One of the most hotly debated topics over the past two years involves the timing of a potential housing recovery.  The staggering numbers of the housing boom and bust have been repeated ad nauseam: homeownership rates increased from an average of 64.4% from 1970-2000 to 69.2% in 2004; the rate of indebtedness of American households rose from 107 percent of assets in 2001 to 140 percent of assets in 2006; home prices nationwide declined by 33 percent from their peak in 2006 through January 2012; and approximately 22 percent of homeowners still owe more than their houses are worth.  Why did the housing bubble occur?  While there was not one specific reason for the housing boom and bust, one factor was the search for yield from investors throughout the world.  As a result of the U.S recession in the spring of 2001 and the terrorist attacks on September 11, the Federal Reserve chose to lower interest rates in order to make credit easier to obtain (the typical monetary decision to attempt to jump start an economy).  This made it more likely that a mortgage applicant would receive the necessary credit to buy a house.  At the same time, global investors from around the world had been made better off by the economic boom of the 1990s.  Individuals (and sovereign investment funds) from countries, such as China, Brazil, and South Africa, had more money to spend and invest.  These investors looked toward the most liquid market and, by most accounts at the time, the safest market in the world: the United States bond market.  However, with yields on Treasuries held down by the Fed’s desire to maintain low interest rates, global investors searched for a U.S. asset with higher yields: mortgage-backed securities.  As money began to pour into mortgage-backed securities, investment banks began to create more of these securities.  Simultaneously, loan officers at commercial banks saw the demand from both investment banks and investors for the mortgage-backed securities.  By selling mortgages to investment banks to turn into mortgage-backed securities, commercial banks determined that they could make more money.  As a result, lending standards eased further, which created more demand for housing.  Home builders began to build more houses: housing starts increased to over 2 million units in 2006[i].  This self-fulfilling cycle pushed both housing supply and demand to a level that was not sustainable.  When some mortgage recipients began to have trouble repaying their mortgage payments in 2006, credit tightened and home prices started their decline.  New construction plummeted.  Investment and commercial banks still holding mortgage-backed securities – especially those created in 2005 and 2006 – saw their stock prices crater.  What started as a search for yield ended in an economic crisis in the United States.

Supply and Demand

During the housing boom of 1999-2006, both housing demand and supply rose above their historical averages.  Housing demand is historically based on the number of household formations – individuals typically between the ages of 25-40 who want to leave their parents’ households, who previously lived with friends in an apartment, or who are now financially well off to afford a house.  According to the Census Bureau’s Housing Vacancy Survey, since 1965 the number of households in the US has increased at an average annual rate of 1.5 percent, adding an average of approximately 1.3 million new households per year.[ii]  Despite demographics being the underlying driver for household formations, there is cyclicality to formations based on economic conditions.  As demonstrated by the chart below, household

 

formations declined during the economic recessions of 1982, 1983, and 1990.  Between 2000 and 2007 household growth increased by an average annual rate of 1.0 percent.  This was above the 0.8 percent average rate in the 1990s, but below the 1.4 percent average rate in the 1980s and the 2.3 percent rate in the 1970s – the time period during which the baby boomers entered adulthood.  According to a study by the National Association of Homebuilders, by extending the 1.0 percent average growth rate for the period of 2007-2010 equates to approximately 2.1 million household formations that were postponed because of the recession.[iii]

Consequently, this means that the excess housing supply can be reduced by not only demographic forces, but also by the pent-up demand that has accumulated over the past 5 years. 

Shadow Inventory

Shadow inventory refers to houses that are either in foreclosure and have not yet been sold or houses that owners are not putting onto the market until prices increase.[iv]  Shadow inventory tends to cause housing data to understate the amount of supply that is actually on the market.  According to real estate information company CoreLogic, the shadow inventory nationwide stood at 1.6 million homes at the end of January, lower than the 1.8 million homes in January 2011.[v]  Of the houses in shadow inventory, 800,000 homes were seriously delinquent (90 days or more), 410,000 were in some stage of the foreclosure process, and 400,000 were already seized by lenders.  Furthermore, Florida, California and Illinois account for more than a third of the inventory.  1.6 million amounts to approximately 5 months supply of housing.  This is approximately four times higher than its low point (380,000 properties) at the peak of the housing bubble in mid-2006.  A study by Morgan Stanley reported that only one quarter of these properties were brought with a subprime loan.  Instead, approximately 55 percent of these properties were bought with a prime mortgage.[vi]

Impact on Future Home Purchases

With many short sales (a sale of a house for less than the homeowner owes on his or her mortgage) and foreclosures having been completed or in the process of occurring, many homeowners have seen their ability to obtain a mortgage decline drastically. 

