Real estate bubble

I’ve been musing the last couple of days over the trajectory of the economy and the housing market, wondering what the recent trends portend. One by-product of the economic decline, neatly summed up in Paul Krugman’s New York Times piece this past Sunday, is that no expert is reliable. The future is unknowable and no one point of view has any great insight.

But I’m at a point in the book where I want to peek ahead a couple of chapters and find out how things are going to end up. Our company has gone through a radical shift over the past two years, with the bursting of the housing bubble and the subsequent crash of the economy cutting our business in two of our three largest areas in half.

The contraction has taken its toll, but we’re still standing. We’ve maintained our energy with our customers, have worked to keep our financial standing solid and have kept our equity stakeholders whole.

We know we have another challenging winter ahead. The question is, How challenging?

The driver of that answer will be in the housing market.

Look at the momentum of the past six months in the resale market and the circumstances appear rosy: sales are improving, prices have posted month-over-month increases, and pending home sales have been up for six straight months. Inventory has worked down from a high of 11 months last November to 9.4 months in July. An expert as august as Robert Schiller has declared that the housing market may have found a bottom — the kind of qualified forecast that most experts are limiting themselves to in these uncertain times.

The last two months of home sales data, though, have presented an interesting anomaly, one that suggests the the market is either at a key recovery inflection point, or that the market is experiencing a mini-bubble, being driven by unnatural market forces.

The charts to the right illustrate the anomaly. The first chart shows the number of homes sold by month from 2007 to June 2009. The fourth data series presents the average of homes sold in each month over the course of the last decade. (Interestingly, the boom and bust of the middle and end of the decade even out to roughly align with the average for the first four years of the decade.)

Traditionally, June is the peak month for home sales in the year, with units sold tailing off quickly through September. In 2007, the most challenging year of the slump, home sales dropped so much that December sales were lower than January sales, the only time in the decade such a phenomenon happened. Conversely, this year sales increased from June to July, only the second time in the decade (the other was in 2004, at the start of the boom), that this happened.

The second chart indexes the sales in each month against January, showing the relative velocity of home sales through the year. The trend in this chart against supports the observation that 2007 was a very weak year for home sales, with velocity never reaching normal highs and dropping more sharply than in other years. The chart also illustrates the rapid shift in velocity experienced this June and July. Through May, sales were gaining at a fairly typical rate during the year. The last two months, however, posted much sharper growth than a typical year: the July velocity, as measured against January sales numbers, was 20% higher than average.

Despite the strong acceleration in performance, observers point to various risk factors to suggest that the increase in home sales is a temporary bubble, and that the market will settle back into a moribund phase.

The two biggest factors cited are the home-buyer tax credit and the significant inventory of foreclosures still to come onto the market. These two factors have driven a high percentage of home sales this year, offsetting weak demand among move-up and existing home owners, many of whom are under water on their mortgages.

Washington has a key decision to make: Should the home buyer credit expire in November, should it be extended, or should it be revised to include all home buyers and create a higher economic incentive? There are few signals coming out of Congress today, as all eyes are focused on the health bills and Obama’s political future. If Congress extends or amends the bill favorably, the demand from first-time home buyers will remain strong enough to create a solid foundation for future sales.

Some observers close to the real estate are less concerned about the impact of foreclosures on the resale market. This is due to an interesting redistribution of housing stock. As a result of the credit crunch and increased unemployment, very little rental stock has been developed over the past two years. Investors are accumulating existing homes at foreclosure prices and creating new rental units. This demand is helping to move foreclosed homes off the market quickly, observers say.

In the short term, consumer confidence will be the primary driver the performance of the housing market. Will consumers believe that they are making a reasonable investment when they buy a house? Will they believe that prices are reasonably stable, and that they have got a good deal on the house they are buying? Will they have enough confidence in their own economic future to risk the transaction?

The Conference Board has tracked a steady uptick in consumer confidence since it reached its low in February. This uptick has been driven by a consensus among consumers that future expectations are improving, despite risk in their current circumstances.

This improvement comes despite a $10 trillion decline in consumer wealth in the last 12 months, despite a conviction that unemployment will top 10%, despite the knowledge that more than 16 million people are currently out of work, despite a sense of political helplessness across a country increasingly out of touch with Washington. The improvement in confidence suggests that consumers have baked these realities into their assessment of their circumstances, and that, on balance, more consumers feel good than they did six months ago.

But the fall will be telling. Lawrence Yeung, the economist for the National Association of Realtors, cites favorable economic data in projecting a recovery for the housing market in 2010, but warns that the psychology of home buyers, and consumers in general, could suffer in November, following the decline of the home buying tax credit. “A decline in the market following the tax credit could shift consumer psychology,” Yeung warns.

These concerns are short-term, but critical. For the long-term, the new normal for housing has begun to take shape. Bill Gross of PIMCO in his September letter forecasts a decline in home ownership from a peak of 69% to about 65% as one element of the new normal. As we climb out of the bottom of this epic trough, we’ll participate in a more orderly and disciplined market, where real estate offers a relatively stable, but slow-growing haven for personal assets.

Over the past three years, I’ve gathered data, analyzed trends and presented projections for our business and the markets.  While the events have unfolded generally along the lines I’ve outlined, the degrees and the timing have been widely divergent from my estimates.  So, as I came to the end of this exercise and looked at all of the information I’d gathered, I found two impulses warring inside me:  an exuberant relief that the market may be on the upturn tempered by a consciousness that more pain is most likely ahead.  Through it all, I’m amazed by the resilience of people and their ability to persevere.  That’s not a forecast.  It’s a fact.

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