Is the Housing Market Rebound Sustainable?

By almost any measure – and as noted regularly in BuilderBytes’ MetroIntelligence Economic Update -- the housing market is not only on the mend, but rebounding much faster than most economists and housing analysts predicted.    Not only did the median price for existing homes rise by nearly 10% nationally over the past year, but they continued rising during the seasonally slow winter months, and already show signs of gaining altitude as the spring buying season continues.

Meanwhile, a combination of reduced new home construction, fewer foreclosures, investors paying cash for homes to rent out and owners still sitting on under-water homes means inventory levels that have fallen to 12-year lows.  So is the current scenario just an economic blip, or have we finally launched onto a sustained rebound that will last?

This answer is that this rebound may have some legs.  For one, home prices nationally are still below their long-run average compared to incomes, and affordability has rarely been higher.  Home builders, who have long struggled to gain traction with skittish buyers and had to compete against discounted foreclosures, are now facing shortages of labor, credit and finished lots to fulfill the rising demand for new housing, pushing NAHB’s Housing Market Index (HMI) in April down by two points to 42 (anything above 50 indicates more builders view conditions as good).  Consequently, whereas housing starts in March rose by nearly 47% over the past year, building permits rose by a much smaller 17% as builders must now address the rough edges of the rebound.

One reason that demand now exceeds supply is that while household formations were in hibernation as people doubled up with roommates, families or simply postponed divorce, population growth continued unabated.  Today, there are potentially millions of renters and households living in shared quarters who are ready to become home buyers given that they pass muster with today’s tougher credit standards.

Another reason for the supply imbalance is that investors -- large and small, foreign and domestic -- have increasingly funneled cash into what is now viewed as a safe investment:  U.S. real estate.  Currently, nearly one-third of all home sales are due to cash buyers, and it was this fairly consistent level of activity over the past two years which put that long-awaited floor under prices (which had foundered as federal and state tax credit gimmicks wore off.)

That fear of catching the falling knife, which froze the housing market for several years, has been replaced by the boom-era fear of missing out on the upside.  For these investors – which include brand-name private equity firms such as Blackstone Group and Colony Capital as well as smaller outfits issuing their own private placements for debt – they’ve managed to ignite a rental property boom, which has in turn put pressure on owners of traditional apartments.  What remains to be seen is what happens to these rentals when prices are no longer rising and rents have stalled, yet fund investors are still demanding the returns they were promised.  In contrast, traditional ‘mom and pop’ landlords can simply pay off the mortgage and then rely on the additional cash flow when they retire.

If there is one unknown which may derail the strength of this recovery, it is interest rates:  what happens when rates return to 5% or 6%, or even the 8.38% average noted over the last 49 years?  It’s hard to over-estimate the power that historically low interest rates have on affordability levels:  the same buyer whose $1,000 monthly payment would allow them to purchase a $165,000 mortgage at 6.1% (the rate in late 2008) could purchase a $222,000 mortgage at 3.5%, thereby boosting their purchasing power by a third.  This provides today’s buyers with a classic dilemma:  pay more today than they did a year ago, or pay even more in the future when interest rates may be higher.

In addition, home equity lines of credit are almost certain to rise as soon as the Federal Reserve ends its current policy of near-zero interest rates.  If the minutes from the most recent Federal Open Market Committee (FOMC) meetings are to be believed, then “QEIII” (the third round of quantitative easing) could end before the end of this year, and that could send variable rates higher – albeit slowly.  But for that to happen, the economy will have likely proven that it’s definitely on the mend, and that’s the sort of problem the federal government –and the yawning deficit – would almost certainly like to face.