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The US Housing Market's Road to Recovery: Slower Speed Limits and Stricter Enforcement

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PIMCO expects housing prices to appreciate 8% to 12% over the next two years.

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Picture a six-lane highway with roughly 110 million cars. The posted speed limit is 55 miles per hour, but there is not a police officer in sight. Since there have not been any major accidents in years, it is common practice to travel at 90 miles to 100 miles per hour, and insurance companies are lowering their premiums – often regardless of the state of the cars.

That describes the US mortgage market from 2003 to 2006. The story ended exactly as you would imagine: a massive accident with severe repercussions not just for housing, but also for the financial system and the global economy.

Today, the six-lane highway has been reduced to three lanes, as origination capacity has been halved. One is a fast-pass lane for customers who have been sitting in traffic the past couple of years and are now being rewarded for good behavior with access to historically low mortgage rates: the HARP lane. (The Home Affordable Refinance Program helps homeowners refinance who are underwater or near-underwater but current on their mortgages.) But for everyone else, the speed limit has been reregulated to 35 miles per hour. There are police officers at every mile marker, and the insurance companies are charging much higher premiums.

Where do we go from here?

Despite fewer lanes on the mortgage highway, we believe the US housing market has bottomed and is showing clear signs of a gradual and broadening recovery. The upward trajectory of housing prices should continue at a moderate pace. Over the past 100 years, housing has appreciated at roughly the rate of inflation. It is only in the past 10 years that housing has traded with substantial volatility due to leverage and "affordability" products. We believe the tailwinds are in place for an 8%–12% appreciation in housing over the next two years. Over the longer term, we expect a return to historical normal performance for housing relative to the rate of inflation.

We consider several dynamics in developing our outlook on housing: household formation, inventories, affordability and access to credit and lending.

Household Formation

The foundation of housing demand is household formation, which can occur via population growth, immigration or a reduction in the size of current households (people moving out of their existing households to start their own). Household formation averaged 1.3 million per year from 1997 to 2007 but declined precipitously during the financial crisis, hitting a low of 357,000. At the end of December 2012, the rate − around 973,000 − was still running more than 300,000 below the pre-crisis 10-year average for several reasons: deleveraging from the great recession, overleveraged college graduates, overbuilding during the housing frenzy and a decline in the homeownership rate, to name a few. We expect household formation to revert to its historical average within the next year or two as the economy recovers.

The homeownership rate, however, has declined from a peak of 69.2% in 2005 to a 17-year low of 65.3% today, and we believe the descent will continue. We see this as one of the secular headwinds for housing.

Inventories

Turning to supply, inventories of single-family non-distressed existing homes, shown in Figure 1, currently sit at 11-year lows, equating to less than five months of supply at the current pace of purchases − a very optimistic backdrop. As supply continues to get absorbed, builder confidence has increased, as evidenced by the National Association of Home Builders Index reaching its highest levels since the middle of 2006, and momentum in housing starts is positive, which will have an explicit impact on GDP via residential fixed investment in construction and remodeling, as well as implicit knock-on effects. Housing, which was a drag on economic growth throughout the financial crisis, is now positively contributing to GDP.


Looking at real estate nationally tells an incomplete story, however. State-by-state differences can be very dramatic, as Figures 2 and 3 show. The stock of housing is not fungible: You cannot take demand for a Chicago apartment and meet it with a farmhouse in New Canaan, Connecticut. (As an aside, if anyone would like a home in New Canaan, please give us a call.)






Geographical idiosyncrasies, such as population and housing stock, are also part of the story. Figure 3 illustrates changes in housing stock relative to population differences from state to state in 2010 and 2011.
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