DGI Digitalglobe, (delisted)

In June, home prices were mixed. The Case-Schiller Composite 10 City index (C-10) rose a slight 0.04% on a seasonally adjusted basis, and is down 3.85% from a year ago. The broader Composite 20 City index (which includes the cities in the C-10) edged down by 0.06% on the month and is down 4.55% from a year ago.

Prices for both indexes rose on a not-seasonally-adjusted (SA) basis (which is how you will probably and incorrectly see most of the reports presented). Of the 20 cities, eight were up on the month-to-month basis (SA), and twelve were down. Year over year, though, all twenty were down. The rise in the C-10 was the third in a row.

The overall indexes are down 31.90% (C-10) and 31.87% (C-20) from the (4/06) bubble peaks. They set an interim low in May 2009 and rallied into the summer of 2010 before turning down again. The bounce has mostly faded, and the C-20 index set a new post-bubble low (ever so slightly). The C-10 has only a little bit more breathing space before setting a new low, up just 1.49% since that interim bottom.

The earlier bounce was due to extraordinary government support in the form of an $8,000 tax credit to home buyers. This very small increase in the C-10 is perhaps more significant since it is organic.

There is a seasonal pattern to home prices, and thus it is better to look at the seasonally adjusted numbers than the unadjusted numbers. Most of the press makes the mistake of focusing on the unadjusted numbers. Thus the numbers you read in this post might be slightly different than the ones you read about elsewhere.

The Case-Schiller data is the gold standard for housing price information, but it comes with a very significant lag. This is May data we are talking about, after all, and it is actually a three-month moving average, so it still includes data from April and March.

The spring selling season was a bit of a bust for both new and used homes, and it doesn’t look like the summer is going any better. While the inventory-to-sales ratio for used homes is down from the year-ago record peak of 12.5 months, it is still elevated at 9.4 months. I don’t think second leg in the housing price downturn is over, but we are probably getting very close to the bottom.

The first graph (from this source) tracks the history of the C-10 and C-20 indexes. Note that on both indexes we are almost back to the post-crash lows. It seems likely to me that we will set new lows before the second leg down is over. We did so on the C-20 this month. Still, if you are looking at a house as a place to live, not purely as an investment, it is safe to go ahead and buy.



Results by City

Of the eight cities that posted month-to-month gains, Chicago led the way with a 1.32% rise. DC was the next best with a 0.95% rise on the month, followed by Charlotte up 0.86%, Boston up 0.73% and the Twin Cities (Minneapolis/St. Paul), with a rise of 0.47%.

On the downside, Portland was the hardest hit, falling 0.77% for the month. Phoenix followed with a drop of 0.61%. San Diego down 0.58%, Las Vegas off 0.36% and Cleveland down 0.34% were also noticeably weak. Tampa was down 1.48% in the month, while Las Vegas rolled snake eyes with a 0.93% decline.

On a year-over-year basis, DC was the strongest city by far with only a 1.20% drop. Only four others have managed to hold the losses to less than 4%. Boston is down 2.17%, followed by Denver off 2.56% and LA down 3.39% year over year. New York rounds out the list, down by 3.64%.

There were five metropolitan areas where the year-over-year declines were more than 7%. Worst hit were the Twin Cities, off 10.91% from a year ago. Portland, Oregon has a 9.59% decline. Phoenix fell 9.27% while Chicago was down 7.49%, and in Tampa prices are 7.03% lower than last year.

The graph below (also from this source) tracks the cumulative declines for each city over time. If the red bar is shorter to the downside than the yellow bar for a city, it indicates that prices in that city have risen since the start of this year (not year over year).

In every city, prices are below where they were in April 2006, but there is a huge variation. Las Vegas is the hardest hit, with prices down 59.16% from the peak, followed by Phoenix down 55.68%. Miami is almost a member of the “half-off club," down 49.44%. Tampa (down 45.90%) and Detroit (down 47.67%) are not far away from joining that rather dubious group.

At the other end of the spectrum, there is just one city that have managed to avoid a double-digit decline: Dallas, where prices are down only 7.87% since April 2006. Only four others are down less than 20%. Charlotte is off 10.62%. Denver is off 10.57% from the national peak. Boston, off 14.96% and Cleveland down 19.14% fill out the list.

(Note, the percentage declines I am quoting are from when the national peak was hit, the numbers in the graph are relative to that city’s individual peak, so there is a little bit of difference). Also keep in mind that these are nominal prices. While inflation has been low over the past few years, it does add up, so in real terms the declines are much greater.



Homebuyer Stimulus Now Long Gone

The homebuyer tax credit was propping up home prices in the spring of 2010, but now that support is gone. The slight rise in the C-10 in the absence of any extraordinary support measure is both unexpected and welcome.

