It appears that California residential real estate is in the second dip of a double-dip decline. California home prices, and sales, crashed at the beginning of the recession. Then, last year they picked up in the first half of the year, a result of temporary government programs and optimism unsupported by economic fundamentals. Talk of green shoots and a real estate recovery was all over the internet and traditional media. Then, like air slipping out of a balloon, the optimism disappeared, as predicted gains failed to materialize. Finally, we started seeing declining prices again.

California led the original real estate collapse, though California home prices remain well above prices in most other markets, and California appears to be leading the new decline. In fact, this decline is very unlikely to be as widespread among states as was the previous decline. Home prices here are likely to decline more than in most other states because California is now seeing an economic feedback from economic activity to real estate prices. States like Texas and North Dakota are unlikely to see residential real estate markets anywhere near as weak as California’s.

While home price declines originally caused economic declines, economic weakness is now contributing to yet more California’s home price declines. California is almost unique in its weak economic prospects, a result of almost continuously bad policy initiatives over the past couple of decades. This weak economic activity, particularly weak job growth is providing a new source of weakness in California home prices.

The impact is not universal. Upper-tiered markets remain stronger than more affordable markets. This is a reflection of the fact that demand for many of California’s most desirable areas is independent of local economic activity. Monterey, Santa Barbara, and Napa are really national, perhaps international markets.

By contrast, demand for many of California’s inland areas is only driven by local economic area job creation, within a remarkably large commuting radius. No job growth; no housing demand. End of story.

California’s commercial markets were hit much later than its residential markets, because it was falling economic activity that caused the decline. Commercial lease rates and property values are directly tied interest rates and the economic activity the property generates. As economic activity declined, vacancy rates increased and lease rates fell. Unfortunately, California’s economic recovery will almost surely lag the United States recovery. This implies that commercial prices are unlikely to significantly increase within the forecast horizon.

Retail properties, in particular, are likely to be very weak for a very long time. Besides weak economic activity, brick and mortar retailers are facing increasingly tough competition from internet sellers. Ultimately, it is likely that we will need less retail space per unit of population. California industrial space may also see long-term weakness, as the State continues to de-industrialize.

Office space markets are a harder call. California retains its natural and cultural amenities, even as its economic vigor subsides. Because of new communications technology, many, particularly top end, office jobs can be located just about anywhere. That would allow, say an executive suite in Santa Barbara or an engineering unit in Orange County, while much of a company’s workforce is in Texas, or even China.

Construction of residential and commercial properties has collapsed, a result of the weak demand we’ve outlined above. We see nothing that would cause any significant change in construction activity.

With few exceptions, it appears that 2011 will be another tough year for those who make their living in California real estate markets.

A couple of weeks ago, somebody–I think it was Shiller–said that they expected residential real estate price to decline by another 20 percent or more. Soon after, I was contacted and asked if I thought that a 20 percent decline was possible. My answer was that the only thing that would surprise me about residential real estate prices was if they went up 20 percent.

So far at least, residential real estate prices have been doing just about what I’ve expected. They’ve stabilized. Prices and sales move around, but no upward or downward trend is visible in the data. That doesn’t keep the rose-colored-glasses crowd from forecasting an imminent upturn. I don’t think a week goes by where I don’t see that type of piece.

Unfortunately, there is no fundamental reason for an increase in home prices, and plenty of reasons why they may yet decline some more: Unemployment is still high. Underemployment is still high. Long-term unemployment is still high. Residential mortgage delinquency rates are still high. Foreclosure rates are still high. The proportion of people who own the home they live in is still too high. Gasoline prices are rising. Food prices are rising.

What do the bulls have to fall back on? Interest rates are low, and we’ve stopped losing jobs. That is just not enough to hang an ebullient real estate recovery on, especially if you realistically confront the negatives.

Don’t expect residential prices to make big positive moves in 2011 or 2012.

The story for commercial real estate is pretty much the same. Although commercial real estate’s decline lagged that of residential real estate markets, commercial real estate suffered similarly big declines in value, while vacancy rates soared. Lease rates, naturally, reflected the changes and fell also.

However, commercial markets are different from residential markets. On the positive side, commercial real estate markets are only about a third the size of residential real estate markets, implying a much smaller economic impact. On the negative side, commercial real estate financing is much more idiosyncratic than residential real estate financing, and it often involves big balloon payments. The big balloon payments imply that lots of properties could be in trouble. The idiosyncratic financing means that new loans will likely be very hard to find for quite some time. It may also mean that existing lenders may be more flexible before attempting to foreclose.

