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Why Housing Could Come Back with a Vengeance

Jeremy Glaser

Jeremy Glaser: Hi, I'm Jeremy Glaser with Morningstar.com. It's Ideas Week. One of the things that a lot of investors have had on their minds is the housing market. Here to discuss it with me is Morningstar's resident expert, associate director Eric Landry. Eric, thanks for joining me.

Eric Landry: Sure.

Glaser: So what do you think about the general state of the housing market for 2010?

Landry: Well, as we sit now, as we speak now, we're firmly in a very weak period for housing seasonally. So true to form, housing prices are weakening as we speak. People refer to Case-Shiller and whatnot, which is still rising, although that's short-lived. But that's yesterday's news. Right now, I can tell you affirmatively that housing prices are weakening.

Now the good news is that listed inventories, we're not talking about the shadow inventories, but listed inventories are also going down quickly, and there was never a seasonal build in the spring. So we have that going for us.

It's difficult to tell what exactly we're looking at in 2010, because there are a number of factors. You've got the shadow inventory, which is coming back, several million homes coming back. But at the same time, what you never hear people talking about is what's priced in.

What is the price of homes right now discounting? And I would argue that as discounting, a lot of them are already coming back, because what you are seeing is prices that will support--people can buy houses for less than they can rent an equivalent house in that market.

So people talking, the mainstream press, the pundits are talking about a lot of pressure coming next year when all these foreclosures come back. I'm not so sure that's already priced in, in effect. I believe it's more likely than not that that's already priced in.

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Glaser: So how important do you think the government has been in kind of stabilizing home prices, and how important do you think they'll be in the future? They've already extended the homebuyer's credit once. Do you think we'll see further extensions or more incentives to get people into houses?

Landry: Well, first off, on the importance question, there's no doubt about it that the government has been the most important provider of financing. You see FHA is basically the only game in town right now. And as we've all seen the press, that particular program is running into some problems here with credit and whatnot. So there are some problems there.

Having said that, if we get rates to tick up and whatnot, you may get some private sector back into the space, or if they can see that prices are starting to firm, you may get some of those folks back into the space.

So as I said before, it's very, very touch-and-go with regards to who's going to provide funding. And it's part of the reason we're really having virtually no activity on the construction side right now.

Real quick, let me may lay this out here. This year we're going to have roughly 530,000 or 550,000 homes started. That is a new record low, which surpassed the old record low, which was last year. So we're now at two record lows as far as housing production. This is significantly less than what happened in the low of 1990, '82, and '75. Those bottomed around a million or 1.2 million starts. Like I said, we're now at 500,000. So slowly but surely, the over-supply of housing is getting sopped up.

Glaser: Well you know, one of the things that people talk about a lot is that new household formation is really important, because if there aren't more people forming households, then you don't have a demand for housing. Do you see an uptick in that for 2010? Or do you think that people are going to continue to forestall divorces and moving out with their parents and things of that nature?

Landry: It all depends on one thing: jobs. Over the long term, the potential household demand is very, very steady. Right now it's actually somewhere between 1.5 million and 1.8 million. That's the potential.

Unfortunately, if your name is not Rockefeller or Buffett or someone like that, you need a job to support a household, and we don't have that right now. So that's compressed, and we have heard estimates of ... maybe half of that. So there are only 700,000 homes being formed.

But as we talk about that, the same thing happened last year, and to some extent, a little bit the year before. So as some of these people just cannot crowd together any longer, this is going to burst at some point, and we will have to catch up for two and a half, three years of less household formation than potential. And once jobs come back, that could really come back with a vengeance.

Glaser: Switching gears a little bit, talking about homebuilding stocks, it seems to be the most direct way to play the housing market. Do you think that the sector is pretty much fairly valued right now?

Landry: Yeah. The time to buy housing stocks was in the spring, just like everything else. Right now, we see most of the housing stocks are fully valued. But if you're looking for something for your radar, there's a very nifty homebuilder called NVR. And it's not subject to the regular ills of most of these homebuilders, because they don't carry an inventory. They have developers develop the land for them. They take the lots on balance sheet right before they sell the house and they get rid of the house.

It's actually more like a normal manufacturing business, and you don't have the risk attached to carrying significant amounts of land. Returns on capital for NVR are among the highest in our industrial sector, so it's a very, very high-quality company, not just a high-quality homebuilder.

Another area you might want to look at if things weaken a little bit, if we get some weakness here in prices, is Mohawk. It's the largest flooring maker in the country. It operates with Berkshire-Hathaway's Shaw Industries as the two 800-pound gorillas in flooring.

Flooring is a tough business. But with all these foreclosures that are coming down the pipe, most of these houses arrive at the new buyers with insides that are just destroyed. So you need to do significant amounts, and usually, carpets are destroyed, flooring is destroyed.

So it's possible that this foreclosure boom could actually be a stimulant to demand for flooring, and Mohawk is relatively cheap on top of it. Not quite as cheap as we would like, but as I said, if you get some share weakness, this might work out.

Glaser: So definitely some things to keep on the radar screen.

Landry: Sure.

Glaser: All right. Eric, thanks so much for speaking with me today. For Morningstar.com, I'm Jeremy Glaser.