’m exaggerating a little bit but I did blow a tire. After dutifully taking my pictures, attaching a receipt, filling out the form, and sending it in I’m still waiting. However, I wouldn’t let that discourage you. Maybe if they get enough forms in the mail they’ll have to do something about it.

We just launched a new, fun feature on our Web site where people get to demonstrate their real estate prowess with virtual dollars and also help us all get a better grip on home prices in the Chicago area. It’s called Price This Home.

This new feature was created based upon three simple facts:

1. When it comes to real estate everyone is an expert - or at least they think they are
2. A group of people can produce better estimates or answers than the average individual (that’s actually a fact)
3. Chicago homes just aren’t selling these days and it’s often because they are mis-priced

Enter prediction markets, which are sort of like futures markets - you know, where all those traders yell at each other about pork bellies. It is said that you can get a more accurate weather forecast for Florida by watching orange juice futures than you can by listening to the national weather service. Well, that shouldn’t be a surprise. After all the NWS is part of the government.

Participants in a prediction market buy or sell “contracts” with either real or virtual money based upon their outlook for certain events - e.g. who will win the presidency. The investment activity influences the value of the contracts, which represent the predicted outcome. For instance, right now Obama contracts on Intrade sell for $.65. If you buy these contracts and he wins you get $1.00 for every $.65 you invested. If he loses you get nothing. Therefore, a contract value of $.65 represents the consensus view that he has a 65% chance of winning.

The really cool thing about prediction markets, just like the financial markets they emulate, is that over time the people who are really good at predicting stuff end up with more money. And people with more money in these markets have more influence over the consensus prediction.

So we thought we would apply this concept to estimating home values in the Chicago area. Here is how it works. When you sign up with Price This Home you receive 5,000 virtual prediction dollars which you can then invest in various home price contracts. For each contract you either buy it in the belief that the ultimate sales price is going to be higher than the current prediction or you sell it in the belief that the ultimate sales price is going to be lower. The market price then moves in proportion to the size of your investment and you either make or lose money based upon how accurate your prediction is.

We are starting out with just a few homes in the market but if there is a lot of interest we will add more. Give it a try and have fun!

It seems like everyone in the Chicago area is trying to time the real estate market these days. Sellers are holding out for higher prices, convinced that the market is going to turn around any day now and they are going to make 50% on the home they bought 5 years ago. Buyers, on the other hand, are waiting on the sidelines for sellers to capitulate on their asking prices, fearing that they might otherwise buy a house that goes down 10% within the first year. The question on everyone’s mind is whether or not home prices in Chicago have bottomed out yet.

In general, trying to time any market is a risky proposition since you don’t really know until after the fact whether or not you bought at the bottom or sold at the top. It’s especially tricky with real estate because you have to really time the size of your mortgage payment, which is a combination of prices and interest rates. It doesn’t do you any good to buy at the bottom if interest rates have jumped up and more than offset the impact of declining prices. For instance, from May to June interest rates have shot up 60 basis points, which is enough to raise your mortgage payments by 6.6%. I also maintain that you shouldn’t look at a house as an investment in the first place because first and foremost it’s a place to live. Do you really want to spend the next 7 years of your life in a house that you picked based upon its assumed appreciation potential?

But let’s move beyond how I think you should be looking at the Chicago real estate market and let’s try to answer the question you are going to ask anyway. I can offer you three different sets of data that might shed some light on where Chicago is in the home price cycle.

First, the stock market is usually pretty good at predicting the future. Stock prices usually reflect what is about to happen to the economy, bottoming in advance of an economic bottom. For this perspective we can look at the S&P Homebuilders index over the last 5 years.

As you can see this index peaked in the first half of 2005 so it did a pretty good job of predicting the housing meltdown more than a year in advance of the peak. Unfortunately, there is no evidence that it has bottomed out yet. The groundhog has seen it’s shadow.

Another financial market that provides a glimpse into the future is the futures exchanges. It is often said that the best weather forecast for Florida comes not from the national weather service but from the orange juice futures market. For Chicago home prices we can look at the futures prices for the Case-Shiller home price index for Chicago, which show a decline until sometime in 2010. As of April the index was at 150.4 and the May 2010 value is 125, which amounts to a projected 17% further decline over the next 2 years. But one has to be careful in leaning too heavily on futures prices. Although the futures markets might be the most accurate forecast on average that doesn’t amount to always being accurate. For instance, for the past year oil futures have been predicting flat oil prices out into the foreseeable future and you all know how accurate that forecast has been.

Finally, if we go back to the long term trend in Chicago housing prices we can see that home prices overshot the long term trend for several years. By looking at the deviation of prices from the long term trend one can conclude that prices should come down by an additional 13%.

OK. So there you have it. Three different techniques that all say that Chicago home prices have not bottomed. Of course, that doesn’t mean prices will come down further. All 3 of these prediction methods could be wrong. Furthermore, even if it is true that prices are still too high they don’t necessarily have to come down in order to get back in line with reality. They can simply stagnate at this level until inflation catches up with them. It all comes down to how quickly sellers get real.

One more note for the sophisticated investor. If you really want to speculate on the direction of housing prices in Chicago or if you want to protect yourself from future price changes you can buy or sell the Case-Shiller futures on the Chicago Mercantile Exchange. For instance, if you want to sell your house but think that prices are going up in the future you could go ahead and sell at today’s price and then buy futures which will gain if home prices in fact go up. That way you can separate the investment aspect of home ownership from the living aspect.

About one month ago I posted a rather lengthy discussion of the truth about Chicago area housing prices. The Case-Shiller price index that I referenced in that article has just been updated through March so here is a quick update on what it shows for Chicago. First, let me show you the trend going back to January 1987:

Just a quick reminder that the price tiers are defined as follows:

• Low - Under $227,766
• Middle - $227,766 - $348,054
• High - Above $348,054

Prices peaked approximately in September 2006 and have since declined between 9% for the low tier to 12% for the middle tier. That puts home prices back to where they were in December 2004. When you look at it that way it doesn’t seem quite so bad, does it?

I wish that over the last 8 years I had recorded all those debates with people who kept insisting that Chicago real estate never goes down.