Could the Housing Market Be at a Bottom?

My previous article took aim at Chinese industrial production, asserting that its manufacturing sector would be the next casualty in this cascade of global recession events. It is as if, one by one, dominoes are falling throughout the world, one sector after another and one region after another. It started with a U.S. housing bubble that inflated, popped and brought down an over leveraged global banking sector. This fall starved the consumer sector of the credit needed to fuel its spending binge, thus bringing down the consumer spending sector (restaurants, electronics, and automobiles). This led to a contraction of manufacturing which is presently wreaking havoc on exporting nations. The final shake out will be one more leg down in commodities. Commodities have a bright medium and long term future but the near term is bleak. On the heels of today’s jump in housing starts, I want to turn my attention back to ground zero in this whole mess: the U.S. housing market. The adjustment down for home sales has been nothing short of unbelievable but has it been enough? Just maybe.

Are unsold home inventories at record highs or record lows? It sounds like a simple question but it all depends on how you interpret the data. The pessimistic case is all over the headlines. Inventories of existing homes (tracked by the National Association of Realtors) and new homes for sale (tracked by the U.S. Census Bureau) stood at 9.6 months supply and 13.3 months respectively. By this measure, the existing home figure is off its April ’08 level of 11.2 and the new home inventory is at a recent high. Five to six months might be considered a healthy level, causing many to lament, “It will take us more than a year to burn off this inventory at this rate.” These last three words, though, are the critical qualification here and reason to expect a turning point before this summer is out.

These much-quoted inventory figures result from the number of homes on the market divided by the current pace of sales, which as shown above is dropping like a rock. Inventories of new homes on the market have actually been in decline for 18 months from a high of 573,000 in July 2007 down to 342,000 yet the decline in the rate of sales is outpacing the inventory correction. It is not that we have so many new homes on the market but that the rate of sales is at a record low. For those that may have missed it, the 23,000 of new home sales that occurred in the month of January corresponds to an annual sales rate of 309,000 a level never seen before. So sharp has been this decline that it has to stabilize this year. It is true that something low can always go lower. Thus it is possible that the sales rate might bottom out at 250,000 or even 200,000 but at the current pace of decline, it will reach those levels before the spring is out.

The ending 2008 inventory of new homes (342,000 units) is approaching the lows seen in previous housing recessions (left graph) of between 250,000 and 300,000 units. The population of the country has increased by 34% over this period, though. Adding the January ‘09 inventory level (shown in red in right hand graph) and adjusting for population, you can see that we have already reached historic trough levels (and will be below them by the springtime).

Foreclosures may not have peaked but notices of default (NOD) appear to have. There have been much said about defaults and foreclosures. Regardless of whether you believe the Obama administration’s foreclosure mitigation efforts will amount to much, the most current data shows a stabilization of households going into default on their mortgages. According to data from RealtyTrac the number of defaults (Notice of Default and List Pendings categories) has been hovering at the 100,000 per month since the beginning of last summer. Default is the first stage in the foreclosure process that RealtyTrac reports. The trend is more debatable in the later stages which include bank repossession and foreclosure sales because there have been various moratoriums on foreclosures. This may be holding back some foreclosures from happening.

The banking system, which is so much at the mercy of housing foreclosures, mostly marks to market and reserves losses based on notice of default, which has leveled out. Banks like Citi (C) and Bank of America (BAC) as well as GSEs: Fannie (FNM) and Freddie (FRE) may very well be holding back foreclosure sales and repossessions but there is anecdotal evidence that defaults, if anything, are inflated as homeowners are going into default to qualify for help from their lenders. Thus while the final step in foreclosure may be understated pending the outcome of government programs, there are few folks arguing that this is true for the first step, default (triggered by late payments). This dynamic can be seen by mortgage insurers like MGIC (MTG) and the PMI Group (PMI) that have set aside billions of dollars in reserves (based on defaults) but have been far behind in forecasted payouts rates (based on foreclosure sales).

This is not to argue that rising unemployment won’t continue to impact the housing market. A RealtyTrac executive commented last week that total foreclosures are increasing in previously untouched areas. He cited a 129% year over year increase in foreclosure activity the state of Idaho. But the 1,764 foreclosures (all categories) in Idaho are a mere fraction of those in California that is coming off a level that peaked above 100,000. The point is that the size of the subprime problem in four states (CA, AZ, NV, and FL) was so large that it overwhelmed the economy last year.

As this situation runs its course and subsides, the net result will likely be an improvement even in the face of rising unemployment. Please remember the U.S. unemployment rate is a lagging indicator, a reflection of poor economic activity, not a cause of one. Housing tends to lead the economic cycle, unemployment tends to lag it. One such indication is that in the western U.S., one of the hardest hit regions and first to adjust, new home sales are up 29% year on year while other parts of the country are still declining.

Home sales near a bottom but prices will continue their decline. So does this mean home prices will stop falling soon? Unfortunately, no. I compared the trend in sales (new home) to the home prices as tracked by the S&P Case-Shiller Index of 20 metropolitan areas. Case-Shiller is the most publicized of many home price indices but the picture is similar regardless of which one you use. Since the peak, home price trends are lagging the sales cycle by 12 to 24 months. If this relationship holds and we are nearing the bottom in home sales and inventories, it means we still have four to eight more quarters of home price declines. Government stimulus and home purchase tax credits could shorten this but first the effectiveness of such efforts needs to be demonstrated.

