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Mark R. Kiesel
I’m back in. Yes, I’ve finally purchased a house after renting for the past six years. I sold my previous house in May 2006 after nearly a decade of being a homeowner because I was convinced U.S. housing prices were set to fall, and I wrote about it in prior Credit Perspectives pieces, “For Sale” (June 2006) and “Still Renting” (May 2007). Many of my friends, family and colleagues have asked me over the past several years, “Are you still renting?” In fact, that is probably the question I’ve heard most often from clients, consultants and the media over the years.
So, next weekend I’ll be moving into a house. My decision to buy was mainly driven by the improved relative value of U.S. housing. When I sold my house in 2006, I purchased mainly corporate and municipal bonds where I believed high-single-digit annual returns were possible. In stark contrast, housing prices subsequently fell an amazing 34% from their April 2006 peak through March 2012, according to CoreLogic.
Today, however, U.S. housing looks like a decent place to put money over the next several years. I’m not sure if U.S. housing prices have bottomed – only time will tell – but there are many more positives today than there were six years ago when I sold my house. Just as important is how an improved outlook for U.S. housing is positive for the U.S. economy, consumers and for the banking sector.
Improved outlook for U.S. housingSix years ago, U.S. housing prices were at elevated levels relative to both income and rents. New and existing inventories were high, and the shadow inventory of bank-owned or foreclosed homes was set to skyrocket due to poor mortgage underwriting standards and products. Finally, job growth was starting to weaken just as housing prices came under pressure.
Today, with non-distressed home prices down 24% and the overall housing market down 34% from the peak in mid-2006, according to CoreLogic (Figure 1), housing affordability is at all-time highs (Figure 2), particularly given record low mortgage rates. While credit standards today are significantly tighter, homebuyers with decent credit can now borrow at less than 4% for a 30-year fixed-rate mortgage and less than 3% for a five-year adjustable-rate mortgage (ARM), according to Bankrate.
As a result of lower prices and rising rents, housing today is becoming more attractive than rental property across many areas of the country. Overall, home prices relative to income and relative to rents are currently at or below levels from eight years ago (Figure 3). Housing inventory for both new and existing homes is also declining (Figure 4) while sales activity is picking up. For example, inventories of existing homes on the market are now at 2.37 million units (near seven-year lows) while pending home sales are up 10.8% year-over-year through March 2012, according to the National Association of Realtors. Meanwhile, the inventory of new homes on the market at 144,000 is at a 50-year low as of March 2012, per the U.S. Census Bureau.
In addition to lower prices and inventories, a slowly improving economy and job growth are helping to improve demand for housing as potential homebuyers appear gradually set to return from the sidelines. As evidence, a Pew Research Center report from April 2011 found that 81% of current renters would like to buy a house at some point in the future. Fortunately, loan delinquency trends are improving for borrowers in both prime and subprime mortgages (Figure 5) as the economy gradually recovers. Overall delinquencies 90 days past due have fallen below 3 million, while levels of foreclosures and REOs (real estate owned properties) have stabilized and are gradually trending lower (Figure 6). Given the above, U.S. housing appears to be gradually turning the corner. In fact, a bottoming process appears to have begun: New and existing home sales are at 4.81 million units, now up 5.3% year-over-year through March 2012 according to the U.S. Census Bureau and the National Association of Realtors.
In total, U.S. housing fundamentals have improved significantly from six years ago, led by lower prices, record low mortgage rates, improving inventory and delinquency trends and a gradually improving labor market, which in combination are helping homebuyer confidence and potential demand.
Challenges and lingering headwinds While the outlook for U.S. housing has improved, several headwinds remain, including tight credit, potential supply from the shadow inventory and weak household formation due to a subpar economic recovery.
