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Calls For Housing Bottom Premature


Based on analysis, crisis has way to go.

Existing home sales rose by 2.9% in February, the first significant rise in home sales since the housing market started to decline last year. I was in my car and listening to CNBC as commentators started to celebrate the bottom of the housing market.

Since the credit crisis has its roots in the U.S. housing market, and will require a resolution of the housing market in order for credit markets to return to whatever will look like normalcy in the future, it's of more than passing interest to get a handle on the actual state of the housing market. So while this is about the U.S. housing market, it will also affect the credit markets worldwide, as well as impact China and other nations who sell to the U.S., because of the connection with consumer spending. This week we look at the data from sources that are actually involved in analyzing these markets. It will make for interesting reading.

But first, a quick note about a new "button" on my web site. As you know, I read a lot of material each week. Some of the more interesting material is passed on to me from readers of the letter. We now have a link on the right-hand side of my site that says, "Recommend an Article to John." You can click on the link and a page will come up that allows you to enter a web address, along with a brief description of the article, report, essay, etc. Of course, you can still reply to this letter with material or comments as well.

And speaking of replying, I am going to be doing a lot of traveling in the next few weeks, giving speeches. My favorite part of the speech is always the question and answer portion at the end. Some of the time on the road I won't have my usual access to research material. So I've decided that I'm going to do one or two e-letters in the next few months that simply respond to your questions. If you would like to ask a question and get my thoughts on a topic, now is your chance. Simply reply to this letter, put "question" in the subject line, and then give me your question in the email. Thanks, and now on to the housing markets.

Housing - Finding the Elusive Bottom

Let me acknowledge up front that much of what you will read is from two main sources. The first is John Burns of John Burns Real Estate Consulting, which he founded in 1989. John consults with over 2000 of the largest banks and homebuilders in the country (his client list is a who's who of banks, builders, and hedge funds). He has a reputation for solid research and pulling no punches. Some of his hedge fund clients were the ones you read about who made billions. (He wishes he had negotiated a percentage!) He's deeply involved in analyzing trends in the housing market. His web site is He has graciously put the PowerPoint presentation that I'm working with on his site for you to read, should you want to dig deeper.

The second source is T2 Partners, a well-known value investing advisory firm in New York. They have a massive 76-page PowerPoint that you can review at your leisure at, crammed with facts on the true extent of the problems in the subprime mortgage markets. It's rather sobering. While the thrust of the presentation is to analyze the true extent of the problems at Ambac (ABK) and MBIA (MBI), there's a lot of data on the housing market as well. Remove sharp objects from your vicinity before you read it.

So, the question we seek to answer today: Have we seen the bottom of the housing market? Was last month's small rise a sign of the bottom, as many on CNBC and elsewhere opined?

First, let's look at five graphs from John Burns (out of several hundred that he graciously allowed me to review!). Starting with conclusions first, John predicted a 15% decline in home prices early last year and has recently raised it to 16%. I pointed out that there are a lot of firms, like Goldman Sachs, who are more bearish, thinking home prices will fall 20-25%.

He laughed and noted that last year he was the bear, and now he is the optimist. But he points out that 16% is a national average, with some markets projected to do a lot worse. Here are his projections for the 20 largest markets. Note that in every market there are still more price reductions projected.

Click to enlarge image

The reasons for the declines are many. Let's look at a few. First, we simply built more homes than the nation could absorb. In 2005 alone, there were 48% more housing-related transaction than there should have been. Note in the graph below the large rise since 2000 of transactions above the expected sales trend line. Sales are now back to that trend line, but are expected to fall further. Burns projects that sales activity will drop another 30%, to 1995 levels, and that will happen relatively soon.

This is going to mean that homebuilding is going to be forced to slow even more. Burns projects that permits to build new homes will fall anywhere from 32% to as much as 70% in the top 20 markets. The large majority of those markets haven't seen permits fall even half as far as Burns thinks they will. Reality has not yet kicked in for many homebuilders.

New and existing home inventories are hovering in the 10-month range and are likely to rise further as foreclosures put more homes on the market. This will likely mean that a buyer's market for at least another 3-4 years is the most likely scenario.

Click to enlarge image

All this speculation created 3.5 million excess homes that need to be filled. There are about 2,000,000 more homeowners than long-term trends would indicate, and many of these are buyers who used questionable mortgages to buy a home and are now in the foreclosure process. And as we will see later, it's going to get worse before it gets better.

Click to enlarge image

But with the dramatic drop in the availability of subprime mortgages, we have reduced the number of potential home buyers. In many markets, the affordability of housing simply prices out many potential middle-class buyers. And potential buyers of rental properties have not seen prices drop to where they can make a profit by buying and renting the homes. The following graph shows that nationwide it costs almost twice as much to buy a home as to rent.

I know that it would cost me much more than twice in monthly costs to buy a condo or home that is the equivalent of my apartment. I can't mentally justify the extra expense today, although that may change, as there are a lot of condominiums coming onto the market this year in Uptown Dallas. It will be interesting to see if prices drop. Note the rise in the differential between renting and buying since 1998.

Click to enlarge image

But here is where the picture gets clouded. There are parts of the country where homes are quite affordable. Note the difference in affordability between the coasts and the middle of America. So, we have to be careful when we talk about the crisis in housing. All real estate is local.

Click to enlarge image

Let's look at a few more facts. Due to falling interest rates, a typical adjustable-rate mortgage, or ARM, buyer saw his buying power rise 55% from 2000 to 2004. Since then there has been a 21% deterioration. That has helped lower sales traffic for new homes to the lowest level since they began collecting statistics in 1985.

But on a note of optimism, Burns notes the housing market is extremely cyclical. We have had times of extreme distress before, which typically last 3-5 years, and this one too shall pass. Burns projects that sales should be higher than current levels by 2012. Median resale prices will bottom out in 2010, only about 16% below the top.

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