Monday, June 25, 2012

"Rebuilding the Housing Economy," UCLA Anderson Forecast, June 2012

After an agonizing six year decline where nearly $7 trillion of wealth was destroyed, the housing economy is now in the process of rebuilding. With average home prices declining by one-third, it has been a searing experience for most homeowners who never believed that housing prices would ever fall. (See Figure 1) As a result, with existing homeowners being foreclosed upon and potential homeowners either unable to meet more stringent purchase requirements or fearful of continued price declines, the homeownership rate declined from a peak of 69% in 2004 to 66% in 2011 and is forecast to drop to 65% by the end of this year. (See Figure 2)
Figure 1 Case-Shiller Home Price Index, 2000 – March 2012, Monthly Data, 2000 = 1.0. Source: Federal Reserve Bank of St. Louis and Standard & Poor's 

Nevertheless, there are many indicators offering evidence that the housing market has bottomed and a recovery is underway. Despite a regulatory logjam in the process, foreclosures appear to have peaked. (See Figure 3) Concomitantly, existing home sales are now on the rise. After peaking at 7.1 million home sales in 2005, the series declined to 4.1 million units in 2008 and is expected to exceed 5.0 million units in 2013. To be sure, about one-third of existing home sales are accounted for by either foreclosures or "short sales," yet, the steady rise in activity is indicative of recovery. (See Figure 4)

The recovery is underpinned by a gradually improving labor market, a rebound in household formations and record low mortgage rates, now below 4%. (See Figures 5, 6, and 7) For example, household formations averaged 1.33 million a year between 2000 -2007 and then collapsed to 327,000 in 2009. By last year household formations recovered to 1,072,000 and we forecast a robust 1.7 million run rate in 2013- 14.
Figure 2 Homeownership Rate, 1990 -2012E, Yearend Data, Percent
Source: U.S. Bureau of the Census and UCLA Anderson Forecast
Figure 3 Loans in Foreclosure and Past Due Mortgages, 2005Q1 – 2012Q1, Percent
Source: Mortgage Bankers Association and The Wall Street Journal
 Simply put there are too many young adults living in their parent’s homes, an untenable situation for all of the parties involved.

Nonetheless the recovery will continue to be gradual and uneven. Though improving, the job market remains far from healthy and higher down payment and credit score requirements are working against the stimulative effects of low interest rates. New to this cycle is the impact of exploding student loan debt that will keep potential buyers out of the housing market for years to come. (See Figure 8)
Figure 4 Existing Home Sales, 2000 – 2014E
Figure 6 Household Formations, 2000 – 2014E

Source: Bureau of the Census and UCLA Anderson Forecast

Source: National Association of Realtors and UCLA Anderson Forecast
Figure 5 Payroll Employment, 2000Q1 -2014Q4E
Figure 7 30-Year Fixed Mortgage Rate, 2000Q1 – 2014Q4E

Source: Federal Reserve Board and UCLA Anderson Forecast

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

At one trillion dollars, student loan debt now rivals credit card debt. And because student loan debt is not extinguishable in bankruptcy, it will impair the ability of younger people to buy homes in the years to come.

After peaking at nearly 2.1 million units in 2005, housing starts plummeted 73% by 2009 to 554,000 units. (See Figure 9) After remaining at roughly that level in 2010 and 2011, housing starts are expected to reach 755,000 units this year and exceed one million units in 2013. Although this looks like a steep recovery, at one million units housing activity would have only recovered from depression levels to recession levels. Remember that from 1991 – 2010 housing starts averaged 1.42 million units a year. As we noted earlier, household formations on the order of 1.6 million a year can easily support this long-run average.

The real drama taking place is in multi-family housing. We are now in the midst of a boom in multi-family construction, especially in rental apartments. Like housing starts in general, multi-family starts collapsed from its peak in 2005 of 354,000 units to a nadir of 112,000 units in 2009. Since then starts will have more than doubled to the 260,000 units forecast in 2012. (See Figure 10) We would not be surprised to see multi-family starts exceed 400,000 units in 2014.
Figure 8 Student Loan Debt, 2000Q1 -2011Q4
Figure 9 Housing Starts, 1991- 2014E, Annual Data

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Source: Federal Reserve and The Wall Street Journal

Figure 10 Multi-Family Housing Starts, 1991 – 2014E

Source: U.S. Department of Commerce and UCLA Anderson Forecast
After all, the flip side of a falling homeownership rate is a rising rate of home renting.

The coming boom in multi-family starts is underpinned by a very low vacancy rate (below 5%), rising rents and a flood of institutional money coming into the sector. (See Figure 11) Although not reflected in the consumer price index where the rent regulated cities of New York and Los Angeles are over-weighted, rents on renewals are now rising at 4% and many of the publicly traded real estate investment trusts are reporting year-over-year rent increases on the order of 5% to 7%.

With 10-year U.S. Treasury yields below 2%, institutional investors are seeking out higher yielding alternatives and they are finding rental apartments to be increasingly attractive. Although going in, cash returns in the more active markets are at historical lows, around 4%-5%, rising rents offer the prospect of higher future income and capital appreciation. With a buying frenzy underway, investors can and do come up with very aggressive assumptions about future rents to justify new construction.

Of course this boom in multi-family construction will have within it the seeds of its own destruc-
Figure 11 Apartment Vacancy Rate, 2005Q1 – 2012Q1, Percent
Source: REIS Reports and Calculated Risk

tion. As rents rise, consumers will shift out of rental into ownership units. The American Dream of homeownership may be comatose, but it is not dead and the wakeup call will come in the form of higher rents.

As a result by 2014, supply will begin to outpace demand. New physical supply will be augmented by the renting of existing single-family homes by a growing number of investor groups. Although much of that supply is on the urban fringe, many observers forget that sub-prime lending financed and refinanced homes in central core areas. As rents increase those areas will become ripe for gentrification and become competitive with traditional rental housing.

When outlining our thesis to several real estate investors we heard a common objection which loosely stated is, "sure the money is there, but you’ll never get the zoning." Our counter to that argument is that the planning and zoning world has changed. Instead of discouraging density, governmental planners are now encouraging it. As examples we point to the passing of California’s SB 375 which more strictly links transportation with land use planning and the "transit village" concept now being employed in New Jersey. Yes, there will still be neighborhood fights, but there will be far fewer supply constraints than heretofore.