The first economic domino to fall in this global economic downturn was the U.S. housing market about three years ago. It put global banks and the American consumer into a state of paralysis, starting a chain of events which is only now ravaging Eastern Europe, China, and other markets. While the last domino is yet to fall, there is reason to believe the U.S. housing market is beginning to heal.

Disclosure: The author does have long positions in a mortgage insurance provider discussed.

Comments

[Ranchr:]

As a former California homebuilder in the late 80's/early 90's and a real estate broker for more than 30 years I congratulate the author on hitting the nail right on the head. Three-years-ago, I penned an article for a local magazine here in Sarasota, FL that I began by saying "When I see my brethren realtors buying homes and condos off-plan they have no intention of closing on much less living in, I see a little old man with a grey beard and a sign that says THE END IS NEAR!"

Recently, the media has failed to notice that even though sales of existing homes, nationwide, in January fell 5.2% year over year and the median price of housing dropped 33%, sales of existing homes in Florida were up 24%. Prices perceived as being at rock bottom spur buyers to buy.

My prediction "the end of the end is near!"

Mar 17 12:54 PM

[scott2002:]

new home prices will decline but, i believe that will be mostly due to the builders changing thier product. builders are getting rid of most of the standard features and are making them optional in order to lower prices of the homes so "declining prices" is not an apples to apples camparison. all new homes are gonna be "boxes" with everything else optional, i can name 20 builders in ca. that have done this in the last 3 months.

Mar 17 01:05 PM

[Ishortyou:]

You guys got to be kidding, the oversupply in housing coming from new house starts alone is now at around 13.3 months ahead, housing permits still coming out and new house starts still at around 500K last month alone, how in the world are we going to fix the oversupply in housing if this is still going on? common sense dictates that this is not possible unless they stop by whaterver 'means necessary' the oversupply in housing, even if they have to shoot somebody in the head, bann counties from giving up housing permits and kill someone to prevent this from happening!!!

Mar 17 01:23 PM

[Ranchr:]

Inventory comes from four sources:
1. Bank foreclosure, short sales or sellers under financial pressure that are priced to move quickly with shorts being the slowest of the two because of the process.
2. Seller's who want to move for whatever reason but that are not under financial pressure to move but because they are motivate price their home to compete with the foreclosures and short-sellers.
3. Seller's who are stuck in 2005. Their house is on the market waiting for the elusive "greater fool" to show up and over pay. That buyer is not out there and that inventory will not move and has the effect of indicating a higher level of inventory than is actual. These sellers would be better off withdrawing from the market and waiting for a better market, rather than watch the paint fade on the sign in their front yard.
4. New home builders. In this area, only those that have created a rock-bottom box are building and only home that are contract builds are being built. There is no builder in his or her right mind building spec homes, in distressed markets and much of what is seen as building permits are for remodel and additions.

We will burn through the inventory that is actually for sale buy sellers with a modicum of motivation; speculative homebuilding is a long way from happening, in over-supplied markets; and, homes for sale by sellers waiting for a buyer with more money than sense are driving down prices by giving neighborhoods the impression of being in severe trouble.

Again, "the end of the end is near."

Mar 17 02:09 PM

[The Optimist:]

Ranchr: I'm afraid what is being overlooked at this time by those feeling "the end of the end is near" is that we still have prices in most geographic areas that are inflated compared to the earnings potential of the American home buyer. Until that corrects and loans are easier to obtain (for loans, a FICO of 740 is the new 720 and you need 10 to 20% down which most people don't have) the end is not in sight. Housing sales spurred by foreclosure sales and rock bottom fire sales by builders who are building apartments instead of condos because people can only afford rent right now? This is not the end of the end. Maybe the beginning of the end of the end.

Mar 17 04:00 PM

[Russ Wetherill:]

A couple of thoughts on projecting a bottom: 1) all real estate is local, so just as the peak occurred at different times in different locals, each individual market will bottom at different times; and, 2) it may be a little premature to call a bottom for the US as a whole, when no individual markets have seen prices stabilize, much less begin appreciating.

As a potential buyer first time home buyer in the California real estate market, I am looking for several things: 1) a 12-month average of the Case-Schiller Los Angeles month-to-month price change breaking back into positive territory (you can make your own chart from their data); 2) unemployment rates to decrease back under 7 percent in LA (currently 10+); 3) interest rates to rise back to historic levels (rates are being held artificially low to prop up home prices - a rise in prevailing interest rates will further drop home prices) ; 4) home prices must return to sustainable price-to-income ratios (between 3 and 4, not the current 7+ down from 10); 5) Loan DTIs back to 31%, not 60%; 6) prices need to fall inline with long-term appreciation rates instead of the 10% to 20% that we saw from '96 to '06; 7) sustained 20% down payment requirements across all lending institutions; 8) appraisals that are not paid for by the mortgage originators (fraud? - hit the number so that the underwriter approves?); 9) changes to the credit default swap regulations (retention of a certain percentage of assets to back the CDSs, similar to ordinary insurance); 10) independent GSEs, FM2; and 11) sustained GDP growth. Until then, I am happy to rent.

