Rosenberg had a great section on the housing market today, with a lot of useful charts, and I couldn’t resist writing on them here. I’ll start with the basic conclusions, then explain the supporting charts (all of which are from Dave Rosenberg’s newsletters, mostly from today’s). The supporting charts will focus on 3 key areas: Supply, Demand, and Interest Rates.
- Avoid all investments related to single-family housing until inventory declines significantly and homebuilders adjust to lower levels of production. This will take years.
- The days of flipping homes are over for the forseeable future. Don’t think of buying a home as an investment, but as a purchase at this time. Unless you are immediately getting rent payments that cover expenses (like Kiyosaki in Rich Dad Poor Dad), expect to lose rather than gain wealth through homeownersip at this time.
- Use extra care when investing in REIT’s. They are by nature highly leveraged, because they are required by law to pay out 90% of net income to investors making it impossible to expand without financing and difficult to pay down debt. This makes them more prone to failure when vacancy rates on their properties increase. The overall demand for apartments should be good enough to be worth looking at, but make sure they aren’t in areas like Detroit which have an employment backdrop dominated by contracting industries.
The only positive here is the big reduction in housing starts. However, (as Rosenberg explains) when you look at the demographics, household formation is at 600,000/year which translates to a 430,000 annual natural demand for single family homes and condos. They will have to reduce production further to effectively bring down the excessive inventories.
There are several fundamental problems with demand right now.
- Unemployment remains high, and it is more concentrated at the younger ages associated with first-time homebuyers.
- The large supply backdrop hints of prices falling further, which will hold potential buyers at bay.
- Foreclosures and delinquent payers are at record levels. People who foreclose are at the proper ages for household formation, and will be taken out of the housing market for years until it clears off their credit records.
- A paradigm shift is emerging in younger generations, who have been or have friends who were burned by the subprime meltdown and housing collapse, and more of them are thinking of home-ownership as a purchase more than an investment.
- Negative equity for many homeowners, who are still paying their mortgages, is stopping them from moving up to a bigger house and making it difficult for them to move.
- Credit scores for Americans are severely reduced, with 25% having a sub-600 credit score. Combined with increasing credit requirements for home loans, this will drag on housing.
- Down payment requirements are increasing. Combined with high unemployment rates and investment losses since 2007, this further reduces the number of prospective buyers.
3. Interest Rates:
Interest rates will likely remain low for years. Because the government runs the mortgage market – with 90% of all mortgages going through Fannie, Freddie or the FHA, we can expect that interest rates on mortgages will also remain low.
Interest rates primarily depend on two things: Inflation and actions of the Federal Reserve.
Inflation: The CPI is getting very close to zero right now, and inflation is likely to stay subdued as Bernanke puts it. Right now we have a backdrop of higher productivity per worker (businesses can lower prices because labor is a major cost), low capacity utilization rates (no need to hire for a while), high unemployment (excess supply in labor and less cash to spend), and unusually high consumer and government debt levels (fuelling credit contraction and higher savings rates). High government deficits and easy central bank policy aren’t enough to drive inflation without increasing private sector demand – just look at Japan for the past 20 years.
Federal Reserve: The federal reserve has a dual mandate for both price stability and employment. They are very unlikely to raise interest rates while jobless claims remain at recessionary levels (above 400k), or while outlook for business remains so low (the Philly Fed business outlook has been declining the past few months, from +21.4 in May to -7.7 for August, and an article in the WSJ points out that most job losses are still with small businesses). Manufacturing is similarly positioned to deteriorate (index of leading economic indicators has been declining, and this leads industrial production by 6 months with an 80% correlation).
The Federal Reserve has clearly pointed out it’s expectations of a slowing economy with it’s last statements that 1. They will not reduce the Fed balance sheet as planned, but roll over their bonds as they mature, 2. They reaffirmed their commitment to keep interest rates low for a long time, and 3. They are prepared to engage in additional quantitative easing (balance sheet expansion) if the economy runs into further trouble. One of the preferred ways for the fed to do this in a zero interest rate environment is to purchase US treasuries of longer maturities to lower interest rates across the curve. Long story short, the treasury rates which the government bases mortgage rates on are not likely to increase significantly in the next few years.