The artificial support is still being felt in the year-over-year numbers. People had until June 30 to close on their houses, and they had to agree to the transaction by April 30. The credit was up to $8,000, so almost nobody would want to close their deal in early July and simply leave that money on the table.

The tax credit is a textbook example of a third party subsidizing a transaction. When that happens, both the buyer and the seller will get some of the benefit. The buyer gets his now when he files his tax return, the seller gets hers a year from now in the form of a higher price for the house. I think we need another month or two of rising prices, and for the C-20 to turn positive on a month to month basis before we can declare the second leg of the down turn in prices over, but I am very happy to see even a slight rise in the C-10.

Sales of existing houses simply collapsed in July 2010, after the credit expired, and have remained depressed ever since. The extremely high ratio of homes for sale to the current selling pace is sure to put significant downward pressure on prices.

There is still quite a bit of “shadow inventory” out there as well. That is, homes where the owner is extremely delinquent in his mortgage payments and unlikely to ever make up the difference, but that the bank has not yet foreclosed on or foreclosed houses that have not yet been listed for sale. It also includes all those people who think that the decline in housing prices is just temporary, and are waiting for a better time to sell.

I had been thinking that the decline would last through the end of the year, but that the size of the declines from this point would be limited. After that, I expect a prolonged period of essentially flat prices for existing homes, not a sharp rebound. The flat period may well be coming sooner than I expected, but it is still to early to be sure.

The Downward Curve Is Flattening

We are unlikely to have a decline anything like the first downdraft in housing prices. The reason is in the next graph (also from this source). People need a place to live, but they do not have to own a house. They have the option of renting.

A house is a capital asset, and the cash flow from owning that asset is in the form of rent you do not have to pay. One of the clearest signs that we were in a housing bubble was that the prices of houses got way out for line with rental prices. While on this basis houses are not yet “cheap” nationally, neither are they absurdly expensive the way they were a few years ago.

If prices fall too far from here, it will become cheaper to own than rent, and lots of people who are now in apartments will start to buy. This graph also includes the CoreLogic housing price data, which is similar to the C-20, but if anything a bit weaker in recent months. Rental vacancy rates have started to fall significantly and in many areas of the country rents are rising, not falling.

The price to rent ratio is already at the high end of normal based on the Case-Schiller index, and in the middle of the normal range based on the CoreLogic index. Rising rents will move the ratio toward the middle or even low end of the range without more weakness in housing prices. The apartment oriented REITS such as Equity Residential (EQR) should benefit from this.



It is existing home prices -- not the volume of turnover -- that is important. The level of existing home sales is only significant relative to the level of inventories, since that provides a clue as to the future direction of home prices.

If there is an excess inventory of existing homes, then it makes very little sense to build a lot of new homes. It is the building of new houses that generates economic activity. It is not just about the profits of D.R. Horton (DHI). A used house being sold does not generate more sales of the building products produced by Berkshire Hathaway (BRK.B) or Masco (MAS).

Turnover of used homes does not put carpenters and roofers to work -- new homes do. When new home construction picks up, it could do so in a very big way from the current extremely depressed levels, and the national homebuilders will probably pick up market share as hundreds of small "mom and pop" home builders have gone out of business in this downturn. A doubling in new home construction would still put the level of construction at historically very low levels, and many of the national builders could see their revenues triple or more.

Housing Wealth & the Economy

Existing home prices, on the other hand, a vital. Home equity is, or at least was, the most important store of wealth for the vast majority of families. Houses are generally a very leveraged asset, much more so than stocks. Using your full margin in the stock market still means you are putting 50% down. In housing, putting 20% down is considered conservative, and during the bubble was considered hopelessly old fashioned.

As a result, as housing prices declined, wealth declined by a lot more. For the most part, we are not talking vast fortunes here, but rather the sort of wealth that was going to finance the kids college educations and a comfortable retirement. With that wealth gone, people have to put away more of their income to rebuild their savings if they still want to be able to send the kids to college or to retire.

That which you save you don’t spend, and if everyone starts to spend less at the same time, the economy will inevitably slow. While thrift may be a virtue on an individual level, it can be a vice at the macro level. Or, to be more precise, the change in the attitude towards more thrift can be a vice at a macro level.

The decline in housing wealth is a very big reason why retail sales have been so weak. With everyone trying to save, aggregate demand from the private sector is way down. If customers are not going to spend and buy products, employers have no reason to invest to expand capacity. They have no reason to hire more workers.

To the extent businesses invest, it will be on projects that cut their costs, more often than not by replacing labor with capital. Investment in equipment and software has been quite strong in this recovery. Investment in equipment can be either a complement to increased employment, or a substitute for employment. If a business buys an additional truck, presumably it will need an additional driver. If they buy a factory robot, that robot might replace a factory worker. The evidence seems to suggest that lately there has been more substitution investment than complementary investment.

