Home Prices Edge Up - Analyst Blog

In November, housing prices increased by 0.24% on a seasonally adjusted basis for both the Case Schiller (CS) Composite 10 (CS-10) and Composite 20 (CS-20) city indexes. The CS indexes are considered the gold standard of housing price indexes, and track actual repeat sales, and are thus not influenced by mix changes the way that median prices can be.

Over the last year, the CS-10 is down 4.5% while the CS-20 is down 5.3%. However, prices appear to have bottomed out for both measures in May and the C-10 is now up 3.76% and the C-20 is 3.38% off the bottom.

While such improvement is encouraging, it will be a very long time before housing prices get back to their April 2006 peak levels. The C-10 index is now 30.4% below its bubble highs, while the C-20 index is off 29.5%. Since the C-10 is a subset of the C-20 (although one with a longer history) it is not surprising that the two measures tend to move together.

California Comeback?

In November, 14 metropolitan areas saw month-to-month increases in housing prices, while 6 saw declines. The biggest month-to-month increases were all out West. Hard-hit Phoenix seems to be living up to its name, posting the largest single increase with a 1.56% gain for the month. However, on a year-over-year basis it is still one of the worst hit, with a 14.3% decline. From the peak, only Las Vegas has suffered a larger decline -- Phoenix is down 51.5% while Las Vegas is down 56.2%.

California is often thought of as the epicenter of the housing crisis, but all three California cities tracked posted solid increases. San Francisco posted the largest month-to-month increase with a 1.47% gain, followed by San Diego with a 1.02 gain, while LA was up 0.97% on the month. All three have done better than the national averages on a year-over-year basis, with both SF and SD actually higher now than a year ago -- San Francisco by 1.0% and San Diego by 0.4%. In LA, prices are 3.5% lower than they were in November of 2008.

The other poster child for the housing bubble, Florida, did not fare as well for the month, with prices in Tampa down 0.51% while Miami prices fell 0.23%. They are both amongst the hardest hit on a year-over-year basis with Tampa prices off 13.2% while Miami is down 12.1%. Both are down hard from peak levels, with Miami down 46.7% while Tampa is off 41.7%.

The graph below (from http://www.calculatedriskblog.com/) presents the data for each city in a slightly different way. It tracks the decline over time, cumulatively. Thus the blue bar shows how far prices had declined from the peak by the end of 2007, the yellow bar by the end of 2008, and the red bar indicates the current cumulative decline. Thus if the red bar is shorter than the orange bar, it means that prices are up year-to-date (through November) for 2009 in that city.

Housing prices are vitally important. For most Americans, home equity represents (or at least used to) the most important asset people have. Stock market wealth is larger in aggregate, but is much more concentrated, especially if just the wealth held directly or semi-directly is considered (an example of semi-directly would be mutual funds, as opposed to indirectly being held in a defined benefit pension).

If people feel wealthy, then they tend to spend more. If their wealth is destroyed by a collapse in housing prices, then they will have to save more out of current income for retirement or college tuitions.

The value of the house relative to the amount of the mortgage is also the single best predictor of if the homeowner will continue to pay the mortgage. Quite frankly, from a strict economic point of view it is irrational to continue paying your mortgage if the value of the property is substantially below the amount of the mortgage. Conversely, if the value of the house is more than the amount of the mortgage, mortgage defaults, and hence foreclosures should be zero. After all, even if you lose your job or face some other economic calamity, you always have to option of selling the house instead of just turning it over to the bank.

Housing Prices and Foreclosures

It is silly to expect that individual homeowners should be held to a different standard than big institutional investors are when they face the same problem. After all, BlackRock (BLK) and Tishman Speyer (TSO) could have come up with the money to pay the mortgage on Stuyvesant Town (the big NYC apartment complex that just went into default) but they chose not to do so because it was far underwater. Their situation was no different than that of an individual homeowner who has a house that is now worth $200,000 that has a $300,000 mortgage on the place.

