Housing is Ready For an Upturn

Philip Guziec: Hi. I'm Phil Guziec, Co-Editor and Portfolio Manager of Morningstar's OptionInvestor Research Service, and I am here with Eric Landry, Associate Director of Industrials and also covering the homebuilding industry and homebuilders.

Eric Landry: Hi, Phil.

Guziec: Good to see you.

Landry: Me too.

Guziec: So, let's talk about housing.

Landry: Let's do it.

Guziec: Anybody who hasn't been living in a cave for the past half a decade knows that there has been some issues with the housing industry. Where we are at in that cycle and what's the basic lay of land now?

Landry: Well, we have hit a bump in the road with the expiration of the Federal tax credit, but I am of the belief that that this is more of a transitory event. If you look at the amount of production relative to the amount of potential demand, we are at all-time lows right now, and it's on a bunch of measures.

You look at the number of starts or new home sales relative to the amount of potential family formations and removals and vacancies that looks very, very positive for a long-term bounce. And you can also see it in some of the other metrics, for instance, gross fixed investment in residential housing as a percent of GDP is at multi-decade lows right now. So, I think as far as both production and prices, we are in the trough about ready for an upturn.

Guziec: So, let's talk about that supply and demand dynamic. I know you are very fundamental, long-horizon driven guy, and you've been looking at these numbers for a while. How does that play out? How do we know how many – becomes the normalized low of housing demand and how are we comparing to that with current?

Landry: When you talk about normalized demand, you have to look over large chunks of time, decades, and then just take an average. So the demographers out there will tell us that there is normalized demand over the next 10 years of somewhere around 1.2 million to 1.5 million homes just from households being formed. That is either in a divorce, where one household turns to two, or kids leaving the nest, where one household turns into two or three depending up on the number of kids, or immigrants coming that shacked up with other families when they first got here, they have established themselves to the point where they can now form separate households.

So there is somewhere 1.2 million to 1.5 million households demanded every year from that. Additionally, you've got a few hundred thousand homes that have either blown over, burned down or simply wear out. So you can see that the numbers there are kind of encouraging.

Now, if you pit that against supply what's being injected into the market right now, which is 500,000 or 600,000 units, you can see that if we do this for a long enough period of time, there becomes a pent-up demand.

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Guziec: And then, what are you looking at to try to figure out when that pent-up demand starts to reverse, let's say, or initially starts to reverse?

Landry: Well, the main driver is economic conditions, right, because unless your name is Buffett, Gates, Rockefeller, you need a job to sort of go off on your own and support the payments for one of these households. So, job formation, while is not a leading indicator of housing starts and new home sales, it is sort of a coincidence in catering you need it to sustain increased household formation.

So to the extent that the country can get back to some sort of job creation condition, that would be very beneficial to sort of getting back to this normal supply/demand situation.

Guziec: So that's the number one thing you look at to say, okay, we're turning the corner, home sales are going to be increasing and prices are going to be normalized.

Landry: Well, like I said, it's not a leading indicator. What I look at is builders' attitudes towards investing in land. There are bunch of other soft metrics that sort of give me a gut feeling we're way through the worst of this. But to confirm this, I would like to see some job growth going forward.

Guziec: Okay. And what do you think is the key couple pieces of disconfirming evidence that might make you think your thesis may not be correct?

Landry: Well, we're seeing it right now, although I believe it's transitory. We had a huge decline in new home sales when the tax credit expired, leading many people to believe that with little demand there was, was brought forward. So if this condition persists for a number of quarters, then I may have to go back and rethink my thesis.

In addition, if this is a recovery, which is without jobs, which I doubt, I think the jobs will come back at some points. There are number of indicators we look at that say the job creation in the future is going to happen. But if I'm wrong on that, which is possible, that would be another disconfirming indicator to this thesis of, you know, at some point this housing market will get back on its feet.

Guziec: Okay. But handicapping the likelihood that we're getting back on our feet now versus it's going to be years, what do you think the probability is one way versus the other?

Landry: Well, that's a tough question, Phil, but it's one we need to answer. And I think the probabilities lie heavily skewed towards that we will get back on our feet at some point in the next three to four quarters, let's put it that way.

One of the things that encourages me is that if you do continue to build at this rate of production that only increases the tilt of the upturn whenever it does come. So you've got a situation where you are building and building and building, and the more we build at this rate, the better off we will be…

Guziec: We can keep coil on the spring.

Landry: Exactly.

Guziec: Thanks for taking the time, Eric.

Landry: All right, Phil. Thanks.

Guziec: I'm Phil Guziec, Co-Editor and Portfolio Manager of Morningstar's OptionInvestor Newsletter. Thank you joining us.