Around the turn of the millennium, fueled by a perfect storm of ridiculously easy credit, non-existent government oversight, and basic human greed, a housing boom was born. By the end of 2006, the median price of existing homes had risen 67% to $225,000 and the National Association of Realtors housing affordability index had declined by nearly a third. New home sales were up more than 75%, housing starts had climbed by nearly 60%, and the U.S. homeownership rate rose from its historic average of 64% to an eventual peak of almost 70%. All cycles end, but because of its meteoric rise and the excessive leverage involved, this one ended badly.
Though difficult to time, the downturn was inevitable, and since the peak the median price of an existing single-family home has dropped by 37% in inflation-adjusted terms. The market value of U.S. home equity was cut in half, wiping out over $7 trillion of household wealth. Both new home sales and housing starts plummeted, while the homeownership rate slipped back to a still-high 66%. In the process, the housing affordability index went full circle, from extraordinarily expensive to remarkably affordable. Other consequences of the housing collapse were the loss of almost 2 million construction jobs and an unprecedented number of home foreclosures.
Unless one spent the last decade on Gilligan’s Island, none of the foregoing should be news. The real issues are: Where are we now in the housing cycle, where are we headed, and what are the investment implications? Our view is that the worst of the housing debacle is behind us and, while the pace of recovery is difficult to predict, recover we will. Home ownership has always been a vital part of the American dream and we do not believe that this has changed in any fundamental way. Using one’s home as an ATM may be a thing of the past, but in our opinion owning a home will for the foreseeable future remain a compelling (and tax-advantaged) way to help build a retirement nest egg.
The most important factor driving the long-term demand for housing is household formation, which is driven primarily by population growth and secondarily by wealth. The latest census showed that the U.S. population grew from 281 million in 2000 to 309 million in 2010, or slightly less than 1% per year – very respectable for the developed world. Annual household formation peaked at over 2 million in 2004, but has since fallen dramatically to around 700,000. Before the bust, strong job growth and lax lending standards allowed for a greater than normal number of people to establish their own households. Today we face the opposite situation, with the difficult economy forcing people back into more extended family-living arrangements. Some analysts believe that the U.S. may be “short” as many as 5 million households, meaning that with normal population growth and continued economic recovery, household formation could exceed the annual average of 1.1 million in coming years. This would augur well for a structural recovery in housing demand.
Other key factors influencing the demand for housing are affordability and the related notion of “cost to buy” versus “cost to rent.” On this score there is virtually universal agreement that for the nation as a whole, houses are now the cheapest they have been in a very long time. Whether one looks at the ratio of median home prices or mortgage payments to income, monthly rent versus mortgage payments, or the ratio of home values to replacement cost, the conclusion is the same: Thanks to a combination of house price declines, low mortgage rates, and continued escalation in rents, now is an excellent time to buy a house – provided one qualifies for a loan.
An offset to our solid population growth is the changing demographics of this nation. The first wave of baby boomers hit 65 last year, while the growth rate of those 20-64 years old has been falling for years, from almost 1.2% in 2006 to less than 0.5% in 2012. Historically, those 65 and older have been net sellers of homes. It is true that older Americans are more active purchasers of second homes and are now living longer, to boot. Nonetheless, the net effect of this demographic shift should be an absolute drop in the number of potential new home buyers added annually.
Other negative factors hanging over from the bust include the large number of “under water” homeowners who can’t afford to move, let alone trade up. Also, there is the risk that younger potential buyers traumatized by the bust (whether from first-hand experience or not) will avoid becoming homeowners for an extended period of time, especially if they owe some of the $1 trillion in outstanding student debt. Taking all of the above into account, however, our belief is that the outlook for housing demand is moderately strong.
The Supply Side
Over the long term, the required housing supply is a function of the rate of household formation and the need for replacement dwellings. While this level is currently about 1.2 million units per year, there was a massive overshoot during the boom years, with annual housing starts peaking at close to 2 million. Thus we were left with a huge inventory of empty homes, which has yet to be sopped up.
Getting a handle on the size of this excess inventory is much more difficult than one might think. Various analytical approaches come up with dramatically different numbers, but most are in the range of 2 to 4 million units. An analysis by Deutsche Bank distinguishes between “normal” and “excess” inventory, since the latter has the most bearing on the timing and speed of any housing recovery. The total inventory of vacant homes (18-19 million) is adjusted for factors such as vacation and second homes. They conclude that the true excess inventory of unsold homes is only 1.2 million and that, at current rates of household formation and housing starts, clearing this overhang should take about two years.