In short, I, and many buyers like me, are not going to catch this falling knife. When, and only when, housing goes up and stays up will I put my 20% down. And by the way, it takes quite a few months to save up 20% of a purchase price here California (if you save 20% of your income and you are qualified for 3 times earnings: months to save DP = .2*3*e =>> .6*e/(.2*e) = 3 yrs, regardless of income or house price). This might slow down home purchases a little. So with the recent change in the down payment requirements and lack of funding above the conforming limits, I would think this will delay the first time buyer from buying for several years in the more expensive areas (which are currently frozen).

Also, the move-up buyer is underwater so they aren't buying, and investors are only buying in the distressed markets where they might be able to rent to cover some of the mortgage, or foolishly hope to flip a $150k house in Compton. Neither of these groups is likely to turn around these markets soon.

What about shadow inventory? Realty Trac estimates that there are approximately 700,000 foreclosed homes that haven't been listed. There are also many regular, instead of distressed, sellers that haven't been willing to sell until prices stabilize. Once there are signs of increasing demand, there will be a flood of homes listed on the market here in California. This will drive the market prices down even further. We saw a similar occurrence in the early 90s. See the Case-Schiller data. This is known as a bull-trap in stock terms. People are fooled into buying in a down market when the bulls appear to run.

We have a long way to go. Just because more trees are being cut down to build more condos this month than last does not mean that we are out of the woods. It only means that the foreclosed homeowners are driving a new market - in condo rentals. To use an baseball analogy, you seem to be calling a strike while the pitcher is still shaking off signs from the catcher. I'm just saying that even a blind umpire waits til' he hears the ball hit the glove...

Mar 17 09:02 PM

[Ranchr:]

Russ, I appreciate your points but what you have laid out is a blueprint that guarantees you will pay more for the home, more for interest over whatever period of time you take your loan out for. There is a price for the insurance you are looking for and that premium is very high.

Take Sarasota, FL for example, I called the excesses when they were apparent to me three years ago but my associates knew I had been warning friends for more than a year before.

We were the highest flying market in part because our demand is not just local or international, it's because as I first said in 1984, while living in Park City, UT "no one wants to be old and cold, if they don't have to." Well almost no one...What the hell was Dr. Atkins doing walking on ice, he'd probably living the life of Riley, today, if he'd been in Sarasota that day.

Sarasota was first in and will likely be first out. The median price YOY has dropped 36.5%. The average price per square foot has dropped 27%. These are both lagging indicators lagging exactly one year in fact, and they are well below the cost of reproduction. Sales, on the other hand, is the leading indicator YOY and that is up 145.2% and has actually been trending up for more than six months now.

Median sales prices peaked in early 2007 and have been trending down steadily since. Number of sales hit bottom in early 2008 and have been trending up ever since.

As you so correctly stated in your first point, Russ, all real estate is local and I built thousands of homes in the Bay Area as division president of a public homebuilding company, when being an officer of a public company was an honorable position. I still don't know how any Californian buys a home and since Governor Moonbeam introduced the Moonbeam Doctrine, "if you don't build a road there no one will go," your California highways have become the worst in the country. In fact, there are Caribbean Islands that begin with a "C" with better maintained roads...Curacao and Cayman's comes to mind.

Your statistics prof probably told you the same thing mine did... there are lies, Damn Lies and STATISTICS, we can all use them to make our point correct analysis is most important and unlike accounting and engineering it's not precise and requires judgment and interpretation.

I happen to agree with the author's analysis but only time will tell if as Confucius said person who predicts the future by looking in crystal ball occasionally eats broken glass.

Mar 17 11:35 PM

[Left Coast ...:]

Pretty good analysis. You will find however, that relying on Case-Shiller at this point in the cycle is misleading. The C-S index relies only on detached housing which has sold more than once, and with broad geography. Right now the data that gets collected is from a market that is dominated by foreclosures mostly in outlying suburbs and exurbs. One doesn't find those price declines in the closer in locations, particularly in places like San Francisco (examples East Bay hills, Palo Alto, San Mateo, Marin)

I'd like to see your chart of new homes plotted against, not population, but new jobs, as that is a better indicator of housing demand.

Mar 18 11:46 AM

[sailingfree:]

Rather than new homes inventory, how about per cent unoccupied units?

Mar 18 02:16 PM

[djhirte:]

Good discussion. The comment about the relationship between stats and lies is salient. Another interesting fact to toss into the equation: Data re sales prices are overstated because in most all US markets MLS data is controlled by Realtor organizations who are almost entirely representing Sellers. These organizations frequently are not reporting REO sales, which would bring down the dollar averages even more, and act as a further downer on sales prices. And of course, lower sales prices mean lower broker commissions. If ever there was an unholy trinity, here it is:
Realtors, MLS organizations, and the NAR. Better take all that data with a large dose of suspicion, in my opinion.

Mar 18 08:08 PM