"In Search of the Real Estate Bottom"
(This is a reprint from USAA's website. I have been a member of USAA since after Officer Candidate School in 1967. It just may be the finest financial company in America)
Industry analyst Joe Kalish of Ned Davis Research says indicators are finally moving in the right direction, but one key factor is missing.
Posted: 06/23/2009
USAA: Joe, when we spoke in December, you said, "We have not hit bottom, and probably won't see one until the first quarter of 2009 at the earliest." What's your view today?
Joe Kalish: We are much more positive and think that the market is in the process of putting in the bottom. January appears to be the trough in terms of total home sales.
USAA: Are you telling us that the nightmare is over?
Joe Kalish: I want to be careful in the terms that I use. We are confident that the market is in the process of putting in a bottom and that the worst of the declines is behind us. But the fact that sales probably bottomed in January does not mean that prices won't continue to decline. To the contrary, we expect them to go down nationally another 9% to 12% this year and the recovery process is likely to be a long one, lasting several years.
Let me step back from the conclusions and focus on the evidence. At Ned Davis Research Inc., we became concerned about signs of speculation in the real estate market back in 2005. In 2007, we developed a set of eight indicators on the state of the housing markets and have regularly looked to these indicators to guide us.
When we spoke to you in December, only two of the eight indicators were positive and as I told you then, consumer sentiment was falling apart. Today, only two of the eight indicators are negative, and we've seen a sharp turnaround in several key areas.
USAA: Please go through your indicators for us, starting with the positives.
Joe Kalish: First, mortgage rates have fallen to around 5%, the lowest in over 40 years. And along with falling home prices, they have created record affordability. Today, a family earning the median income of $60,000 can afford to buy a $300,000 home, which is well above the current median home price of $170,000 (with 20% down).
The next big positive is new building activity, with both housing starts and permits at a post-war low. Builders are now building only what they can sell, when historically building has exceeded sales by about 400,000 units. Building permits are at less than one-third of their 10-year average, when at previous troughs in the market they were about half.
Concerned about your investing decisions?
USAA: Weren't these indicators also positive last December?
Joe Kalish: Yes, but they are much stronger today. We can't work off the excess inventory that exists if we are still building new inventory and if people can't afford to buy homes, so the fact that these indicators are positive is absolutely essential to any bottoming and subsequent recovery.
That brings us to our next indicator, the rate of decline in home sales, which bottomed in January and has since moved in a narrow range. Pending homes sales have turned higher, and when we get the existing home sales data for May, it could top last year's peak month.
Perhaps the best news is that the markets that have been hit the hardest — Nevada, California, Arizona and Florida — are starting to clear. Sales are up 117% in Nevada over last year; 81% in California; 50% in Arizona, and 25% in Florida. These four "boom and bust" states accounted for one out of four sales nationally in the first quarter.
Of course, credit conditions have vastly improved, as the spreads for mortgages relative to Treasury's have narrowed considerably.
Another indicator that wasn't in our original list, but turned positive, is homebuilder confidence. The National Association of Home Builders/Wells Fargo Housing Market Index bottomed in January, the same month that sales troughed, which is exactly what happened in the last major housing market downturn in 1991.
So we have five positive indicators, and one neutral one, the S&P Homebuilders Index. This index of homebuilders' stock prices has gone higher in the big stock market rally since March 9, but it hasn't broken out in a way to signal all clear.
USAA: That leaves two indicators, which must be negative.
Joe Kalish: Yes, the picture isn't all rosy. The first problem is lack of end-user demand, as evidenced by the Mortgage Bankers' Association index of mortgage applications for home purchases, which doesn't include refinancing. While mortgage finance is obviously in much better shape than last December, the Index is near 10-year lows and down nearly 30% from a year ago. We need to see this pick up and break the downtrend.
Finally, the inventory-to-sales ratio remains swollen. There's roughly a nine-month supply, well above the six months you would normally see in a healthy market. Unfortunately these nine months don't include shadow supply from owners who want to sell but don't have to, and therefore are waiting for prices to rise.
USAA: What's the big picture moving forward? What should USAA members take away from this conversation?
Joe Kalish: The worst may be over, but recovery will likely take a long time. The patient is out of the ICU because prices have come down far enough for investors to step in and buy. That doesn't mean the patient is healthy enough to leave the hospital. About 50% of all sales are distressed homes, such as short sales and foreclosures and many of the investors buying these homes aren't moving into them. We still have 17% more housing units in the country than we have households, a number that needs to get down to about 14% to correct the excess supply.
Overall, sales bottom before prices. Should our call that sales bottomed in January prove correct, prices will probably fall another 9% to 12% by the end of the year. Real house prices are back to the 40-year trend line, so we've definitely squeezed the speculation out of the market.
In terms of what gives us a truly healthy patient, it's employment. As we look back to previous downturns, what we see is housing prices stop falling when the unemployment rate peaks. When workers no longer feel they are going to lose their jobs, they are willing to take advantage of low prices and low mortgage rates. That leads to stability in pricing. In terms of prices actually rising faster than inflation, it happens when labor markets get tight.
USAA: So we still have a way to go.
Joe Kalish: Absolutely, but housing markets are beginning to clear, value is returning to the markets. This is neither the deepest nor the longest downturn on record. Even in normal cycles it takes a long time for the market to restore equilibrium.