Lending standards remain tight, and down payment requirements have increased significantly. In addition, some potential homebuyers have had to cancel contracts where the loans fell through escrow prior to closing due to more conservative appraisals and mortgage underwriting standards. Banks’ tighter mortgage underwriting standards reflect not only conservatism but also legal concerns from ongoing representation and warrantee claims from several years ago. Tighter credit is a major reason the U.S. homeownership rate is at 15-year lows at 65.4%, as reported by the U.S. Census Bureau at the end of the first quarter of 2012.
On the supply side, the overhang of shadow inventory remains large, with more than four million units in the foreclosure process or 90 days or more delinquent according to the Mortgage Bankers Association. Supply could also increase should prices fall materially from current levels, as roughly 11 million homeowners owe more on their mortgages than the current value of their home (according to CoreLogic as of the fourth quarter of 2011). In addition, homeowners today have only 7% equity in their homes, vs. 45% as recently as 1990, according to an April 2012 American Enterprise Institute (AEI) report. A few states including Florida, California, Michigan, Arizona and Texas are particularly vulnerable as 49.4% of all completed foreclosures have been concentrated in those five states as of February 2012 according to CoreLogic. Meanwhile, Nevada, Arizona and Florida are the three states which have the highest negative equity at 61%, 48% and 44% respectively as of the fourth quarter of 2011 according to CoreLogic.
Finally, the recession and weak economic recovery have caused fewer households to form in recent years than population growth would suggest. A December 2011 Pew Research survey found that 24% of adults aged 18-34 moved back in with their parents after living on their own because of economic conditions. A weak economy and poor household formation represent challenges for the U.S. housing market, but they also present an opportunity for policymakers.
Opportunity for policymakersPolicymakers can take several actions that could improve the outlook for the U.S. housing market and the overall economy. First, political leaders can sponsor financing programs that help move the shadow inventory into the rental market. Given declining housing prices and rising rents, many investors and entrepreneurs have growing interest in buy-to-rent opportunities.
Consumers need affordable housing solutions as well. An increase in rental supply could help ease the pressure of rental price inflation. The economic recession led to a collapse in both residential and multi-family construction. As a result, rents are rising sharply for apartments, particularly in major cities. Equity Residential (EQR), the nation’s largest landlord, just reported average rents increased 5.5% through the first quarter of 2012. Financing programs that help move homes out of inventory and into the rental market should help stabilize housing prices while providing relief to consumers who are enduring rising rents and occupancy trends due to tight rental inventory and declining rental vacancy rates (Figure 7).
Second, policymakers can help by providing leadership and clarity on both the tax and regulatory fronts while addressing long-term fiscal reform. Businesses need to know what the rules are so they can plan future capital spending and new investments that could help foster job creation and housing demand. Consumers need clarity and transparency as well before they will commit to a long-term investment such as buying a home. Tax and regulatory reform will help in this regard, and it should start with budgetary and pro-growth leadership in Washington.
Finally, pro-growth economic policies should be implemented to improve private sector job creation. Strong economic growth and job creation would significantly strengthen housing demand and housing starts (Figure 8), and would also improve household formation, a leading indicator of housing completion (Figure 9).
In summary, policymakers can help improve the outlook for both housing and the overall economy by working together on pro-growth regulatory and tax reform while promoting longer-term fiscal reforms that improve the outlook for business investment and private sector economic growth across the country.
Implications for U.S. economyAn improving outlook for U.S. housing combined with supportive policies from Washington would have significant implications for the overall economy.
First, real residential investment is now finally contributing to real U.S. economic growth (Figure 10). A government-sponsored buy-to-rent financing program that helps to clear excess inventories could go a long way to improve residential investment as homebuilders would likely be more aggressive in starting new homes. This would add momentum to a housing market that is already beginning to pick up; for example, building permits, a leading indicator of housing starts, are up 33% year-over-year to 764,000 units as of March 2012, according to the U.S. Census Bureau. Through the first quarter of 2012, nominal residential investment grew 9.1% year-over-year according to the Bureau of Economic Analysis.
