The housing market had been in an upward growth cycle since 1996, so a deflation was inevitable. It is remarkable it took so long to emerge. This is due to:

• A continued robust and diversified economy, including a low unemployment rate of 3.9 percent compared to 4.2 percent for the United States, job growth and population growth. By the end of 2006 the region will add about 22,000 jobs, 4,000 more than last year.
  
  
• Historic low interest rates that even now remain very, very low at 6.42 percent for 30-year fixed, coupled with the plethora of loan instruments.
  
  
• A still strong national economy and no immediate signs of recession, record Dow Industrial average, dropping gasoline prices and other fairly positive factors. A loss of construction jobs could cause a major ripple in the economy, but it hasn’t so far. But real Gross Domestic Product continues to rise at an annual rate of 3.3 percent.

What is perhaps different about this downturn is the barrage of media reports, mainly in headlines, emphasizing the negative. The media’s roles are more pronounced in the housing market than ever before because there are more media, more competition (Internet, blogs, etc.) and more pressure for instant conclusions.

The problem is the real estate market is not instant. It makes no sense to suggest that a one-month drop of 1 percent in pricing is an “event.” Call me back when the quarterly, or better yet, year-to-year stats are released. The point is it takes a long time for any meaningful “story” to develop in the market and the media have no patience.

The residential market will probably continue to trend downward, but at a gradual, presumably manageable pace. The trend is likely to stabilize, and then go flat. This market downturn, or at least sluggishness, could last three to four years.

The factor mattering most at the moment is median housing price vs. median income. Median housing prices in San Diego stand at $550,000, about 8 1/2 times the median household income of $64,273. While San Diego is by no means the most expensive housing market in the nation, nor even on the West Coast — coastal Orange County, Los Angeles, Santa Barbara and the San Francisco Bay area are all more expensive — the difference between housing and income is the largest we have experienced. The combination of liberal lending instruments, low down payment requirements and few barriers to loan qualification suggests this gap is felt deeply in people’s psyches.

The divide has to narrow. Until it does, the housing market will remain sluggish.

Yet we do not expect a strong depreciation in housing values. Certain spot markets that are over-supplied may suffer, but in general the market is light on inventory. Only 10,000 housing units are under construction in the county. Normal demand, while temporarily on the sidelines, is double that amount. The region’s population grew by 4.9 percent between 2000 and 2005, while new construction grew by only 2.5 percent. This gap will ultimately stabilize the market and again bid up the price of housing.

Public Home Builders

The long-term shortage of housing supply is owed mostly to a daunting entitlement process in the California coastal markets. In the coming two years the culprit will be the delivery system: the home builders who dominate the industry are large, publicly traded companies who report earnings on a quarterly basis. When the market peaked in 1989, it took two years before home builders shut off the home delivery valve. This time, most of the public builders brought construction to a screeching halt, cutting production and personnel quickly. They will be reluctant to start building homes again until they are absolutely certain they will sell.

The big builders also have cut prices. The latest 4.4 percent year-to-year drop in median housing prices for the overall market is almost exclusively due to a 17 percent drop in new home prices over that same period. The resale market has held relatively firm.

During the last great recession of 1991 to 1995 — a major economic event causing catastrophe throughout the San Diego region — housing prices ended up sliding only 7 percent. However, along the way some buyers experienced a much larger loss in value if they purchased at the top of the market, and were then forced to sell during the ensuing downturn.

Similarly, a buyer who purchased a home last year and must sell this year or next likely will experience a loss. So will those who purchased homes with the riskiest variable loan instruments on the assumption they could “flip” the property for a profit. That party has been over for a year.

But most homeowners will simply stay put. Only 8 percent of houses transact in the region in any given year. As real estate listings expire, most people will simply not re-list. They will wait it out. Unless you are moving, face dire personal economic circumstances or see an opportunity to move up into that now-discounted dream house, head to the sidelines. Most homeowners will wait this thing out rather than sell at lower prices than they perceive to be the value of their homes.

Signs Of Strength

Strong points do exist in the market. First and foremost is the residential rental sector. Vacancies remain low at 2 percent in the San Diego region, and rent levels are rising. This can be attributed to a combination of factors: some loss of rental inventory through conversion to condominiums, virtually no construction of rental units and would-be first-time buyers opting to rent for the foreseeable future rather than rush to purchase. In other words, supply is down, demand is up.

Look for the next big wave of residential construction to be in the rental sector. But it will be a bit of a wait: apartment rents still have to rise to meet high labor and material costs. That said, lumber costs are diminishing — the latest figures show a 32 percent drop in prices — and other material and labor costs are sure to follow. This is an important marker.

In addition, the commercial office, retail and industrial markets remain strong. While some argue that many investors have overpaid for existing office buildings and that rising lease rates are unsustainable, there are few signs of weakness. Importantly, employment losses in the residential sector are likely to be offset by relatively strong commercial construction activity.

No Quicksand Here

Make no mistake about it: the real estate market is mired in the softest sand it has seen in 10 years. It may sink farther. No honest person could have predicted otherwise.

But this is not quicksand. So far this is not a calamity. We won’t sink down to the neck. The best advice to prospective buyers is to trust your future, take a deep breath and find opportunity in the weakening market.

The best advice to sellers is: don’t.

Gary H. London is president of The London Group Realty Advisors Inc., providing real estate consulting and economic analysis. Check him out on the Web at www.londongroup.com or e-mail him at glondon@sandiegometro.com.