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I stumbled across an interesting article on the United States housing market released back in late February 2011 written by Paul Dales, a Senior US Economist with Capital Economics. In the article entitled "US Housing Market Analyst Q1 2011 – Another Year of Falling Prices", Mr. Dales analyzes the next year in the American housing market and offers his prognostications.
Mr. Dales starts with a brief look at the United States economy. He notes that, while GDP is expected to rise by 3 percent this year, it will likely slow in 2012 back to the 2 percent level.
He notes that the main problem that households have is the accumulation of too much debt. Although the household debt-to-income level has dropped from 135 percent to 122 percent, it should be in the 100 to 110 percent range for consumer spending to pick up meaningfully. He also notes that household income is not growing in real terms, particularly when higher prices for food and energy erode any modest income gains. As well, the American labour market has only marginally recovered its losses from 2008 – 2009 despite the recent drop in the unemployment rate. This drop is likely due in part to workers falling off the Bureau of Labor Statistics radar screen because disillusioned workers are leaving the labor force rather than meaningful long-term job creation.
On to the housing market. First I’ll look at the supply side, followed by demand and lastly Mr. Dales’ prediction about where prices are headed.
On the supply side, the number of all homes listed for sale is very high at 4 million in Q4 2010. This is about 700,000 more than one would expect in a healthy market and the excess has dropped very little quarter-over-quarter. The number of new homes that are listed for sale fell to a record low in December 2010. One statistic that I found particularly interesting is the number of vacant homes. In the fourth quarter of 2010, 2.7 percent of American homes are vacant, up from 2.5 percent in the third quarter. This means that roughly 2.5 million listed homes are vacant on top of the 3.6 million homes that are vacant but not yet listed for sale. That is a stunning number. To make matters on the supply side even worse, it appears that the supply of listed homes will not shrink meaningfully over the coming months as over 8 percent of American households had missed at least one mortgage payment in the fourth quarter of 2010. Over 4.5 million households have missed three monthly payments or are already in the process of being foreclosed upon. As it stands now, there is an 8.7 month supply of homes listed for sale at the current rate of uptake, down from its peak but above the 7 month median.
On the demand side, home sales had recovered to the depressed levels of 2008 – 2009. Sales numbers have been supported by the demand for discounted foreclosures and the sale of distressed homes reached 36 percent of all sales, the highest since January 2010. One major impact on the demand for housing has been the drop in the formation of new households. In 2010, only 360,000 new households were formed, the lowest number since World War II; this is down from two million new households in 2003 and the ten year annual average of 1 million new households. This is related to several factors; less immigration, the "doubling-up" of households where multiple families or multiple generations of the same family occupy the same dwelling, increasing number of young adults between the ages of 25 and 34 living with their parents and the impact of demographic changes as the population of the United States ages. Demand for homes is also lower because of declining creditworthiness of potential homeowners who do not qualify for conventional mortgages. At least part of this decline in the ability of Americans to qualify for mortgages is related to a lack of positive equity in the homes that they do own; where homeowners have less than 20 percent positive equity in their existing home, they have insufficient funds for a down payment.
The combination of stubbornly high supply and low demand bodes ill for the American housing market. Despite the fact that sales are rising, we are living in one of those rare periods where increased sales are not matched with increased prices. The large number of foreclosures entering the market and the large number of homes that are either underwater or where mortgages are in arrears are keeping prices increases in check. Data shows that the average price of foreclosures has dropped by more than the average price of all homes putting downward pressure on the prices of all listed homes. The Federal Housing Finance Agency report for January 2011shows a month-over-month price decline of 0.3 percent and a year-over-year price decline of 3.9 percent. Overall, since the peak of the market in April 2007, the market has dropped by 16.5 percent and the index has now reached the same level as it was in May of 2004. Here is a graph showing the Monthly House Price Index (HPI) since 1991:
Here’s a bar graph showing the year-over-year price changes for each of the census divisions and how prices in different areas of the United States have been impacted differently over the past year:
The Case-Shiller price index also shows that the rebound in prices seen in 2009 has been all but negated as shown here:
Mr. Dales concludes that it is most likely that, over the coming year, the American real estate market will experience a further price drop of five percent, even when recent modest improvements in the economy are taken into consideration. This would leave prices 10 percent below the level reached in the second quarter of 2010. He feels that prices will drop the most at the low end of the market as potential first-time buyers struggle to save for a down payment and attempt to secure credit although he notes that homes at all price levels will be impacted to some degree.
His conclusion could be affected by improvements in the unemployment picture; Mr. Dales uses the rule of thumb that suggests that every 1 percent drop in unemployment results in one percent inflation in house prices. As unemployment drops, the number of foreclosures would also likely drop and vice versa. On the other hand, a rise in interest rates related to concerns over the mounting U.S. debt situation could severely weaken the housing market, detrimentally impacting the supply and demand balance. For every 0.25 percent increase in mortgage rates, after a one year lag, prices are depressed by between one and two percent per year and by year five, house prices have dropped by nearly 10 percent. This downward pressure on prices will be exacerbated by additional households finding themselves in a negative equity situation and facing foreclosure.
From Mr. Dales’ analysis, we can see that there are a multitude of variables that will impact the American real estate market over the coming months and years and that it is unlikely that we’ve seen the end of the down cycle in real estate. In my opinion, the greatest unknown variable is changes to mortgage interest rates. Should the world’s bond markets become skittish over the state of the United States’ debt and deficit situation and start attaching an interest rate premium for the perception of risk, it could be a very long time before the domestic real estate market stabilizes and moves to the upside.