The biggest factor that will determine the rate at which these excess homes enter the market is the level and pace of foreclosures. Prior to 2008, the mortgage default rate was approximately 1%. However, as of September 2011, 4.4% of mortgages were in foreclosure and another 3.5% were severely delinquent. The foreclosure process slowed temporarily due to legal problems that surfaced over the banks’ procedures, but now that a settlement has been reached with the government, the process is likely to accelerate. Then we will see how quickly the banks release foreclosed homes into the market. Thus far they have been quite disciplined, if only because they don’t want to record losses on the sales. As long as these reluctant “owners” continue in this deliberate manner, housing prices should recover more quickly than otherwise.
Our strong belief is that we are past the low point of the housing cycle, and that a gradual recovery can and will occur. While the return to more normalized conditions may take two or more years, existing home prices may again begin to rise this year or next, but only at a measured pace. The speed and strength of the recovery will vary by state and by market. The two biggest threats to a housing recovery would be a return to a recessionary environment that crimps demand or a sharp acceleration in foreclosures coupled with the banks dumping foreclosed homes on a still oversupplied market.
The most obvious investment implication is on the individual decision to buy or rent. Since affordability indices are at near-record highs and we believe we are past the bottom, now seems like a good time to purchase a home. Of course, this is a general statement and real estate is a very specific decision. As noted, we believe the recovery will be neither rapid nor evenly distributed, with some regions having excess supply for many years to come.
Regarding more liquid investments, there are a number of possibilities, beginning with the homebuilder stocks. Given the risks inherent in their distinctly cyclical and seasonal exposure, we would focus on companies with strong balance sheets, adequate cash, lean overhead, and greater exposure to geographies exhibiting strong job growth. While the S&P 500 Homebuilders Index has more than doubled off its October low, it remains more than 70% below its 2005 peak. While we may not see that peak again anytime soon, there could still be further opportunity.
Next are the home improvement retailers. Since these companies sell into both the new construction and remodel markets, they tend to be less cyclical than home builders. Note that in a housing market recovery, an increase in the percentage of foreclosed properties coming to market is actually a good thing for the home improvement market as such properties tend to be in worse shape and therefore require more work. Our investments in this group have strongly outperformed the market since last October, but for now we would suggest waiting for a more attractive entry point. A third choice are companies that manufacture structural housing components or home furnishings, but with few exceptions the stocks of these commodity-like businesses hold limited appeal for us.
Also, there are a number of different Real Estate Investment Trusts (REITs) that focus on the multifamily housing sector. As noted, rents have been rising in recent years and may continue to do so as more owners become renters by foreclosure or by choice. A major attraction of many REITs is their above-average dividend yield. In looking at this sector, one wants to focus on exposure to markets where renting remains cheaper than owning (whereas when looking at builders, one wants to focus on exposure to markets where house affordability is the greatest).
Finally, and most importantly, it is hard to overstate the impact of housing activity and the related wealth effect on the general economy. The mid-2000s boom was largely driven by these phenomena. A recovery in home construction would undoubtedly be positive for the stock market as a whole as construction jobs tend to be well-paid, and each has a robust multiplier effect that leads to the creation of ancillary jobs.
Stock Market Comment
It is said that the stock market climbs a wall of worry, and that has certainly seemed the case over recent months. Skeptical investors park money on the sidelines until the continuously-rising stock market seduces some of them into the fray. That provides additional fuel to drive stocks still higher, which in turn entices still more money to come off of the sidelines, and so on. So, where are we now?
The primary bear case relates to “tail risks,” of which there are a number: European debt problems, Iran, a seemingly broken U.S. political system, and the fear of a hard economic landing in China. Other issues include excessive regulation, rising gasoline prices, and a probable peak in corporate profit margins.
The bull case focuses on rising global demand for goods and services, extremely accommodative world monetary authorities, the superior financial health of corporate America, and the modest U.S. stock market valuations. In addition, returns on the massive amounts of investor cash reserves are negative when adjusted for inflation, and those on bonds are not much better. When interest rates inevitably rise further, the returns on many fixed income investments will be negative as well.
In the end, we continue to believe that the long-term trading range, as outlined in our year-end Investment Strategy Update, is still intact and that a few more years will need to pass before the start of the next secular bull market. Yet, we also believe that the bottom of this cycle was reached in 2009 and that, while elevated levels of volatility will continue, we should experience reasonable overall returns. Insofar as 2012 is concerned, we think that there will be at least one meaningful pullback, but we do not know when or from what level. Our strategy is to become increasingly defensive on further stock market strength, while remaining committed to our primary investment themes.