Why There's No Such Thing As a Housing Bubble

Includes: CTX, DHI, LEN, PHM, TOL
by: Clay Kime

It seems that wherever we go, everyone asks us the same question . . . “what’s going on in the Real Estate Market?” Opinions are all too readily available, particularly in the press and blog. One thing we noticed about the sources the news media quotes is that they are almost universally from Wall Street stock analysts and rarely from within the real estate industry.

In the process of conducting the research for this report, we noticed that none of the other reports contained actual analysis of pertinent data and facts. More typically we find musings and circular reasoning about business cycles, speculation about “speculators” etc., all peppered with anecdotal stories of historical boom and bust, peaks and troughs, as though they were substantive, informative, conclusive and otherwise inescapable.

This surprising lack of industry data caused us to independently collect actual data and develop our own comparative financial models to analyze the data, to identify facts, causes, trends and forecasts. This required the compiling of more than 20 databases including Federal Reserve Board Historical Data, National and Regional Mortgage Histories, FNMA & FDIC Home Loan Histories and Regional Home Sales Transaction Histories for Condominiums, Townhomes and Single Family Homes.

The Sky is Falling, the Sky is Falling! (The Bubble is Bursting!)

The concept that there is or was a “housing bubble” is simply the nonsensical and fancifully imaginative story of Wall Street Stock Analysts, who have been chanting this exact same “mantra” since the late 1990’s in an effort to divert investment activity back into the stock market.

They would have us believe that the public suddenly and simultaneously woke up/sobered up and realized/decided that home prices were just “over-inflated” and simply bailed-out, resulting in a “burst bubble!” The facts are, however, that upon detailed analysis of the principle factors affecting the housing market’s demand, we begin to see that the housing market is “responding” to external forces which have exerted artificial economic conditions upon it. The primary factors are, “supply” (the inventory of available homes) and “demand,” including the affordability of those homes (the buyer’s ability to pay.)

Additionally, it should be noted that the preponderance of commentaries on the “Housing Market” are authored by Stock Market Analysts with a myopic view that whatever is affecting the business and stock performance of Toll Brothers (NYSE:TOL), Pulte (NYSE:PHM), Lennar (NYSE:LEN), DR Horton (NYSE:DHI), Centex (CTX), and the like are the true indicators of the condition and future of the housing market. Indeed these publicly traded companies are likely to be the hardest hit, already taking hundreds of millions of dollars (most likely billions when the dust settles) in write-offs from the cancellation of their speculative land options. Additionally they have and are making substantial price adjustments to reduce the glut of speculative inventory upon which they now sit.

During the go-go days of the first half of the 2000’s, most of the builders also took a “take-no-prisoners” attitude toward their buyers. Further, many of them compelled purchasers to use their in-house mortgage companies who “shoe-horned” many buyers into homes and loans they really couldn’t afford. This rough and tumble business practice has made it psychologically easier for buyers to simply cancel their contracts and buy elsewhere!

So what is the “cause?” In order to apply logic and the law of causality (that every effect must have an antecedent cause) to the housing market we must fully understand the “effect” before we can even hope to identify the cause.

The State of Market Values – A Look at the Regional Data

Throughout this report we will be looking at all of the data (comparatively) from January 2004 through December 2006 in twelve quarterly segments. All data are based on “averages,” so there are transactions both above and below the average prices used for evaluation.

Northern Virginia home prices appreciated at an unprecedented rate during this period.

Single Family Home prices appreciated 33.2% in 2004 & 2005 before the 2006 adjustment of -7.03% for an average net increase of 26.2%. (Average Sold Price difference Q1-04:$552,985 to Q4-06:$697,839.)

Peak period, average price: $753,569 Sold Q3-05 & Settled Q4-05.

Townhome & Duplex prices appreciated nearly 38.4% in 2004 & 2005 before the 2006 adjustment of -5.3% for an average net increase of 33.13%. (Average Sold Price difference Q1-04: $348,044 to Q4-06: $463,344.) Peak period, average price: $489,035 Sold Q3-05 & Settled Q4-05

Condominium prices appreciated 31.8% in 2004 & 2005 before the 2006 adjustment of -7.7% for an average net increase of 24.07%. (Average Sold Price difference Q1-04: $258,604 to Q4-06: $320,870.) Peak period, average price: $340,569 Sold Q3-05 & Settled Q4-05

In all three home types, the common denominator is a market peak in Q3-05

. . . Interest Rates? (Have they gone through the roof?)

It is true that 30-Year Fixed Rate home loan mortgage rates have increased from 5.65% in January 2005 to about 5.875% today. If you say this is not a big change, you are right! There was a peak rate spike in July of 2006 to 6.875% but now we are back to ~6.0% which is historically very competitive. In fact, 30-year fixed rates have remained in this range since 2003 with a slight push upward in Q3-05. But, there is more telling evidence when we look at the historical data on Adjustable Rate Mortgages [ARM].

Throughout 2003 and 2004 ARM rates were about 2.0% lower than 30-Year Fixed. In 2005 this eroded to just 0.5% difference and today’s rates show less than 0.25% difference. Why have the ARM products risen so high? The answer is that these loans are indexed to short-term financial rates, which the Federal Reserve Board influences directly with their manipulation of the Federal Funds Rate (Discount Rate). These rates have been increased from 1.0% (July 2003) to 5.25% (July 2006) where it remains today. (Note that the current Fed Funds Rate of 5.25% is the highest rate since March of 2001.