In sum, the long nightmare that has so tormented real estate market participants is probably not over. Anyone buying in this market needs a very long investment horizon.

Are we out of the woods?  No.  Is this an identifiable trend to recovery?  Not yet. 

From the charts, you can see that job levels are still 3.4 percent lower than they were at this time last year.  Also, the ranks of the long-term unemployed, those workers who have been unemployed for 27 weeks or longer, have grown to almost 6 million.

You can also see that the unemployment rate fell in July, before rising by more than 50 basis points during the next three months.  Hopefully, this time, the unemployment rate will not rise in December, but continue falling.

A key dynamic that has been going on for about a year now appears like it will continue at least through the middle of 2010, and that is the negative feedback from jobs to residential real estate.  This recession started in residential real estate with deflation of an over-leveraged housing bubble.  It then spread to virtually every other sector in the economy, and once job losses started, the negative feedback loop started.  Certain aspects of the housing correction were worsened by the job losses – especially foreclosures.

With high unemployment rates, lots of long-term unemployed persons, and job-levels still relatively low this feedback will continue.  The most recent United States residential foreclosure rate data indicate that the foreclosure problem is worsening.  The most recent data on commercial real estate loan delinquencies also indicate a steadily worsening problem.

What drove jobs down?  One of the biggest factors was the tremendous fall in consumption during the second half of 2008.  Our interpretation of that fall was the household sector moved to correct over-leveraged balance sheets.  With ongoing real estate loan delinquency problems, we are not convinced the household sector will be motivated to increase their spending levels in the near term.

This sad state of affairs is presumably brought about by an evil collaboration between “irresponsible lenders,” governments, and credit counselors who “scare and shame borrowers into making what is in many cases a bad financial decision to stay in their home.”

Before we begin, we need to recognize that Professor White is a law professor and not an economist. We can therefore forgive his bombastic quotes and apparently incomplete analysis.

Unfortunately, we now need to take a small detour to discuss the economics of lending. There are two types of credit default: strategic and inability to pay. Since Professor White’s article is about people who could pay, we are discussing strategic default.

It is well understood and generally accepted among economists that, absent an enforcement mechanism, the risk of strategic default results in the under-allocation of credit. Fewer loans are made than are optimal. For the law professors across cyberspace, that means that some people who should get credit won’t get credit.

So, society has created disincentives for strategic default. Over time, those disincentives have been weakened. We no longer have debtor prisons, and the stigma attached to bankruptcy or foreclosure has declined. However, we still have disincentives. Default on a home may make it difficult to finance another home, or to obtain future consumer credit. Foreclosure is also a very public process, and it could damage some people’s reputations.

With these disincentives, it is often entirely rational for a homeowner to pay for an under-water home.

But I don’t think Professor White was truly saying that homeowners were being irrational. From the quotes I’ve read, I think Professor White was complaining about the very existence, small as they are, of disincentives for strategic default.

That’s just muddled thinking. I would ask that we consider the possibility that current disincentives for strategic default may be too small. I’m not advocating debtor prisons. There are plenty of disincentives between debtor prison and what we have now. Eliminating limited liability comes to mind. As things now stand in California, a person can walk away from under-water home while having, say, $1 million in the bank. Having to pay any deficiency when ability exists would be a formidable disincentive to strategic default.

If we do accept wholesale strategic default, as Professor White apparently advocates, credit availability will decline.

There you go. This is a bump in the road in a widening recovery, the existence e of which is generally accepted, with only some lingering doubts.

Even if you don’t buy our analysis, which is pessimistic, the quotes reflect a remarkable confidence. Given the massive weaknesses in our economy—over-leveraged businesses, banks, and consumers; continuing defaults on loans of all type, the worst job market in decades, and the ineffectiveness of both monetary and fiscal policy are just a few that come to mind—I can’t see how anyone could be so sanguine. Seems to me that analysts that have only “lingering doubts” are the letting their hearts lead their analysis.

We all hope for a recovery. The recession is ruining families and lives, but I don’t think analysts do a service when they let their analysis or forecasts reflect their hearts. The public is best served by our best detached analysis.