Housing

Tom Beilstein, Portfolio Manager

Occasionally we look into specific sectors of the market in an in-depth manner. This month we are taking a closer look at the housing market. Much of the information in the following article was supplied by a Ned Davis Research special report on housing.

The Housing Market

Since the mid-90s, we have experienced a strong housing market. The rate of home price appreciation has been steadily rising since 1995. We are finally beginning to see this rate slow and the current year-over-year change in home prices is 6.4%, close to the historical average of 5.9%. Although the home price appreciation rate has slowed to near historical levels, it remains greater than the finance cost. Whenever the rate of appreciation is above the financing rate, it is bullish for future home investment. However, real home prices are posting gains well above their historical average. Since 1995, real existing home prices have risen 2.6% per year, compared with 1.1% since 1966.

Can We Afford It?

One measure experts look at to see if we are extending ourselves is the ratio of home prices to disposable personal income. In the first quarter this ratio climbed to a record 173%, well beyond the mean of 135% since 1952. This would seem to indicate that we have extended ourselves to dangerous levels. However, although this is a handy ratio, home prices do not appear to be linked to income growth and the ratio does not take into account mortgage rates. A better indicator is the Housing Affordability Composite Index. This index relates the price of an existing home to the ability to finance its purchase. As of June, a household earning the median income could afford to purchase 140% of the median priced existing home at the prevailing mortgage rate. Housing affordability has been in a tight range the last decade and indicates that houses remain affordable. Similar to purchasing power parity, home prices have been adjusting relative to income and interest rates to keep affordability stable.

Where Are We Heading…Short-term?

Housing is a cyclical industry and there are a number of indicators that help us evaluate the cyclical conditions. These indicators can be grouped into two general categories: financing and supply and demand. Changes in mortgage rates and financing conditions are the most effective ways to judge the condition of the housing industry. Three years ago, 30-year fixed rate mortgages were going for over 8%. Now these same mortgages are going for around 6%. This enables a homebuyer to purchase a house that is 22% more expensive with the same mortgage payment. The easy availability of credit in the late 1990s helped expand the homeownership rate. Lower mortgage rates have helped improve credit quality and we finally saw delinquency rates on higher-risk mortgages peak in early 2002.

On the supply and demand side of the equation, demand remains strong and supply tight. Currently, the typical existing home has sold in five weeks, one week longer than in 2001, but down from eight weeks that was typical in the 1990s. The nature of the housing market has changed over the years. Prior to the 1980s, housing would weaken during recessions, as people would fear for their jobs and would become reluctant to make long-term commitments. Now, homebuyers have learned that low interest rates are an opportunity and the housing market has remained strong even with unemployment rising and consumer confidence sliding.

Where Are We Heading…Long-term?

In addition to cyclical factors, there are a number of secular factors supportive of a continued strong housing market. First; the trend towards homeownership. From the mid-eighties through the mid-nineties, the homeownership rate held steady around 64%. But with the help of government programs and low mortgage rates, the homeownership rate has climbed to a record 68%. Second; the tax-code. The home mortgage interest deduction and the capital gains exclusion are both positives towards homeownership. Third; investment characteristics. Since WWII, there has never been a yearly decline in the value of household real estate. Some local markets have seen a decline, but the national average has not been negative since WWII. Long-term returns have also been decent. Real estate values have increased at an 8.4% annual rate since WWII with much less volatility than stocks. The standard deviation of stocks was 17.0% over that period, while the standard deviation of real estate was just 4.4%. Fourth; demographics. Household formation is expected to grow around 1.2 million per year, which is comparable to the 1980s and 1990s. Household formation in the 25-29 age group, which has fallen at a 1.5% annual rate since the mid-1990s, is expected to grow at a 1.8% rate through 2010. There are 100 million people under 26 years old. Finally; GSEs. Government Sponsored Enterprises (GSEs) such as Fannie Mae and Freddie Mac have greatly helped the lower end of the housing market. Any slowdown or cutoff of credit to the housing sector could pressure home prices lower, perhaps leading to an overall decline in prices nationwide.

Conclusion

Over the past decade housing prices have appreciated at a greater pace than historical levels. However, it did not increase at such a breakneck pace that we could call it a bubble. Our managers estimate that real estate is trading at fair value or at a slight premium. Since secular forces are providing a solid foundation for the housing market, cyclical factors will be the driving force for the direction of this market. Specifically, as long as mortgage rates remain around 6% (or below) there should be enough demand to maintain at least historical price appreciation.

Source: Ned Davis Research; Housing’s In a Box, Not a Bubble, by Joseph F. Kalish