Friday, July 25, 2008

Houses Houses Everywhere and Still a While to Sink

Whereas two years ago real estate was cocktail party talk, now it is a walk away subject. As the pain felt by builders, banks, and municipalities as well as owners surpasses that of the dot com bubble it now reaches into the very heart of American values and wealth. It was not so long ago that federal gadabouts were touting the blessed event of home ownership and doing all in their power to put any and all into a mortgage obligation. Now they seem more inclined to talk about personal responsibility than the policies put in place to encourage moral hazard and high risk behaviour.

How long does the housing and real estate market have to slide before reaching its end. When will it be safe to go back in the water and consider real estate again a viable place to put money or buy a home? Unfortunately, while our positive attitudes tell us it has to be nearly over, the facts speak truth to power. Real estate becomes just another product when we strip away the emotional aspect of hearth and home.

Currently there are approximately two million too many houses for sale or rent. That does not include what is referred to as "shadow supply," those units simply sitting vacant and not offered in the market.

There are approximately 129 million housing units in the nation. That figure includes single family dwellings, duplexes, apartments etc. On any given night about 14% of those units are empty. This is far beyond any previous vacancy levels nationally. Understanding the make up of those empty units will give us a clue to how close we are to the end of the housing crisis.

Of the 129 million units therefore, 18.5 million are vacant. The approximate figures by catagory are 7M second homes, 2.2M vacant homes for sale, 1.4M vacant houses for rent and the remaining 7.9 are duplexes, condominiums and apartments.

Clearing this market overhang will 0ccur either be by sale or by bulldozer. It is expected 300 to 400,000 will become teardowns in areas that become blighted by vacancy. A large number of the other inventory however, is relatively new construction and will not likely be taken from the roles in such dramatic fashion. In the last national housing decline of 1980's, housing prices and activity began to recover meaningfully after unsold inventory had been decreasing for two years. Currently the inventory is still increasing so we have not even yet hit that tipping point.

Apart from housing inventory we look at mortgage defaults. There are approximately 55 million mortgages in the country. Currently about 5 million are in trouble and nationally 2.5% are in default compared to a norm of 1%. In other words additional forclosures are coming.

Over the past decade, the U.S. has seen home ownership increase from 64% of households to 69%. It seems likely we will return closer to the historical level prior to the "mis"incentives provided during recent years. The reasonable conclusion is that only demographics will pull us from the clutches of this speculative housing glut.

We are only now beginning to see significant increases in bank foreclosure sales. Those will naturally remain a significant downward pressure on pricing. To clear the market based on the affordability index at current mortgage rates of about 7%, prices need to fall nationally another 10% to begin clearing inventory. The affordability index is based on price, mortgage rate and income and is a dynamic equilibrium. If unemployment rates rise as predicted, either prices or mortgage rates would have to fall as well to approach clearing levels.

One aspect of the housing crisis not often discussed is the price of land. We are beginning to see significant collapses in land prices in various markets. In the weakest, land prices have already fallen 60% to 70%. If considering that the cost of housing is made up of land, labor, capital and material you can see where the pressures will focus. Capital costs are relatively transparent, at historically lower levels and market driven so probably not a focus of cost cutting.

Labor is already under severe pressure and subject to prevailing wages. Expect to see additional pressure here.

Materials costs are in new territory because of the globalization of commoditiy prices and the building boom in Asia in particular. Lumber, cement, metals and plastics are now subject to global pricing pressure more than ever before. In previous building slow downs, domestic materials costs reacted quickly. Now there are other markets ready to provide demand for the physical components of building.

The final factor of production is land. Particularly in those relatively unregulated building markets such as Florida and Las Vegas that have experienced vast building booms, expect land to also begin bank sale foreclosures.

I don't expect to see a flattening of the housing market until 2009/2010 on a national level, and even then it will be longer before consumer balance sheets are repaired sufficiently to provide sustainable upward pressure on housing. The real estate bubble fed on the expectation of higher prices to come. Conversely this deflation will continue to feed on the expectation of lower future prices. As all products in mature markets, prices will migrate to the marginal cost of production and then overshoot to the downside. Keeping capital intact will provide excellent opportunities a few years hence.

On a personal level there will certainly be opportunities to buy in particularly distressed circumstances, but the cost of patience will be very low in the next couple years.

There will continue to be significant market specific aspects of real estate, but in most markets there will be better opportunities to those who wait in the weeds.

John Barnyak