Two Views On Home Prices

Barry Ritholtz has a really good post which outlines the reasons that he doesn’t think house prices have come anywhere near a bottom. Here is his logic:

• Prices: By just about every measure, Home prices on a national basis remain elevated. They are now far off their highs, but are still remain about ~15% above their historic metrics. I expect prices will continue lower for the next 2-4 quarters, if not longer, and won’t see widespread Real increases for many years after that; Indeed, I don’t expect to see nominal increases for anytime soon;

• Mean Reversion: As prices revert back towards historical means, there is the very high probability that they will careen past the median. This is the pattern we see after extended periods of mispricing. Nearly all overpriced asset classes revert not merely to their historic trend line, but typically collapse far below them. I have no reason to believe Housing will be any different;

• Employment & Wages: The rate of Unemployment is very likely to continue to rise for the next 4-8 quarters, if not longer. This removes an increasing number of people from the total pool of potential home buyers. There is another issue — Wages, and they have been flat for the past decade (negative in Real terms), crimping the potential for families to trade up to larger houses — a big source of Real Estate activity. Plus, more unemployment means more . . .

• Foreclosures: We likely have not seen the peak in defaults, delinquencies and foreclosures. Many more foreclosures — which are healthy in the long run but wrenching during the process of dislocation — are very likely. These will pressure prices yet lower. And Loan Mods are not working — they are redefaulting in less than a year between 50-80%, depending upon the mod conditions themselves.

• Inventory: There is a substantial supply of “Shadow Inventory” out there which will postpone a recovery in Home prices for a significant period of time. These are the flippers, speculators, builders and financers that are sitting with properties that they do not want to bring back to market yet. Given the extent of the speculative activity during the boom years (2002-06), and the number of foreclosures so far, my back of the envelope estimates are there are anywhere from 1.5 million to as many as 3 million additional homes that could come to market if prices were more advantageous.

• Psychology: The investing and home owning public are shell shocked following the twin market crashes and the Housing collapse. First the dot com collapse (2000-03) saw the Nasdaq drop about 80%, then the Credit Crisis of 2008 saw the unprecedented near halving of the market in about a year. Last, Homes nationally have lost about a third of their value since the 2005-06 peak. Total losses to the family balance sheet of these three events are about $25 trillion dollars. These losses not only crimp the ability to make bigger purchases, it dramatically curtails the willingness to take on more debt and leverage. Speaking of which . ..

• Debt Service/Down Payment: Far too many Americans do not have 20% to put down on a home, have poor credit scores, and way too much debt. All of these things act as an impediment to buying a home. At the same time, to get approved for a mortgage, banks are tightening standards, including 1) requiring higher Loan to Values for purchases; 2) better credit scores to get approved for a mortgages; 3) Lower levels of overall debt servicing relative to income for applicants. Yes, theNAR Home Affordability Index shows houses as “more affordable,” but it conveniently ignores these real world factors.

• Deleveraging: For the first time in decades, the American consumer is in the process of saving money and deleveraging their balance sheets. After a 40 year credit binge, its long overdue. The process is likely to go on for years, as a new generation is losing confidence in the stock market, Corporate America and their government. Think back to the post-Depression generation that were big savers, modest consumers, who eschewed credit and borrowing. The damage is going to take a while to repair.

That’s a pretty well thought out argument for a sustained period of flat or falling home prices. But there’s always a different way of looking at the issue. On VoxEU William Wheaton argues that household formations are going to lead the way to higher prices.

Here is the crux of his argument:

As housing is a physical asset, its price must eventually equal or exceed the full cost building or rebuilding it – that is, as long as the market requires the construction of additional housing. So the real questions in the current crisis are a) when and how much future housing will the US need to construct, and b) are prices today so much higher than the cost of construction that they could still fall significantly and have development remain economically viable?

During the last decade, net new household formation averaged approximately 1.4 million per year. Last year, the Census reported that the US added only 544,000 new households – during severe contractions the young stay at home, singles “double up”, and household formation (normally) slows. Even with declining demographics, however, most analysts foresee new household growth resuming to a level of at least 1 million by 2010 and beyond. If we conservatively add 200,000 demolitions per year, the US economy will “need” at least 1.25 million new units yearly in the near future. With today’s currently depressed construction, this generates a yearly deficit of 750,000 units. At that rate, the current excess inventory of units for sale or rent will be back below normal by 2011. Prices historically have a strong relationship with sales “duration” – the ratio of inventory-to-sales. Hence under reasonable conditions, in two years we will have to increase construction considerably and prices will have to justify the cost of that construction.

Wheaton’s point is an excellent one. So long as you have positive demographic trends the problem will be self-correcting and the demographics will largely determine the pace of price recovery.

While it appears as if the two opinions are contradictory, I don’t really think that’s true. One of Barry’s arguments in favor of falling prices is inventory. He calculates a larger supply than, I suspect, does Wheaton. That’s a critical point from a timing standpoint but doesn’t invalidate Wheaton’s argument that population growth will eventually cause prices to begin rising again.

I accept Ritholtz’s other arguments and tend to believe that they will act as a brake on the growth of the housing sector and prices but demographics is like moving water; it’s a force of nature that cannot be stopped.

The real question isn’t so much when prices begin rising again but where. Will the sand states get back on their growth curve or has this recession permanently altered the historical dynamic of migration and growth? Figure out the answer to that one and you too can be a millionaire.

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