As demonstrated by the chart the impact on a person’s FICO score depends on the starting FICO score.[vii]  All other things remaining constant, the higher a person’s starting FICO score, the greater the percentage drop as a result of one of the credit events.  Also readily apparent is the fact that there is no difference in FICO score impact by a short sale or a foreclosure. 

Further studies have also shown that the higher the starting credit score, the longer it takes for he or she to recover his or her original FICO score.  Do these numbers provide any particular insight into future housing demand?  In the twelve months ending in February, there were

862,000 completed foreclosures throughout the United States.  In February, approximately 60

major markets saw a decline in their foreclosure

rates compared to a year ago.[viii]  Furthermore, across the country the highest number of foreclosures occurred in 2009 and 2010.  If the average of 3-7 years remains the time it takes for those homeowners to recover their credit scores, then between the years 2013- 2016 could be a time when many Americans become mortgage-worthy in the eyes of banking institutions.  Combined with a potentially improving economy that could cause a burst in pent-up demand from household formations, 2013 could begin a string of years in which price appreciations could occur in all areas of the country.

Renting: The Solution?

Because of the economic turmoil in the United States over the past 5 years, a good amount of people chose to delay buying a house and instead chose to rent.  This choice has been evinced by the upward pressure in the Consumer Price Index by the housing category.  Throughout the past 3 years, the Core CPI – which excludes food and energy prices – has risen primarily because of the increase in rent prices.  Housing makes up almost 41 percent of the Core CPI.  All housing prices are calculated as if each person had to pay rent in order to live in his or her house.  Therefore, the cost of rent is a major determinant in the CPI figure.  Nationwide, the apartment vacancy rate is down to 5.2 percent, its lowest level in more than a decade.[ix]  Home ownership has fallen from its peak of 69.4 percent in 2004, according to census data.  In the fourth quarter of 2011, home ownership was down to 66 percent.  This means that almost 2 million more households are renting now than in 2004.  The demand for rental property has brought large investment firms into the fray.  Historically, buying foreclosed homes has been dominated by individual local investors.  However, many investment managers are buying rental properties with the hope of achieving net annual returns of around 10-12 percent.[x]  These institutional investors buy hundreds of properties, team with local investors who know the houses and can find the renters, and then hope to flip the houses in the future when prices increase.  This process is ongoing particularly in the markets that were hit hardest by the housing downturn: California, Arizona, Florida, and Las Vegas. 

[xi]

More locally, rental prices have continued to rise in the metropolitan Boston area.  Moreover, the vacancy rate dropped to a nine-year low of 4 percent in the fourth quarter of 2011.[xii]  With rent prices increasing and houses prices decreasing, does this imply that individuals will begin to make the switch back to buying houses?  In October 2004, Fed economist John Krainer and researcher Chishen Wei wrote a Fed letter on price-to-rent ratios.[xiii]

From 1983 to 2000, the price-to-rent ratio fluctuated between 1.0 and 1.15.  Then, from 2000 to 2006, the ratio shot up to 1.8 before crashing down to 1.2 in 2008.  Currently, the ratio stands at around 1.1.  This is approximately what the ratio was in the mid-to-late 1990s.  This suggests that the ratio is approximately near its average level for the 1980s and 1990s and implies that only further increases in the prices of rent should cause people to choose to buy a house instead of renting. 

Conclusion

The data on supply and demand, shadow inventory, credit scores, and the price-to-rent ratio suggest that the fundamentals of housing portray a sector that has begun to stabilize.  Combine this data with record low interest rates and the positives of buying a house increase.  Therefore, a housing recovery could begin in early 2013.  During this recovery, there could be a slow appreciation in housing prices depending on the state of the rest of the economy.  Consequently, the probability of a burst in the prices of houses remains subdued for 2012.  A stock market and economy driven by the housing sector could still be a year or two away.    

*The opinions and forecasts expressed are for informational purposes only and may not actually come to pass.  This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan.  The representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions.

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