Wednesday, May 27, 2009

The Anatomy of a Housing Recovery

We receive monthly housing data from a variety of sources, and some of the reports seem to conflict with others, so an understanding of the basic economic forces behind a housing recovery is helpful for evaluating that evidence.

As in any market, the amount of housing and its prices (both purchase and rental) are determined by supply and demand. What is somewhat unique about housing is that houses last so long, which means that the demand for houses depends not on what they do for us now, but what services houses will provide over the next 50 - 100 years. The demand for houses rises when expectations about the future are revised upward, or when time passes toward an already anticipated increase in the services houses.

The U.S. population continues to grow. As I wrote earlier, population will soon be catching up with housing supply, which means that home building should continue at a more normal pace. For home builders to be willing to renew home building, the prices for homes must be higher than they are now relative to the costs of building new homes. As home builders build more and demand more workers and equipment to do their jobs, home construction costs will rise.

The "fiscal stimulus" is another factor. To the degree that the government will be hiring construction workers and equipment away from housing, home construction costs will rise. This by itself will reduce home construction and increase home prices.

Thus, it has been no surprise that the housing bust has been characterized by: (a) sharply falling housing construction, (b) sharply falling housing prices, and (c) costs of home construction that have fallen, but not as much as housing prices have. If it were not for the fiscal stimulus, a housing recovery would have all of these elements in the opposite direction. When it happens, the fiscal stimulus will add a wrinkle: more of the housing recovery may be in the form of rising prices rather than rising construction activity (that's crowding out).

The chart below shows the BLS monthly measure of home construction prices. They continue to fall, but a lesser rate in 2009 than in 2008. The April 2009 decline is steeper than the declines in the other months of 2009, though.

This chart shows three quarterly measures of home purchase prices as a ratio to home construction prices.

Two of the series show housing prices increasing relative to construction costs 2008 Q4 - 2009 Q1 (that is, falling less than construction costs did). This should encourage building.

One of those two series -- OFHEO -- is also available monthly and its March value was released today: the housing price drop February - March was even greater than the construction cost drop. However, the ratio of OFHEO housing price to construction cost still remains higher in March 2009 than it was in any of the four months September - December 2008.

Another monthly housing price measure (not shown) from the National Association of Realtors shows housing prices repeatedly higher in each of the months January-March.

On the other hand, the Case-Shiller index continues to drop more than construction costs. If this index were right, construction spending will be less than ever.

The Census Bureau's Housing construction data suggest that seasonally adjusted housing construction has continued to hit new lows in January, February, and March, even when measured relative to construction costs. Even the rate of decline of housing construction spending does not seem to have declined.

Is the Case-Shiller index, despite its contradictions with the three other measures, right that housing prices have not yet hit bottom?

1 comment:

Garth said...

I hear people talk about 3 or 5 or 10 years as the time line for a recovery, but I don't hear anyone define what recovery means in terms of appreciation rates. As a small time, long-term investor in single family homes, I am wondering how to analyze my ROI going forward. Unless someone can give me a more interesting measure, I am defining a housing recovery for myself as that time when houses appreciate at the rate of inflation. It makes sense to me that houses are not appreciating in our current flat or deflating market place, but when inflation begins to tick again. If houses tick up at that time, then I expect that to be called a housing recovery. Any elaboration on this idea would be appreciated.