Has the Housing Market Bottomed Out?

Posted: 05/06/2008

For the third time since the housing slump began, Joe Kalish of Ned Davis Research explains where we are now and what may be around the corner.

USAA: Joe, since we spoke a year ago, virtually every measure of the health of the real estate market has sharply deteriorated. Have you been surprised by the extent of the downturn?

Joe Kalish: In a normal credit environment, we would not have expected the housing market downturn to accelerate like it has. Unfortunately, the credit crisis has exacerbated the downturn, and issues related to the credit crisis are standing in the way of the recovery.

USAA: Where do things stand right now? Are we anywhere near the bottom?

Joe Kalish: Last summer before the credit crisis hit with full force, we identified eight indicators that would signal a bottom. At that time, none of the indicators were positive; today at least half of them are.

USAA: What are the positive indicators?

Joe Kalish: The first is the stock prices of the homebuilders as measured by the S&P Homebuilders Index. This is important because the stock market looks forward and discounts future activity. Historically, the Index has bottomed three to five months before the housing market. The Index bottomed in January, and tested those lows in mid-March; the Index did not make a new low and has since moved up. Additionally, from its housing boom peak through the January low, the Index was down 78%, which matches the fall of the NASDAQ in the bear market of 2000-2002.

Moreover, the price-to-book value of the homebuilders recently fell to 0.6. The general rule has been that a ratio above two times book indicates homebuilders are overvalued while a ratio of less than one times book indicates homebuilders are undervalued.

USAA: But couldn't it just be that the homebuilder's stocks are cheap because the market is so bad? Couldn't the Index hit a new low tomorrow?

Joe Kalish: Of course it could, but in our view that's not likely over the next few months. By themselves these indicators are not a reason to get bullish on housing, but they have proven significant in the past. Just as important, if not more so, other indicators are signaling improvement in housing fundamentals. For example, mortgage rates have dropped, with a conventional 30-year fixed rate mortgage below the 6% level that we would consider bullish.

You'll recall that in the past we've talked about affordability as a big problem for the real estate market because it got so out of whack by mid-2005. Affordability is a measure of three critical home-buying variables: personal income, mortgage interest rates and home prices. As we look at affordability today, we note that personal incomes have continued to rise, mortgage rates are coming down and home prices have fallen. So, affordability is moving in the right direction and has gotten back to a level that would indicate homes are very affordable by historical standards.

USAA: Given the credit crisis, are mortgages readily available today to qualified borrowers?

Joe Kalish: I think this is where we really get into the heart of the matter in terms of the housing market getting healthy. Conventional mortgages are still readily available, but they've been constrained by government limits on the size of mortgages that can be backed as well as on the capital requirements for Fannie Mae and Freddie Mac. This is an area where the government has taken supportive action, increasing the conforming loan limit to $729,750 and reducing the capital requirements for Freddie Mac and Fannie Mae, allowing them to buy more mortgages. We're just seeing these changes come online now, and they could have a very positive impact on the market.

At the same time, we're still seeing elevated spreads on the rates of jumbo (over $729,750) and subprime loans. For these spreads to come down, the credit crisis needs to settle. We're pleased to see the multiple steps the Fed and Treasury are taking to normalize the credit markets.

USAA: What other signs do you look for to give you confidence that we've reached a bottom? 

Joe Kalish: We want to see a moderation in the rate of decline of home sales and an increase in mortgage purchase applications, which are at four-year lows. Inventories are too high, at about 10 months supply relative to current sales. Overall sentiment is so negative that we may need to see government action to sop up the supply or buy some of the troubled mortgages. This might be along the lines of the Resolution Trust Corporation in the early 1990s, which actually made a profit for the government while it cleaned up the savings and loan mess.  

USAA: What's your best estimate of where we are today ─ when will home prices stop falling? 

Joe Kalish: It could take two or three years to work off the inventory, with a total real price drop of 15% nationally. Of course the real estate market is not national. The pain has been, and probably will continue to be, much worse in areas such as Florida and California that had so much speculation during the boom. It's interesting to note that the homeownership rate in the U.S. rose from 64% in 1994 to more than 69% in the second quarter of 2004, and has since fallen back to 67.9%. So the peak was really a couple of years before the boom ended, which means that much of the activity from mid-2004 to mid-2006 was simply speculation.

As dark as it seems today, the government has taken some steps in the past few months to ease the credit crisis and make mortgages more available. Prices are falling, and while that's painful for speculators and people with mortgages they can't afford, it's a necessary part of the process of re-establishing affordability. It's important to recognize that even though we could see a bottom at some point this year, the overhang of inventory could be with us for a while. It's not going to feel like 2004 or 2005 for a long time.