Of course, if you combine being underwater with being unemployed, then simply not paying the mortgage and waiting for the sheriff to show up at the door is by far the smartest move. It might be the only way for the family to survive in this environment.

Yes, there are non-economic factors involved, and most people who are only slightly underwater do not default unless they run into cash flow problems. Still, if housing prices start to move up, then thousands of people who might be right at the line of stopping payment might just decide it is worth it to keep the house.

It is the flood for delinquencies and ultimately foreclosures that has been at the heart of the economic crisis. Rising prices greatly improve the situation for firms throughout the mortgage complex, from Fannie Mae (FNM) and Freddie Mac (FRE) to the mortgage insurers like MGIC (MTG) to the big banks like JPMorgan Chase (JPM).

Can It Be Sustained?

The big question is: how sustainable is the housing price rally that we have seen since May? There has been extraordinary government support for the housing market. This has included the “first time" homeowner tax credit, which has since been expanded to incude "move-up" buyers, and the Fed buying up just about all the GSE-backed mortgage-backed securities out there.

The Fed program is to buy up to $1.25 trillion of residential mortgage backed paper, or about 25% of the outstanding issued by Fannie, Freddie and Ginnie, and is scheduled to be completed by the end of March. So far they are about 92% of the way there. That program has probably reduced mortgage rates by close to 50 basis points (based on historical spreads relative to the 10-year T-note).

What happens to housing prices after the Fed stops buying and mortgage rates rise? What happens when the tax credit expires this spring?

Ultimately, over the long term, housing prices have to be related to incomes and to rents. The biggest red flag that we were in a housing bubble was when those relationships got way out of whack with historical norms. Now prices are back close to normal relative to both incomes and rents, but are not particularly cheap from a historical perspective, even after a 30% drop.

Vacancy rates are at record highs for rental properties, and that means that rents are likely to fall over the course of the next year. That is extremely good news on the inflation front. However, it means that housing prices are shooting at a falling target.

Incomes are under pressure from a 10% unemployment rate, and an underemployment rate of 17.3% (U-6). The first-time buyer tax credit simply encourages people to move from being renters to being owners. However, as they do, it means that the rental vacancy rate situation deteriorates, putting more pressure on rents. Thus it can goose housing prices in the short term (economic theory tells us that if a transaction is subsidized, both the buyer and the seller will share in the subsidy, even if it is directly offered only to the buyer, with the seller portion showing up in higher prices). However, over the long term, it might even be making the problem worse.

The real answer is more jobs. That will stimulate household formation, which will increase the real demand for housing. A good job will get the recent college grad out of Dad’s basement and into a place of his own. A good job or a raise will get the people who are double or tripling up in an apartment into their own apartments.

The Monster Chicken and Egg

Unfortunately, historically the primary driver for getting the economy out of a recession is residential investment. Residential investment is primarily new home construction. But if there is a glut of housing on the market, it does not make a lot of sense to build more.

This then creates a monster "chicken and egg" problem. You can’t get the housing market healed long term without an improvement in the labor market, but you can’t get the labor market really going without an increase in residential investment.

Homebuilders will build houses if the price of used housing moves up enough that they can sell a new house for more than the cost of the land, labor and materials needed to build that house. If existing home prices are falling, the number of new houses build will be lower, unless the costs to build the new house falls even more.

Prices for raw land have already come down far more than housing prices, but other costs have not fallen that much. While we might see a good percentage rebound in housing starts, that is only because they are at near record lows at an annual rate of 557,000 or roughly one quarter of peak levels. In other words, even if we were to see a doubling in housing starts this year, they would still be at half the peak level.

A doubling in housing starts seems to be very unlikely this year. From the peak we have lost 1.83 million construction jobs, or 23.6% of peak levels. Through multiplier effects, each one of those jobs lost probably cost an additional job, so construction accounts for a very big part of the economic downturn. How do we revive construction activity and jobs and not exacerbate the problem of having too many buildings?

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market-beating Zacks Strategic Investor service.

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