January 18, 2011
Key points
It's been a while since I wrote specifically on the state of housing and the questions are cropping up again. In particular, I've been asked a lot about the relationship between housing and employment, and housing and the economy, both of which I'll address in this report.- Housing is becoming less national and more regional in terms of strength/weakness.
- Affordability is up but so are foreclosures.
- Employment remains key to housing, but be aware of housing's diminished impact on the economy.
Let me start by summarizing where I think we are in the cycle. Although I believe the overall residential real-estate market is generally finding its bottom, I think we have to take a step back and begin again to look at real estate regionally, not just nationally.
Housing is not a monolith. Yes, when the bubble was inflating the rising tide did lift all (house) boats, and when the tide went out with the bursting of the bubble, it took all (house) boats with it. But I think that's coming to an end, and going forward we'll see both pockets of improvement and continued malaise.
Not all housing markets are created equal
Geographic pockets of strength or weakness are typically a function of local economics, inventories and demographics. We're starting to see more differentiation when diving into the numbers across the country. The S&P/Case-Shiller Home Price Indices were recently released, with data through October 2010. They include a 20-city composite of metropolitan areas, and in terms of the one-year percentage change, here are the top and bottom five regions:
Another way to slice the data is to show the actual index level. For instance, an October index level of 186.7 in Washington DC indicates that average home prices are more than 86% above their January 2000 values. An index level of 68.9 in Detroit indicates that average home prices are still more than 30% below their January 2000 values. That's the worst showing by far. Below are the rest of the top and bottom five regions based on index level:
Ugly year for foreclosures
The biggest black eye that remains on the face of housing is the foreclosure problem. In 2011 lenders are likely to foreclose on more homes than any other year since the housing crisis began in 2006. The only saving grace is that RealtyTrac believes 2011 will be the peak in foreclosures, predicting 1.2 million homes will be repossessed this year, up from one million in 2010.
The pain will likely be the most acute in states that have already suffered the worst, including Nevada, Arizona, Florida and California, or in states with bleak economic outlooks, including Michigan and Illinois. More than half the country's foreclosure activity occurred in five states in 2010: California, Florida, Arizona, Illinois and Michigan; meanwhile, Nevada posted the highest foreclosure rate in 2010 for the fourth consecutive year.
Affordability has spiked
But all is not bleak. Most measures of housing affordability have improved markedly. As regular readers know, I keep a close eye on "real mortgage rates."
Like real gross domestic product (GDP), which is nominal GDP less the inflation rate, the real mortgage rate is the nominal mortgage rate (30-year fixed) minus the rate of inflation (or deflation) in home prices. Remember, it's not just the mortgage rate that matters to demand, but also the rate at which houses are appreciating or depreciating.
As you can see in the chart below, real mortgage rates have come down substantially from their peak (which corresponded to the trough in the housing market), but remain well above their trough (which corresponded to the peak in the housing market).
Real Mortgage Rates Coming Down
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Source: FactSet, Federal Reserve, National Association of Realtors, as of November 30, 2010.
The traditional measures of housing affordability have improved meaningfully, too. The first chart below shows the Housing Affordability Index, which is composed of mortgage rates, home prices and personal income data. As you can see, affordability is at an all-time peak. The second chart below shows the ratio of home prices to disposable personal income, and the news is good here, too, as prices have come down to at least a 30-year low.
Housing Affordability Hitting Records
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Source: FactSet, National Association of Realtors, as of November 30, 2010.
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Source: FactSet, Federal Finance Housing Board, High Frequency Economics, as of September 30, 2010.
Housing and employment … the connection
The key to improving demand may lie in something else besides affordability, and that's job growth. The prospects for employment and housing are likely more linked today than any time in history, given the severity of the crisis in both.
As detailed in a study by Ned Davis Research (NDR), real (inflation-adjusted) house prices have historically stopped falling when the unemployment rate has peaked. This potentially bodes well for the housing-is-bottoming story given the drop in the unemployment rate from its October 2010 peak of 10.1% to its present 9.4%. However, real house prices have historically not started to rise until the unemployment rate approaches the "full employment rate (NAIRU)."
