Although the mission of Housing Chronicles is to provide a balanced portrayal of the housing market and related economics, that's not been easy to do lately, with various prognosticators calling for cataclysmic peak-to-trough pricing declines approaching 40 percent. So it's certainly nice to provide the occasional item that suggests that the doomsayers might be off the mark for a variety of reasons.
At the Motley Fool -- which has no reason to either support or discourage homebuilding activity -- writer A recent BusinessWeek cover story touted the idea that housing prices could fall by another 25%. Although some areas are looking at a precipitous drop in prices, for the most part, current housing prices are nearing bottom. Forces other than loose lending standards and a corresponding spike in demand are responsible for the recent rise in housing prices, and these have not abated.
The BusinessWeek article used an index that tracks home prices as far back as 1890 to conclude that home values have historically risen annually from 0.2% to 0.8% above inflation. Using these trend lines, the article found homes to be significantly overvalued. But there are problems with drawing this inference.
First, today's homes are not the same homes that were built three decades ago. Census data show that in 1973 the median size for a newly built home in the U.S. was 1,525 sq. ft. In 2006 it was 2,248 sq. ft., a 47% increase.
Second, today's homes feature sturdier construction materials, more expensive siding, outdoor additions like in-ground pools, more complex wiring to support an increasing number of electronic devices, sophisticated heating and cooling systems, and larger kitchens (which translate to increased cabinetry). Simply, these are better homes -- and "better" here means more expensive to build.
Third, prices of inputs into the construction process are more expensive these days in relative terms. The bull market in basic materials that started several years ago has raised the costs of construction, and these costs have been passed on to the consumer.
Taking these factors into account implies that housing prices should have grown at least 2% above inflation in the past 30 years, putting the current median home price about where it should be.
The largely fixed expense of building today's homes gets us to the next reason why most homes are probably priced near their fair value. The table below shows gross margins for a collection of eight publicly traded homebuilders. (For homebuilders, gross margins represent the difference between the price at which the home sold and how much it cost to build, inclusive of any land acquisition costs. The cost of superintendents and sales staff to move the properties is not recorded here; it's a part of SG&A and often runs above 10% of revenue.)
| | 1998 | 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 |
|---|---|---|---|---|---|---|---|---|---|
| DR Horton (NYSE: DHI) | 19% | 18% | 20% | 21% | 20% | 22% | 24% | 27% | 24% |
| Centex | 7% | 9% | 9% | 10% | 11% | 10% | 13% | 14% | 13% |
| KB Home (NYSE: KBH) | 20% | 20% | 21% | 21% | 23% | 23% | 24% | 27% | 20% |
| Lennar (NYSE: LEN) | N/A | 12% | 11% | 15% | 15% | 14% | 14% | 16% | 7% |
| MDC Holdings (NYSE: MDC) | 8% | 11% | 14% | 14% | 14% | 14% | 18% | 17% | 24% |
| Meritage Homes (NYSE: MTH) | 20% | 19% | 20% | 21% | 19% | 20% | 20% | 24% | 21% |
| Ryland Group (NYSE: RYL) | 19% | 19% | 18% | 20% | 23% | 24% | 25% | 27% | 23% |
| Toll Brothers (NYSE: TOL) | 23% | 23% | 25% | 27% | 28% | 28% | 29% | 30% | 26% |
| Average | 17% | 16% | 17% | 19% | 19% | 20% | 21% | 23% | 20% |
| Median | 19% | 18% | 19% | 21% | 20% | 21% | 22% | 25% | 22% |
Most homebuilders operate without particularly high gross margins. Although there has been a steady rate of margin expansion since the late 1990s, note that margins in 2006 had already returned to 2003 levels, the beginning of the current housing boom.
Net margins for most builders are of course even smaller, and typically averaged in the mid- single digits prior to the latest building boom.
Thus, even a 3% drop in prices would bring builders' gross margins well below the levels seen in the previous recession, threatening their profitability. (Land costs, which are not tied to increased costs of construction, would have to fall substantially to negatively influence home prices -- a general rule of thumb is that, for most residential homes, land comprises only 20%-25% of total value.)Of course in areas such as Southern California, land costs as a percentage of total value are much higher than the 20-25% range, often reaching up to 50%. That's why builders were focusing more on larger luxury homes -- it took the higher margins on the home itself to justify the higher land costs.