People pulling money out of their houses was a big force behind what growth we had during the previous expansion. Mortgage equity withdrawal, also known as the housing ATM, often accounted for more than 5% of Disposable Personal Income during the bubble, thus greatly lifting consumer spending. Since the bubble popped, people have been, on balance, paying off their homes (or defaulting on them through foreclosures).

The comparison of the next two charts shows how important housing wealth is to the middle class. The first graph includes home equity wealth, the second looks only at financial assets like stocks. The upper middle class (50 to 90% income brackets) had 26% of the total wealth in the country in 2007, and just 9.3% of the wealth in the form of financial assets. The value of non-financial assets, mostly home equity, has declined significantly since 2007, and with it the wealth of the middle class.





Also, as housing prices fell, millions of homeowners found themselves owing more on their houses than the houses were worth. That greatly increases the risk of foreclosure. If the house is worth more than the mortgage, the rate of foreclosure should be zero. Regardless of how bad your cash flow situation is -- due to job loss, divorce or health problems, for example -- you would always be better off selling the house and getting something, even if it is less than you paid for the house, then letting the bank take it and get nothing.

How the Government Assists

By propping up the price of houses, the tax credit did help slow the increase in the rate of foreclosures. Still, more than a quarter of all houses with mortgages are worth less than the value of the mortgage today. Another five percent or so are worth less than five percent more than the value of the mortgage. If prices start to fall again, those folks well be pushed under water as well.

On the other hand, it is not obvious that propping up the prices of an asset class is really something that the government should be doing. After all, it is hurting those who don’t have homes and would like to buy one. Support for housing goes far beyond just the tax credit. The biggest single support is the deductibility of mortgage interest from taxes. Since homeowners are generally wealthier and have higher incomes than those that rent, this is a case of the lower middle class subsidizing the upper middle class.

If you are in the 35% bracket, then effectively the government is paying 35% of your mortgage interest; if you are in the 10% bracket, the government is effectively picking up only 10% of the tab. The same, incidentally, holds true for other tax deductions, such as charitable contributions.  Also, even if they are home owners, people with lower incomes are more likely to take the standard deduction rather than itemize their taxes.  The mortgage interest deduction only applies if you itemize. 

There has been much discussion of trying to rationalize the tax system and bringing down tax rates, but to do so the base would have to be broadened through the elimination of deductions. The mortgage interest deduction is one of the biggest of these. Any attempt that leaves the mortgage interest deduction in place would have to be mere tinkering around the edges. While the concept of lower rates and fewer deductions is a good one, transitioning from here to there in the current weak housing market is going to be difficult to say the least.

Housing Prices at Fair Value

Fortunately, relative to the level of incomes and to the level of rents, housing prices are now in line with their long-term historical averages, not way above them as they were last year. In other words, houses are fairly priced: not exactly cheap by historical standards, but not way overvalued either. That will probably limit how much prices fall, and I don’t think they will go down more than about 3% from current levels. That, however, is more than enough of a decline to do some serious damage.

Despite the seasonal bounce in the unadjusted numbers, the second down-leg in prices is probably still underway. Fortunately, it will probably be a much shorter leg than the first one. Still, that is bad news for the economy.

Used homes make very good substitutes for new homes, and with a massive glut of used homes on the market, there is little or no reason to build any new ones. With used home prices falling, they undercut the prices of new homes. A homebuilder simply cannot compete with a bank that just wants to get a bad asset -- a foreclosed home -- off of its balance sheet.

Residential investment is normally the main locomotive that pulls the economy out of recessions. It is derailed this time around and there seems to be little the government can do to get it back on track. Eventually, a growing population and higher household formation will absorb the excess inventory.

The key to higher household formation ("economist speak" for getting kids to move out of Mom and Dad’s basement and into a place of their own) will be more jobs. Unfortunately, residential investment is normally a key source of jobs when the economy is coming out of recessions. Sort of a tough "chicken and the egg" problem.

If the stabilization of existing home prices can continue -- and not just because of an expensive artificial prop -- it is extremely good news for the economy. It will stop the foreclosure problem from getting worse, since being “underwater” is a necessary, but not sufficient, condition for a foreclosure to happen.

It means that the wealth of the average American is not being eroded. That should help consumer confidence. It also lays the foundation for a pick-up in new home construction. When that happens, the economy will see a huge benefit.

This recovery has been lacking the normal locomotive, residential investment, which historically has pulled it out of recessions. When that locomotive gets back on track, the economy will pick up speed.

Three months of ever-so-slight improvement on a seasonally adjusted basis on the smaller of the two indexes is not enough to declare the end of this downturn, but it sure is a hopeful sign.
 
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