Declining Unemployment Rate Should Help House Prices
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Source: FactSet, Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2011 (c) Ned Davis Research, Inc. All rights reserved.), as of September 30, 2010. Yellow shaded areas represent periods of rising unemployment. Gray shaded areas represent periods from unemployment peaks until 1.2% points above Non-Accelerating Inflation Rate of Unemployment (NAIRU), a level of unemployment below which inflation rises.
The gray shaded areas represent the time from the unemployment rate peak until it falls to within 1.2 percentage points of the full employment rate. (Although it appears as if the unemployment rate peaked last October, until that's confirmed, the most recent span will remain shaded yellow.)
Assuming the full employment rate is around 7% (NDR's estimate), real house prices likely won't start rising until the unemployment rate falls below 8%. If the full employment rate is closer to 6%, as is assumed by many economists, then the recovery could take even longer.
Burst bubbles take longer to heal
As you can see in the chart below, we're already more than five years into the home-sales downturn, by far the longest stretch (gray bars) in history. The decline in price is rivaled only by the downturn from 1978-1982 when mortgage rates were in double digits and the United States was heading into back-to-back recessions.
Sales Finally Picking Up?
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Source: FactSet, National Association of Realtors, Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2011 (c) Ned Davis Research, Inc. All rights reserved.), as of November 30, 2010. Gray shaded areas represent downturns.
This downturn is the result of a bubble that burst, but was certainly exacerbated by the related financial crisis and severe recession. NDR compared this bubble to a composite of the four historic mega-bubbles: the Dow Jones Industrial Average in 1929, crude oil in 1980, the Nikkei in 1990 and the NASDAQ in 2000, seen below.
Housing Following the Bubble Path
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Source: FactSet, Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2011 (c) Ned Davis Research, Inc. All rights reserved.), Standard and Poor's. Historical Bubble Composite as of January 1, 2002, thru May 31, 2016. Case-Shiller Composite as of October 31, 2010.
The picture of the prior bubbles is consistent with our view that housing has probably broadly bottomed, but the path up is likely to be relatively flat, elongated and volatile among geographic regions.
Housing and GDP … the connection
Finally, the real key question is the impact of housing on the overall economy. One of the most common questions I get is whether we can get decent GDP growth without housing doing the heavy lifting, as it did in the last up cycle. Here's where I think many people have it wrong, much as they did after the bursting of the tech bubble in 2000.
As the economy exited recession in 2001, the thinking was that the economy couldn't recover without leadership by technology, given its prior power as an economic driver. However, from the peak in 2000 when equipment and software represented more than 9% of GDP, it was subsequently on its way to near 6% by 2008 … only since then has it begun to rise again. The economy recovered, as did the stock market, without leadership from technology.
As you can see in the final chart below, housing has been on a similar path. At the peak, residential real estate represented more than 6% of GDP, whereas now it's a record low of little more than 2%.
Housing Is Less Important to GDP
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Source: Bureau of Economic Analysis, FactSet, as of September 30, 2010.
That of course doesn't mean housing can't be a negative contributor—it just means there are other forces that have gained power as this cycle has unfolded. As an example, auto production now accounts for a larger share of GDP than housing, and its prospects are looking much better.
Upside potential?
The potential good news is that housing starts have been running at a pace of only 40% of their 30-year average, well below the household formation rate. In addition, we're seeing improved price and volume performance for non-distressed sales. Supply is heading back up thanks to increasing foreclosures, but we could be getting close to the last ugly Case-Shiller report and the market-clearing process should pick up in the spring selling season.
Necessary ingredients for a healthy recovery in housing would be the aforementioned down slope in the unemployment rate, a further loosening of the credit environment, no significant (further) spike in mortgage rates, and general improvement to consumer confidence. Again, we believe the prospects for housing are improving, though certainly not stellar, but our optimism about the economic recovery could feed into better-than-expected housing news as well.
Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
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