What is going on with the real estate market in the U.S.? How bad will it get? When is it time to jump back in? Should sellers wait it out? These are questions frequently posed to me. My answers often disappoint people, which is no fun but I am not one to say what I do not believe. Obviously, different regions have their own set of circumstances. As a general rule, any markets that experienced phenomenal appreciation in the past couple of years are getting slammed. Manhattan is an exception to this because it was a direct beneficiary of Wall Street’s leveraged buyout mania. 2008 will be a different story for Manhattan as well. It is always ultimately a question of supply and demand so let us explore this balance in order to make an informed assessment.

On the supply side we have one positive development. Builders have dramatically cut plans for new construction. However, because many projects take years to build, there is still a last wave of supply coming online in many struggling housing markets. Right now, builders are primarily concerned with getting rid of their bloated inventories and shoring up their balance sheets. This has led to some welcome and significant price reductions and added incentives. Builders are clearly ahead of the curve by adjusting prices more than the average home seller that is still in denial. Some institutional investors have taken advantage of homebuilders’ desperation by buying bulk properties from them at a fraction of their book value. Case in point, Lennar Corp. agreed in December to sell a portfolio of 11,000 properties for $525million at 40% of book value to a joint venture with Morgan Stanley. However, these kinds of fire sales are extremely rare if not impossible for the average home buyer to come across at this point.

And then, there is the hidden supply. I know from experience in Miami that many would be real estate investors bought multiple pre-construction condo units, with as little as 5% to 10% down and never had any intent on renting them out. After they were built (some are still not built yet), many individuals were content to keep them vacant with the logic that they would sell them someday soon so why complicate matters with tenants. Now that these owners are upside-down on their mortgages (owing more than their property is worth), most of them are deciding to find tenants and “wait it out.” This is leading to a dramatic increase in the supply of rental units and decrease rental rates in a lot of markets. As a result, many potential buyers are choosing to sit on the sidelines while they move into their posh new rental unit at cheaper rent. Eventually, many over leveraged condo investors that expect either a quick escalation in rents or a rebound in sales prices will not be able to cope with the bleeding and will have to foreclose.

The declining price of homes normally attracts more buyers to the market. However, one must factor in the total cost of ownership, not just the selling price. Even though average sale prices have gone down, taxes and insurance rates have gone up in many markets. In numerous cases, tax assessors are appraising home values higher than their actual market value and most homeowners are not taking steps to fight these assessments. The cost of home insurance is rising despite the depreciation in home values. While mortgage rates may have gone down for the absolute best borrowers, mediocre to weak borrowers are facing either a higher interest rate or not getting a mortgage at all. Condo maintenance fees for new condo developments will increase. This is because the artificially low introductory association fees guaranteed by developers for a set period will expire and the new rates will have to reflect real costs and added wear to new buildings. Because there was so much new development in recent years, the effect of this adjustment will have a greater impact to the market average than usual. While none of these rising costs by themselves would have significant impact. Added together, they certainly dampen the ability of declining property values to restore balance to the marketplace.

Then there is the rise in foreclosures that will also add to supply and put pressure on prices in the coming years. The federal government and the nation’s largest banks are taking several steps to prevent the tsunami of foreclosures that would happen if interest rates reset as stipulated in many mortgages contracts. However, they will not be able to stem the increased flow completely. Why should someone that already has bad credit and a mortgage that is more than the value of their home continue to make mortgage payments when they do not see prices rising anytime soon to give them positive equity? More and more people will just walk away.

On the demand side we have two major players almost completely out of the marketplace. Most of the speculators are gone. Some speculators are looking for bargains but they are not impacting the market the way they did a couple of years ago. The first time buyers and those with spotty credit are very scarce because mortgages are not readily available. Even many willing buyers with good credit are having a tough time because they now have to come up with a larger down payment.

The lack of mortgage financing will be one of the primary forces driving prices lower in the coming years. Banks and mortgage companies are having a tough time selling portfolios of mortgages to anyone except to Fannie Mae and Freddie Mac. Even though new legislation expected to pass will raise the loan sizes that Fannie Mae and Freddie Mac can purchase, this does not make up for the fact that these agencies already have their hands full and cannot be expected to support the entire mortgage market and bring it close to where it was. Not only are banks having a tough time selling the mortgages they have on their books to free up cash to make new loans but they are having to cope with losses related to bad loans as well as turbulence in the overall financial markets. As a result, mortgage issuance will continue to retreat for some time regardless of how low the Fed lowers rates.

Ok so things are bad. We get that part. Isn’t now the time to be a contrarian and jump in while things look the ugliest? The answer is no. The reason lies in one little known fact: Most homeowners are still in denial. A recent survey was conducted by Harris Interactive for Zillow.com, a Web site that gives estimated home values. The survey of 1,619 homeowners found 36% believe their home has increased in value during 2007, and another 41% believe their value has stayed the same. Only 23% believe their home has lost value. This is in direct contrast to the Case-Shiller index that measures home values and the National Association of Realtors that concluded a 2007 average national decline of home prices between 6% and 7%. Home owners will have to come to grips with reality before we can begin to feel that the worst is behind us for both the housing market and the overall economy. The obscure nature of real estate valuation always leads to slower adjustments than other asset classes such as stocks, bonds, or commodities. Housing inventories are increasing while absorption rates are decreasing in many of the once white hot markets. We will also have to see the inventory levels (measured by time) begin to decrease before we can be more confident about a bottom. Even at the point that inventory levels stabilize and begin to decline, the sentiment will probably continue to get worse (because of the irrational behavior usually exhibited at market extremes) causing impatient and fearful sellers to continue to lower prices even though the fundamentals of supply and demand will have begun to improve. That is the time to get in.