As with the technology bubble before it, severe pain accompanied the bursting of the bubble, and it took nearly a decade for the industry to recover some sense of normalcy. (Hint: bond investors and taxpayers, beware.)
The good news is that the housing industry is finally well on its way to getting back on its feet again.
Although very few experts will date the recovery the same way that I do, it’s fairly obvious that the real estate market bottomed exactly one year ago today, on February 28, 2012. That is the day that I closed on the sale of our old house on Catalina Court. That date represents the absolute nadir of home values in Mesa County, and most likely the rest of the country. I don’t want to overstate the importance of personal, anecdotal evidence. It is quite probable that Europe and Asia will be on a different timetable. For most of North America, however, I think it’s safe to say that 2/28/2012 was the bottom.
Prices have been going up and prices should continue to rise, at least until they’ve reached an equilibrium with replacement costs.
And I would like to take this opportunity to personally apologize to all of my old Paradise Hills neighbors for the horrible comparable sale that will haunt real estate appraisals in that neighborhood for the next few years. On the upside, we found fantastic buyers who, word has it, are a real asset to the cul-de-sac.
This week’s Case-Shiller home price index confirms that home prices are on the rise, and also the time frame of February 2012 as marking the bottom.
The main reason that prices are starting to move up is that the swollen “shadow” inventory of existing homes, and especially foreclosed and “distressed” homes, has declined significantly in the past year. The National Association of Realtors inventory statistics reported this week that total inventories, reported in months’ supply, are at a record low. At the onset of the Great Recession of 2008, the industry professionals were quick to cut prices and unload inventory while existing homeowners were reluctant to recognize how quickly values were falling. New home inventories plunged, almost as fast as sales. Having cut new home inventories at the outset, the industry kept them low for most of the past four years. However, during 2009 – 2011, existing home inventories ballooned and for most of the past four years the gap between low “new” and high “existing” home inventories grew. This inventory of existing homes for sale, and additional foreclosed real estate inventory on the books of banks (the so-called “shadow inventory”), weighed heavily on real estate values.
Home prices fell furthest when distressed sellers had to unload existing homes “at any price.” Given the dramatic oversupply of existing home inventory, buyers were able to purchase homes at prices well below replacement cost. This isn’t news to anyone reading this blog, of course.
What is new is that this month’s statistics indicate that the excess inventory has been worked off. The fact that “total (home) inventory” is at a record low confirms this. This should dramatically reduce or eliminate the number of distress sales. Supply and demand are no longer so out of balance that buyers can drastically under-bid sellers, and be successful. As a result of both government policies and the horrific unemployment numbers, we started with too many "renters" who were given mortgages without equity and eventually these renter-owners needed to be replaced, in many instances, by landlord-owners. This transition was painful and costly. But with these pricing pressures relieved, home prices finally bottomed and should now rise to where home prices are roughly equal to replacement cost.
Now we are seeing experienced home builders, in Mesa County and other markets, go back into the homebuilding business. The only way they can do this is if they are able to sell product above cost. Therefore, prices generally should rise at least to the point where houses are selling above replacement cost, which wasn’t true at the bottom, a year ago. There's no way that you could rebuild my old house, and acquire a lot, and put in landscaping, for our selling price - even after factoring in about 13 years of deferred maintenance because I'm not too handy of a guy.
The dwindling supply of existing homes means that more demand will be met through new home construction. During the bubble years, new home sales peaked at around 1.3 million homes per year. Recently, we have been selling nearly 425,000 annually, up significantly from 2009/2010 levels. With the excess existing home inventory worked down, new home sales will likely continue to improve to something in the range of 600 thousand to 1 million, annually.
There will be some “wealth effect” as homeowners “write up” the value of their homes, but I wouldn’t expect this to be significant.
What will likely be significant is that the shift from people buying existing inventory to new homes will reduce unemployment, some, and begin to put upward pricing pressure on copper, lumber, and building materials prices. After all, one reason that we haven’t experienced inflation in recent years is that there has been virtually no demand in the U.S. for new construction. Looking out into 2013 and 2014, this should change.
It will also be interesting to see if construction methods change as well. Necessity is the mother of invention. During the good times, buyers weren’t cost sensitive and builders were happy making money the old fashioned way. With new Computer-Aided Design technologies and pre-fab building techniques, it will be interesting to see if new companies and processes emerge as this new cycle progresses. If you know of any such stories, please give me a call. Talking with a skilled professional in the plumbing trades, which is an industry which is increasingly moving toward pre-fabricating systems that are quickly assembled on-site, it’s not an easy transition to make.
It is good news, however, that we are making headway working through the real estate bubble. I still don’t expect the construction industry to lead the U.S. out of its current economic doldrums, which is traditionally how the economy does get out of a recession. But maybe, if the recession lasts long enough, and the building industry continues to improve, it will have a greater impact than I expect.
Homebuilding stocks, which are very cyclical, historically trade in a wide range around a Price/Earnings ratio of roughly 11.5-times earnings. Based on current earnings, the stocks trade at a multiple of about 28X. Even based on projected 2014 earnings, the stocks are expensive at 16.2X forecasted earnings. This is clearly an instance where the stocks rebounded in anticipation of the industry fundamentals. Still, industry earnings in 2014 are only expected to recover to about 20 percent of 2006 earnings levels, and the stocks themselves remain at only 50 percent of their previous highs. There could be more upside, but current valuations make it hard for me to get too excited about investing in those companies.
Whether the stocks are ahead of themselves, that’s the question. Whether the future of the homebuilding industry looks better than the recent past – well, that looks like a much better bet and this week’s industry statistics help explain why.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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