Analysis of the Current Housing Market and When It May Turn Around
The excerpts from a Barron’s article is a nice analysis of the housing market and how the bottom is still a year or two away. The article is worth a read and has some really good charts with a different way to examine the demand for homes. Also at the end of the article are some comments about what the decline in housing sales and changes in the price of gasoline have on the consumer purchasing.
THE SPEED OF THE DROP IN HOME SALES has slowed over the past few months, leading some commentators to argue that the housing-market crisis will soon be over. But it's far too soon to start anticipating a recovery. In fact, there are solid reasons to think that the bottom might not be reached for a year or more.
The dynamics have changed since sales began to fall in the summer of 2005. At that time, the Fed was in the middle of its program to normalize short-term interest rates, which inexorably raised the cost of adjustable-rate mortgages. The flood of cheap ARMs when the fed-funds rate was very low was a key driver of the housing boom's latter stages. Many borrowers who were lured into the market by the availability of cheap ARMs should never have been granted loans, but there weren't many complaints at the time.
While demand was beginning to falter, home builders were still running at full tilt. The flow of new homes onto the market didn't slow significantly until 2006's second quarter. Partly because of the time needed to build homes, and partly because of many builders' hubris, this slow response to falling demand ballooned inventory.
From 2005's fourth quarter through this year's first three months, the supply of new homes rose to a level equivalent to 7.9 months of sales at the then-current pace, up from 4.7 months. During the boom years, from 1998 through 2005, supply typically equaled just over four months of sales.
Falling demand and rising supply rapidly slowed the gains in home prices. According to the Office of Federal Housing Enterprise Oversight, their peak year-over-year rate of increase was 10.9%, in the middle quarters of 2005. By this year's first quarter, prices were up only 3.0%. This downshift, accompanied by outright declines in cities where oversupply is acute, has changed the downturn's nature.
The key problem now is not the level of nominal mortgage rates, which are not particularly high by the standards of the past decade. Instead, buyers are backing off because the real mortgage rate has rocketed and continues to rise. At the peak of the boom, people essentially were being paid to buy a home. The average 30-year fixed mortgage rate in 2005 was a tax-deductible 5.9%. The Office of Federal Housing Enterprise Oversight says that home prices rose 10.7% that year.
As long as buyers expected prices to keep rising, the implied real mortgage rate -- home-price increase minus mortgage-interest rate -- was minus 4.8%. This was an enormous incentive to borrow heavily to buy real estate. Result: a bubble.
But recently, the average 30-year mortgage rate was 6.5%, so with home prices up just 3%, real mortgage rates are now 3.5%. And with most potential buyers well aware of the huge excess supply of homes, there's no reason to expect prices to rebound soon. A reasonable person might expect them to fall further, boosting the real mortgage rate further.
Over the past 30 years, there's been a very close association between our measure of real mortgage rates and the pace of home sales, adjusted for the U.S. population's expansion.
. . . . without further movement in nominal mortgage rates or the pace of home-price gains, sales must fall another 10% to 15% to match historical norms. But if our projections for home prices are correct, and the rate of increase almost hits zero this year, home sales will slip by an additional 20% to 25%. That would make the total decline almost 40% from their mid-2005 peak.
If home sales do drop for another year or more, even at a slower pace, expect further pressure on retail sales of housing-related items, such as building materials, furniture and appliances.
At the same time, the end of the boom in home-equity extraction means that all consumption is vulnerable, even with employment and wages still rising. The early part of this year saw quite robust spending, but this should be viewed in the context of the biggest drop in gasoline prices in 20 years in 2006's fourth quarter. Now that fuel prices have rebounded again, chain-store sales are suffering badly, and there is no reason to expect improvement.
In sum, the consequences of the bursting of the housing bubble will be felt for years.