What's The Real Cause of Housing Softness?

| About: Toll Brothers (TOL)

Toll Brothers (NYSE:TOL) CEO Robert Toll acknowledged in an interview with Reuters that the housing market is experiencing something "harder than a soft landing" but attributes it, not to macroeconomic factors, but to the impact of global issues such as Iraq, terrorism and the slow U.S. response to Hurricane Katrina on the psyche of the American consumer. The National Association of Realtors [NAR] Housing Affordability Index suggests a different explanation: that homes in some parts of the United States have become so expensive, even a decline in interest rates won't help much.

The Affordability Index is defined such that 100 means median family income is equal to the income it would take to qualify for a mortgage on a median-priced home, assuming a 20 percent down payment and that debt service would be 25 percent of income. An index value of 120 would mean median family income is 20 percent above the mortgage-qualifying level. A figure below 100 would mean there's an income shortfall; that a mortgage could only be issued if the lender stretches standards by accepting a smaller down payment and/or a heavier (than 25 percent) debt-service burden.

For July 2006, the preliminary index calculation came to 102.8, down from 112.2 in the 2006 first quarter, 114.6 in 2005, 123.9 in 2004 and 130.7 in 2003.

The overall decline in affordability, often discussed anecdotally and confirmed statistically by the Index, is significant in and of itself. More interesting, however, are the regional variations, as shown in Table A, along with key data-points used by NAR to compute the index.

Source: National Association of Realtors
Note: 7/06 data is preliminary

The traditional analysis of the housing situation blames higher mortgage rates for the sluggishness we've been seeing , and suggests things will get better once the Federal Reserve stops raising rates or, better still, lets them edge back down.

Table B shows that prices for housing futures, contracts based on the value of the S&P/Case-Shiller Home Price Index [CSHPI], reflect assumptions that prices will fall mainly in the 3-4 percent range for over the next six months. (Note: Because of time lags between when buyer and sellers come to terms on price and the time when the deals close, as well as lags in data calculation, the February 2007 contract reflects expectations of prices being agreed to at approximately the present time, while the August 2007 instrument is based on expectations of agreements likely to be reached around February.)

Such expectations may pan out in some areas or even average out for the United States as a whole. Indeed, the NAR just issued a revised forecast calling for weaker-than-previously-expected construction activity but only a mild downturn in pricing, with overall annual median gains of 2.8 percent and 0.2 percent for existing and new homes respectively.

But when considering regional variations, one has to wonder about the Northeast and West, areas where Toll Brothers does much of its business and which include most of the cities covered by the CSHPI. While a more dovish Fed would certainly be welcomed by the housing market, there's reason to wonder how much impact lower rates could have without help from lower prices.

Tables C and D show Affordability Index values for the Northeast and West, respectively, recomputed by us based on various assumptions of lower mortgage rates or median home prices.

There's an important wild card that could make many of our recomputed Index values too high. In all cases, we used present median family income figures. But if interest rates were to actually fall as far as some scenarios assume, it would most likely mean that the U.S. economy would be significantly weaker. That would make a case for lowering income assumptions, something that would depress index values.

But even if we adopt the all-else-being-equal scenario and hold income constant, it's clear that affordability problems in the West are so severe that they cannot be corrected by any plausible Fed-easing scenario and argue for a more-than-trivial decline in prices.

The situation is less stark in the Northeast, but even there, it would seem to require home-prices to fall by more than the low-single-digit percent range assumed by the housing futures market. Declines of about 10 percent would seem necessary to move the Affordability Index to adequate, although still far from comfortable, levels.

In any case, while geopolitical developments may, indeed, be impacting the psyche of the American consumer, Toll does seem to be underestimating the pain financial factors are inflicting on many wallets.

At the time of publication, Marc H. Gerstein did not own shares of TOL, nor did he have any position in housing futures. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.