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The housing market is and always has been loosely connected to the long-term trends in employment and the economy. Homes prices move up as more jobs are created because there are more households created and those family units need housing. As the economy grows and incomes improve it creates more demand for bigger and newer homes by the newly affluent.

But the reverse is also true, at least if the trends persist for more than a few months in duration. When people lose their jobs, they can no longer buy a home, removing demand from the marketplace. If those unemployed remain so for much more than a year, a percentage of those who have mortgages will lose their homes to foreclosure. If the number of families losing their homes is greater than the number of buyers in the market for a new home, supply rises and prices usually fall (or at least move up much more slowly). We experienced a bubble in housing and it burst. But now we are about to experience the spiral effect that rising foreclosures and lingering unemployment create.

It appears we have more fundamental economic weakness on the near horizon. While the economy had started to create new jobs, it will also have to withstand the impact of the end of the 2010 Census and the 1.2 million jobs that will be lost over the next few months. In order for the jobs picture to just stand still without losing ground the private sector will need to create an average 200,000 new jobs per month (1.2 million divided by 6 months) for the remainder of the year. In that scenario, we would have achieved zero job creation over the next six months.

If the private sector falls short of that level the economy will be losing jobs and unemployment will rise. Of course, by not extending the unemployment benefits, Congress will fix that potential problem. The millions of people who no longer qualify for benefits will no longer be included in the workforce nor will they be considered unemployed. So the unemployment rate could actually drop as we lose more jobs. Such is the mystery of government statistical reporting.

The net effect of the gulf oil disaster will be more job losses. Some will get temporary jobs in the clean up, but most will not.

What does unemployment have to do with housing? Well, first, one must have a job to qualify for a mortgage. Second, one usually needs a job/income to pay a mortgage. So, demand for housing will drop because fewer people can qualify. And more people will lose their houses to foreclosure if they can’t find a job adding to inventory or supply of houses available for sale. Lower demand usually means lower prices. Increased supply of anything (except tulips) usually means prices have to be lowered to match demand. All this is to say that as the employment picture dims further housing prices are likely to take it on the chin, again.

Here is where the spiral begins: As the number and rate of foreclosures continue to rise, more squatters (people who stayed in their mortgaged homes but stopped paying the mortgages) will be dispossessed of the "free" shelters and will have to pay for rent. Oops! There goes some more money that could otherwise have been used for consumption. Just think of it this way.

Right now we have some 5-7 million families living rent free because they stopped paying their mortgages. Some will move back in with parents or find friends to live with temporarily, but the majority will eventually have to pay rent. So, when that happens we can assume that at least 4 million families will have about $600 or more per month less to spend than they currently have. Now I realize that this only takes about $3.6 billion out of the economy each month, but hey, it is still a negative.

Now let's look at housing from a different angle. As all the new foreclosures are completed, those homes will hit the market increasing the inventory available for sale. As that supply increases it becomes more and more difficult for sellers to maintain price levels. Supply and demand. Prices are more likely to drop further than rise over the next two years as we reach the peak of foreclosures in 2011 and have to work down the inventory over the next year just to get back near where we are today.

But wait! If home prices fall more, won't more people be enticed to stop paying their mortgages? Yes. So there will be some offset in the lost consumption described in the previous paragraph. But it will also be temporary and result in an even larger drop in consumption eventually when they, too, lose their homes to foreclosure.

A lot of mortgages are near parity with the value of the underlying homes and even more are only slightly under water. Another 15-20% drop in home values will put millions more families in the unenviable place where they will be making that choice of walk away or pay. The values underpinning our society tell me that most will walk away and take the credit hit for seven years. Trust me on this: when the equity in your homes goes from being plus $20,000 to a negative $20,000 most people are negatively impacted psychologically. They perceive themselves as being poorer. They feel the loss. This will also take a toll on consumer confidence and, eventually, in the nation's rate of consumption.

And, of course, this adds more supply of homes available for sale and adds more downward pressure on prices. Do you start to see the spiral effect?

When does it stop? In my humble opinion, the answer rests on employment and income. When the private sector (not the government) begins sustainable job creation about the 2 million mark per year (the level that is needed just to absorb population growth and new job market entrants), we could see a bottom. But housing will probably have to drop to a level that enables first-time buyers to qualify for a conventional mortgage. A lot of young people have been priced out of the market by the bubble and that problem has to be undone.

That said it may be a while before many people can get up the nerve to buy a house because of the perceived risk. Owning will most likely have to be cheaper than renting to encourage many people to make the plunge. That can be achieved in two ways: home prices continue to fall until the necessary level is achieved or rental rates rise enough to achieve the imbalance favoring owning. The market will adjust at varying rates in different regions of the country on a local basis.

How long will this take? Who knows? It could be a year or two or it could take longer. But the market is more likely to work from both ends at the same time with rents rising as demand increases and home prices falling as demand slackens further relative to supply.

Also, when home prices become “cheap” relative to average income, investors will start to enter the market because they can develop a positive cash flow from renting purchased assets. But this will not happen until the home price market stabilizes somewhat because investors instinctively seek greater returns and will likely wait until the market appears to have bottomed. But this effect could provide needed support to help stop things from getting worse.

My take away from all this is that there will be another opportunity to invest in and own rental property in the not too distant future. But I would not recommend entering the market with the intent of “flipping” properties for a quick profit. This time investors will need to take the longer term view of buy and hold. With positive cash flow from the beginning and a potentially significant capital gain in the future, there will be few other investments that will offer a greater total return. That is how real estate investing was when I was younger and, hopefully, we’ll return to that state of sanity again in the future.

Disclosure: Author is long SRS

Source: The Future of Housing, Near and Far