It appears clear that the Fed’s rate hike in August, 2005 to 3.5% was the primary catalyst that spurred the shrinking demand for housing purchases. While most people would opt for the 30-year fixed loan (if rates are nearly identical), the ARMs were popular for buyers who just wanted lower monthly payments as well as those who wanted to qualify for larger loan amounts in the booming market. ARMs are also the favorite financing vehicle of speculators and “flippers” (no, not Bud’s pet porpoise) who wanted to buy-fix-and-flip properties quickly. We now see that in the ARM-world, rates have risen steadily from 3.5% to 6.0% since January of 2004. That’s a 71% rate increase in the last 3 years, which represents a 34% reduction of buying power (affordability) for those buyers using the ARM products for financing.

According to major lenders as well as FNMA and FDIC, ARM products comprise over 50% of newly originated home loans in our region. So it’s not difficult to see that since half the potential buyers have lost over 30% in buying power, demand has synchronistically been reduced, and home purchase prices have been steadily re-aligning with purchaser’s ability to pay.

In the third quarter of 2005 (Q3-05) we see that the external forces of the Federal Reserve Board’s policy decisions to manipulate interest rates manifested what we are calling the “housing affordability GASP.” (The sound one makes after being punched in the stomach . . . or wallet.)

While we can see the effects of the Fed on all industry and businesses, the “cost of money” factor becomes apparent at many different “critical points” for manufacturing, construction, transportation, distribution, services and retail, etc.

When GM and Ford’s sales are down, was there a “car-bubble?” Is there a “Google-bubble” since its selling for over 60-times more than it earns and 10-times its book value? Dow Jones up 2,000 points in 2006 . . . a “stock market bubble?”. . . Of course not!

Housing is no different than any other industry and should not be expected to be immune from external forces over which it has no control. For the housing market though, we can see that a “critical point” was realized in Q3-05. (Note that while the factors were brewing in the previous quarter(s), the critical point “manifestation” in the housing market actually occurred in Q3-05).

Fed Rate Hikes Create Home Price Yikes!

During Q3-05, ARM rates, subject to increases by the Fed, increased to nearly 5% and the Oil & Gas industry graced us with $3.00+/gallon gas (sort of frosting on the cake.)

Inventories of available homes had equalized with demand. But with home buyer’s affordability eroded by the Fed’s rate hikes, nearly half of the potential buyers necessarily headed for the side-lines.

With half of the homes remaining unsold and new properties being offered in the market, inventories quickly grew over and above the newly diminished absorption rate. Average “days-on-market” which had been measured in days or a few weeks, suddenly jumped over the “month” mark and has steadily grown to an average today of 3+months.

Seller’s expectations of holding out for a further appreciated price was no match for buyer’s inability to pay and prices had to begin to come down to “market-level.” But actual “asking (list) prices” continued to increase through the third quarter of 2006 (Q3-06) by nearly 20%. However, after price reductions and closing cost incentives, the actual net sales prices declined by about 24% from the increased list prices.

It was not until the current quarter (Q4-06) that average list prices began to decline to meet buyer’s affordability. From Q3-05 through Q3-06 we witnessed nearly half of the available properties were either withdrawn from the market, or converted into rental properties. This pattern has begun to ease the large inventories of competing homes and re-direct the trend toward balance of supply and demand.

What’s Next for 2007? – An Analysis, not a Guess!

Where is equilibrium and market balance, and when will it occur? We know of no credible source that knows precisely, but we can use the data compiled and results of our analysis to make a rational, educated assessment.

Using Q3-05’s data points to assess where the market was just before the “Gasp,” we see an across the board correlation of average home prices (Condos, Townhomes and Single Family) and the then available mortgage rates, specifically ARMs.

By imputing today’s ARM rates into Q3-05’s ARM rate payments and the “then average sold prices” we yield an Affordability Index [AI] differential of slightly over 13%. Subtract from that the declining “net sales prices” of today, we are still looking at some likely decline in “average” sales prices ranging from 0.7% for single family homes, 2.35% for townhomes and 6.85% for condos, which have had the least amount of price reductions. As a shorter answer: Today’s affordability is 13% less than it was in Q3-05, or about where average prices were in Q1-05 at today’s ARM rates.

Although “net sales prices” are very close to our “AI,” “high list prices” remain a barrier to “timely sales.” List prices for Single Family Homes are still 10.5% above the “AI,” Townhomes are 9.35% above the “AI,” and Condos are 14.09% above the “AI.”

It is likely we will witness market balance in the first or early-second quarter of 2007. We are very close today with sales prices near Q1-05 levels!

Regional job growth is robust, personal income is up and there is some growing speculation that the lower-than-expected consumer price index [CPI] numbers, issued December 15th may lead to the Fed easing rates at the March ‘07 FOMC meeting.

Conversely, other economic conditions and/or political events could result in higher rates, prolonging the journey to market balance into mid-late 2007, or beyond.

It’s also important to note that arrival at “market balance” will always remain somewhat of a moving target, but as we come into that range, the “normal” annual rates of appreciation will slowly return, although in the 7% to 10% range (not the 14%-20% that the last 5 years delivered.)

Disclosure: Author has no position in the above-mentioned stocks.