This is important because it creates a floor for the price at which homebuilders will be willing to create additional inventory. Buyers will thus be faced with builders willing to slash prices drastically on existing inventory but unwilling to offer similar discounts on future projects.
What does all this mean for the housing market? When the financial institutions rediscover how to assess effectively borrowers' default risks, the supply of existing homes will fall fairly quickly. And the moment that the supply of existing homes begins to shrink, potential first-time homebuyers will realize that between low interest rates and homes that sell at (or below) replacement cost, they can grab the deal of a lifetime.
I'd add to that group income property investors, who can snap up properties and carry them for less than what they'd get in rent, thus giving them instant positive cash flow and be positioned for future equity increases in the future as well as slowly paying down the mortgages.
In 1999, tech investors bid up pieces of paper that were backed by fictitious profits of economically stillborn companies. When the bubble burst, the search for the asset's true worth -- often close to zero -- was a painful one. But houses are a different type of asset; they depreciate slowly and meet a need for which there is plenty of demand: shelter.
Overall, the condition of the U.S. housing market is not nearly as bad as some analysts would have you believe. So, the entire homebuilding industry is worth a closer look.
Over at Mortgage Credit News, syndicated columnist Lou Barnes argues that the wrong parties are being blamed for the housing bust and the S&P/Case-Shiller index greatly over-states pricing declines:
The real causes of this credit crunch -- still called “subprime” -- and the recession it has spawned are the grotesque failure of structured-finance products on the Street, and failure of oversight by their regulators.The strange story of mortgage-rate spike and reversal began with the January fable that mortgage-backed securities (MBS) issued by Fannie, Freddie, and Ginnie (the “GSEs”) had become too toxic for investors to hold. That notion made no sense here: these GSE/MBS are as good as Treasurys, no matter what the ultimate default rate of mortgages within (Ginnies are guaranteed by the Treasury, F&F clearly “too big to fail”). The GSE/MBS market is $4.5 trillion, the deepest and most liquid market for anything on the planet except US Treasurys.
Yet, traders said throughout February: “Too many MBS sellers.” The excess on the market was certainly not new loan production. Now we know who those sellers were: big banks and Street dealers, capital impaired, dumping the only liquid assets they have to make room for trash flooding back onto their balance sheets. The back-wash: the remains of deals they sold but agreed to support if “something went wrong.”...
The financial press is having a wonderful time ginning-up a housing depression, this week shrieking about new home-price data: “Decline in Home Prices Accelerates” (WSJ), emphasizing the Case-Shiller index, down 8.9% in ’07.
Case-Shiller is designed to magnify home-price declines. Mr. Shiller correctly called the stock market bubble (his book “Irrational Exuberance” appeared on the day of ’00 collapse), and has spent the last several years mis-applying financial-market principles to real estate, gleefully predicting a 30-40% national crash in home prices.
The design flaw: it captures only sales of homes, obviously heavy with distressed transactions. For the authentic story and great methodology, visit www.OFHEO.gov and its All-Transactions House Price Index, which includes repeat appraisals in refinances, by definition free of distress. By that measure, national home prices in the 4th quarter rose by .8%. Prices fell in only 11 states, and in only five of those were declines in excess of one percent. See page 21 of the report for its critique of Case-Shiller.
At the micro level, some spots are in horrible trouble: of OFHEO’s 291 Metropolitan Statistical Areas, 15 had price declines last year in the 10%-19% range (all CA and FL). And the national market is decelerating: of 39 states with positive appreciation in the 4th quarter, 32 had gains of less than 1%.
The key to this unpleasant situation: housing is sinking because of credit starvation, not the other way around, housing wrecking credit markets. No matter what it takes, the supply of credit must be restored to housing and the rest of the economy.
The public policy response is still frozen, Democrats trying to help families who cannot afford their homes to stay in them, Mr. Paulson refusing assistance to the financial system: “I’m not interested in bailing out investors, lenders, and speculators.”
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