Deep problems remain in the market, but there are reasons to believe spring was a turning point.
At the epicenter of the financial crisis is the U.S. housing market. We recently sat down with Eric Landry, an associate director on Morningstar's equities team who oversees coverage of homebuilders. His team sees signs that the market is stabilizing, which, if true, would have positive implications for a number of other sectors of the economy.
Haywood Kelly: Let's start with where the housing market sits now. Bring us up to date.
Eric Landry: Every person not living under a rock knows the U.S. housing market has been a disaster for the past three and a half years. Home starts peaked at a 2.1 million annual rate in January 2006 and have fallen straight down a very steep hill ever since. In fact, April's seasonally adjusted annual rate was 458,000, the lowest amount of homes started since 1959, or as far back as the data extend. That said, some in the industry see evidence of a bottom. They have seized upon the fact that for four consecutive months through May the number of single-family starts has been steady-to-increasing.
We think these optimists are on to something. This spring, we started to see encouraging signs. After years of decline, prices finally seem to have found levels that are attracting buyers in several of the former bubble markets. We're seeing existing home sale volumes up by 30% to 120% year over year in several markets across sections of California, Nevada, Arizona, and Florida. These states led the country off a cliff three years ago, so I think it's good news that they're finally reaching clearing prices. Believe it or not, California residential real estate is now in better shape than most markets in the country. San Diego, San Francisco, and several other cities are all markets that, we think, may have turned the corner earlier this year.
HK: One factor that will determine when the housing markets stabilize is supply; much hinges on how much will be coming on line over the next few years. What do you forecast?
EL: Unfortunately for the homebuilders, but fortunately for the rest of the housing market, this year looks to be another record low for housing starts. If we add up the backlogs of the 15 builders we cover, assuming market shares aren't radically altered and cycle times stay relatively constant, we come up with an annual estimate of around 500,000 to 600,000 home starts for this year. To put this in context, last year's 906,000 was the lowest on record. In the past, the housing market has generally bottomed at the 1 million mark. To have two consecutive years well below that level is unheard of, and it illustrates the severity of the current downturn.
The reason that I say this condition is "fortunate" for the rest of the market is because it's very obvious that the builders are now undershooting by a large margin what we would consider a normal level of demand.
HK: Which brings us to demand. How do you see that shaping up over the next few years given rising unemployment?
EL: The U.S. economy has the potential to create as many as 1.4 million net new households per year over the next several years. Echo boomers (the offspring of baby boomers) have just started to enter their prime household-formation years, creating a mild tail wind for housing production for the next several years. Also included in that 1.4 million number is demand from immigrants who came to the United States several years ago, as well as nontraditional households created through divorce and other means.
We also need to account for demand created by removals of homes that are destroyed, as well as second-home demand. All told, we estimate that the U.S. produces an overall demand of about 1.8 million homes in a normal economic year. Unfortunately, some level of employment is usually needed to support a new household, so 2009 and 2008 can hardly be termed normal. Adding up all the puts and takes, we come up with demand of roughly 1 million more units than will be put into the market for the two-year period ending in 2009.
HK: Another key factor you've pointed to is the number of extra homes needing to be absorbed. What do housing inventories look like today?
EL: We estimate the builders started to overproduce homes as far back as 2001. This situation persisted through 2006 and in the process likely created as many as 2 million extra homes by the end of that year. We reach this estimate through a number of analyses, the easiest of which to explain is an examination of the nation's vacancy rates. When the unused vacancies of rental properties and owned homes are combined, a picture emerges of a vacancy rate that began a steady climb in 2001 as the housing market started to heat up and landlords were unable to keep tenants. This rate reached a peak in 2006 to 2008 as "for sale" vacancies of owned properties started to spike. The rate remains elevated today. By taking the difference between the steady-state rate and the peak rate achieved in the past couple of years, then multiplying it times the housing stock, we arrive at our 2 million number.
Across the nation, if we compare supply with likely demand, we come up with a scenario in which the market clears its excess inventory by the end of next year, and much earlier in some local markets.
HK: To absorb the inventory, we need market-clearing prices. Do you think housing prices have come down enough?
EL: This is the key point that we think many are missing. According to Case-Shiller, which has become the de facto benchmark when referring to home prices, there are two cities where prices have retreated by more than 50% and another six that are more than 40% below peak levels, as of March, the most recent data available. In most of these markets, we've recently begun to see activity spike as investors and first-time buyers take advantage of outstanding affordability coupled with down payment assistance from Uncle Sam. In Las Vegas, for example, existing home sales in May weren't far off from a monthly record. The story is the same in markets such as Orlando, Tampa, Phoenix, and so on. In markets with huge price declines, it's almost as if a switch was flipped earlier this year with regard to buyers.
All of this activity is the first step toward stabilization, and it indicates to me that future prices are unlikely to suffer the bone-chilling declines of prior months.
HK: What if mortgage rates rise significantly? Does that ruin any chance of a near- term stabilization?
EL: It surely doesn't help, as higher rates mean that less of the income spectrum is eligible to buy. We've recently run several scenario analyses, however, and found that if mortgage rates went to 7%, affordability in almost half of the 20 Case-Shiller cities would be still higher than what it was in at least half the periods between the mid-1980s and today. While not as good as current levels of affordability--affordability has never been better in five of the 20 Case-Shiller cities and is better than average in 19 cities--it's not a disaster.
HK: Could an upcoming foreclosure tsunami overwhelm this analysis by throwing millions more homes on the market?
EL: The short answer is that it could but probably won't. It's been impossible to have a conversation about housing at any level of sophistication for the past several quarters without discussing foreclosures. In fact, it's now universally taken as fact that prices absolutely must continue to fall because there is, as you mention, a tsunami of foreclosures hitting the market. Further, the logic goes, the recent nascent strength we've been seeing and the resultant lessening in standing inventory is simply a function of recent moratoria enacted by several banks and government agencies.
As a stock analyst, I've learned throughout the years that whenever a subject comes up as often as foreclosures do in today's conversations and analyses, it's generally already discounted, or as we say in the business, it's "in the price." What you don't hear being talked about are the rational sellers that have decided not to sell their houses at what they believe are "give-away" prices, partially offsetting the inventory glut perceived to be coming from the foreclosures. As a result, you're seeing very subdued activity in the inventory numbers this spring for the first time in two years. What usually is a high-growth period for inventories is being constrained because, in my opinion, sellers are saying, "Enough is enough." That's not to say we can ignore the foreclosure problem, because we can't. But by the time there's consensus that the problem is behind us, prices will be materially higher in many desirable locations.
I believe there's a chance that the housing market actually reached an inflection point earlier this spring in many of the hardest-hit areas. It's correct that there's still too much inventory, foreclosures are likely to be a plague for some time, job losses remain highly problematic, and rising interest rates make homes less affordable. But prices in many regions have found levels at which inventory is starting to clear, and several are now starting to steady themselves. We're not calling for an imminent boom in the housing market but believe the seeds of stabilization may have finally been planted this spring.
Haywood Kelly, CFA, is vice president of equity research at Morningstar.