Spring Winding for Long-Term Housing Demand

Last week I interviewed Eric Landry (), associate director of Morningstar's industrials and homebuilding team, following a very poor report on new U.S. housing starts.

Eric noted that the starts number for the month set a record low at 550,000 on an annualized basis and that full year 2008 sales amounted to a mere 904,000 new units. The outlook is for overall starts to be even worse for calendar-year 2009. The bright side is that these horrific numbers are extremely low compared with "natural demand," which we estimate at 1.3 million to 1.5 million units per year. In effect, the current situation is now winding a spring for long-term housing demand.

Natural demand is driven by population increases and the proportion of the population approaching the normal home-buying age. Each and every year, population continues its inevitable upward march at a roughly 3-million-person pace in the U.S. In the short run, a few things such as slowing immigration, slowing divorce rates, adult children moving back in with parents, and residents acquiring roommates to help with the rent can offset the natural demand for housing and slow demand for new housing. That is exactly what is happening now and in almost every other recession. But these are not optimal living arrangements. So when the recession lifts, the number of people per household tends to decrease and housing demand increases. Once the bottom has been hit, we have a double positive effect. First those hitting the normal home-buying age pour in at their usual rate, plus we have all those people who have been stuck in suboptimal living arrangements who are demanding out.

When you also consider that destruction and the aging of housing stocks take some homes out of service every year, you can see how tightly we are winding that spring if natural demand hits 1.5 million units with only 900,000 new starts in 2008 and potentially just 600,000-800,000 starts in 2009.

Existing Home Sales and Inventories
On the margin, housing starts are always interesting to watch, but as Eric pointed out, the inventory of existing homes is the key metric that he uses to evaluate the health of the housing market. On Jan. 26, the National Association of Realtors reported on sales, inventories, and months of supply of existing homes. Because of their size, the existing home sales and inventories data points can prove to be much more useful than new home sales/starts, which are a fraction of existing home sales.

The National Association of Realtors data showed inventories dropping from 4.16 million units in November to 3.68 million units in December. Inventories do tend to go down naturally in December as homeowners take their houses off the market for the holidays. (Hence, it would be very natural for this number to rebound in January.) However, inventories in December 2008 still fell by 7% compared with December 2007. Since April, inventories have declined each and every month. Months of supply slipped to 9.3 in December from 11.2 in November on the back of higher sales and lower inventories.

We are pleased the inventory numbers are moving in the right direction. I have always believed that inventories had to improve before real estate prices could stabilize and the overall economy could begin to recover. But inventory levels are still elevated at 9.3 months of supply versus a more typical 6 months. We would need to see inventory levels below 3 million units before pulling out the champagne.

Digging Into the Numbers
Skeptics could argue that several factors unnaturally suppressed the inventory level over the past several months. One claim is that several financial institutions and at least one state have imposed moratoriums on foreclosures. Therefore, there is a big "shadow inventory" of houses that will appear only when prices move up. There is some merit in this; however, not all of these programs have occurred at the same time, and they really haven't shown up dramatically in other months' numbers. I would also argue that a substantial number of homes that were about to enter into foreclosure might already be on the market.

Other inventories may remain in the background because the potential sellers are not desperate for a sale and have taken their homes off the market to wait out the storm. However, we think any shadow inventories will emerge after the market has actually bottomed rather than driving the housing recession deeper in the short run. It is possible, though, that they could slow price increases in a recovery.

In conclusion, the inventory of existing homes for sale is moving in the right direction, even if there is room for discussion on the exact magnitude and a few special contributory factors. We would expect to see a small rebound in inventories in January due to normal seasonality. We will continue to monitor this key statistic and will report back next month.

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