Second, stabilization in housing prices, and in particular the labor market, would likely improve overall consumer confidence, which in turn should help support consumer spending and credit quality by providing support for consumer net worth. The most recent loan officer survey by the Federal Reserve indicated a moderate strengthening in demand for prime residential mortgage loans suggesting animal spirits for housing may be picking up as of the end of the first quarter of 2012. In terms of the labor market, job growth is picking up with near 2% growth in private-sector employment or 2.1 million new jobs added over the past 12 months according to the Bureau of Labor Statistics as of March 2012.
Finally, banks’ balance sheets would likely continue to improve as housing prices stabilize, which should lead to a gradual pickup in bank credit expansion, and over time easier credit standards. A continued pickup in banks’ willingness to lend would likely be very positive for consumers as well as for financial markets by contributing to a “multiplier effect” on the overall U.S. economy, supporting further job creation. In this regard, U.S. banks reported easing standards on credit, auto and other consumer loans according to the Fed’s most recent loan officer survey.
Relative value in U.S. housingThe U.S. housing market outlook has improved considerably due to lower prices, record low mortgage rates and declining new and existing inventories. In addition, U.S. housing looks increasingly attractive – in fact, outright cheap – on a relative basis compared with many international housing markets. U.S. real housing prices have fallen over 40% from the peak in 2006. Among Organisation for Economic Co-operation and Development (OECD) nations, the U.S. has seen the largest real price declines from peak of any country other than Ireland (Figure 11).
Not surprisingly, low prices and a weak dollar are attracting foreign investment in U.S. housing across many major cities, including Miami and Phoenix, where prices are now up 3.3% and 0.8% respectively year-over-year through February 2012 (according to Case-Shiller). This improved outlook is in sharp contrast to Europe, where in Spain, for example, the housing market appears significantly overvalued relative to the U.S. housing market (Figure 12). Given these trends, banks are tightening credit in Spain and gradually easing credit in the U.S. Should U.S. prices continue to stabilize, U.S. banks will likely ease lending standards further even as European banks could tighten lending standards considerably, particularly in peripheral European countries with overvalued housing markets.
With 10-year U.S. Treasuries yielding less than 2% and U.S. Treasury Inflation-Protected Securities (TIPS) offering negative real yields out to 13-year maturities, many investors are looking for an alternative investment. In addition to looking more attractive on an absolute and relative basis, U.S. housing also now looks increasingly appealing relative to many other investment alternatives. Of course, as with any investment, potential homebuyers should consider the costs and risks: Real estate is subject to operating and property maintenance costs and liquidity risk, and home values can fluctuate with economic and market conditions, interest rates, property taxes, regulations and zoning. That said, many investors will likely begin to embrace housing as an attractive option given its attractiveness as an inflation hedge and as a potential buy-to-rent investment opportunity.
Back InThough I can’t predict when U.S. housing prices will bottom, I can say the outlook for U.S. housing looks considerably healthier today than it did six years ago when I sold my house and moved into a rental property. U.S. housing looks increasingly attractive today. As evidence, U.S. household tangible assets (i.e., housing, real estate, automobiles) as a percentage of disposable income are at 20-year lows (Figure 13), suggesting plenty of room to grow.
And while U.S. housing’s outlook has improved, policymakers around the globe, including the U.S., will likely need to maintain reflationary monetary policy as fiscal policy in most developed economies has reached its limits and Europe still represents considerable downside risk for the global economy. The combination of aggressive central bank support, attractive valuation and a gradually improving labor market should provide support for the U.S. housing market.
For those of you renting or on the sidelines, I recommend you at least consider getting “back in” and buying a house in the U.S., particularly in an area of the country where supportive fundamentals and policies could cause inventories to fall and job growth to improve. The future is hard to predict, but U.S. housing is healing and is probably close to a bottom given reflationary policies are likely ahead, housing absolute and relative valuations are now attractive and leading housing market indicators are picking up.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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