| Homebuilders |
According to the U.S. Census Bureau, the average American has well over
one-third of their personal wealth tied up in their primary home. That makes
real estate far and away the largest single investment for most consumers.
Moreover, roughly two-thirds of families owns a home -- the fate of the real
estate market has a direct impact on the majority of Americans.
By
and large, the past few years have been a great time to own real estate. At the
beginning of 2000, the median price of a single family U.S. home was $141,800.
By September 2005, the median house in the U.S. was worth $229,200, a gain of
nearly +62% (see our chart). That sure beats the -10% return delivered by the
S&P 500 over the same time frame. And some particularly hot markets -- such
as Arizona, California, New York, and Florida -- handily outpaced these national
averages.
But this unprecedented real estate boom has hit some speed bumps recently.
There's no single reason to blame for the slowdown -- a number of factors likely
contributed to the shift. Specifically, with the Fed slowly but surely boosting
interest rates, the cost of borrowing -- the interest rates on mortgages --
began to creep higher. That made homes less affordable.
Meanwhile, homes in the hottest markets rose to prices that just weren't
affordable for a lot of buyers. As a result, would-be homebuyers started looking
instead for rental properties. And finally, a slowdown in economic growth in the
latter half of 2006 began to chip away at consumer confidence and job security
-- sentiment can have a major impact on an individual's willingness to buy a
home.
The sector most directly affected by this dynamic: the homebuilders. The S&P
500 Homebuilding Index soared +566% from the end of 1999 to the end of 2005 as
buyers queued on waitlists for years to grab the most coveted properties.
Homebuilders had no problems selling their inventories of homes and could demand
steadily higher prices. The biggest concern voiced by the builders during the
big run-up: an inability to secure enough land to keep pace with demand.
But now, we're faced with a far different picture. The S&P 500 Homebuilding
Index has tumbled -35% from its high in mid-2005. Inventories of unsold homes
have soared, forcing homebuilders to offer attractive discounts, subsidized
financing, and other incentives in an attempt to woo buyers. The previous land
and home shortage in markets like Phoenix and Florida has now turned into a
glut.
Even
worse, housing starts -- new homes just starting construction -- have collapsed,
as have sales of existing homes. In fact, housing starts have recently fallen
faster than at any time since the housing bust of 1990-91 (see our chart).
Meanwhile, some builders are writing down the value of the homes in their
inventories -- with the market softer, these homes aren't worth as much as they
were just a year ago.
There are even worries that the home boom and bust may cause broader economic
troubles -- a rising number of U.S. homes have gone under foreclosure over the
past few months. Though overall foreclosure rates remain low, this figure may be
an early sign that some marginal buyers are having difficulty meeting their
mortgage payment obligations.
But just as investors couldn't seem to get enough of homebuilders back in 2004
and 2005, the sentiment is now overly gloomy. While it may take time for the
housing market to recover, there are some tentative signs of stabilization in
the industry. And while the group is off its summertime lows, most homebuilders
are still trading well under their late 2005 prices. This offers savvy investors
a chance to buy at reasonable valuation levels -- to buy when there's too much
fear and loathing on the Street.
Here are some of the factors that currently underpin a housing recovery:
Interest Rates
Most homebuyers finance the majority of their purchase using a mortgage.
Therefore, the prevailing interest rate on mortgages is probably the single most
important factor influencing home affordability. Simply put, when interest rates
are low, buyers can afford much more expensive properties and are more likely to
buy.
Mortgage rates are usually benchmarked using some basic measure of interest
rates plus a margin, or spread. For example, a customer with excellent credit
and relatively high income might receive a small margin over the benchmark rate,
while a riskier debtor might pay 1-3% above the benchmark. Some mortgages use
the prime rate -- a rate that represents the interest rates banks give to their
best customers -- as a benchmark.
No matter what interest rate benchmark a bank uses, the yield on the 10-year
U.S. Treasury bond gives us a good idea of how expensive it is to borrow money.
In mid-2005, the yield on the 10-year Treasury hovered around 4%; by mid-2006
that yield was closer to 5.25%. This significant tightening in the interest rate
environment undoubtedly contributed to the housing slowdown.
But after the Fed started pausing its rate hike campaign, yields once again
began falling. In late 2006, yields dropped back under 4.5%. Lower rates clearly
make housing more affordable and could serve to reinvigorate the market this
spring -- the peak home-buying season.
Lower Prices
Ironically, the drop in median home prices is likely a positive for home sales
over the long term. While the median house price on a national basis remains
barely under its highs, some formerly red-hot markets have been hit much harder
than the national averages suggest. Cooling prices have vastly improved home
affordability in these markets.
In addition, several major homebuilders have reported that discounts and other
incentives have helped clear inventory and encourage sales. While this spells
lower profit margins for the builders, it should reduce the inventory of unsold
homes on the market today. The falling supply of unsold homes will eventually
put a floor under prices.
Rising Incomes and Employment
Ultimately, no matter how low interest rates go, homebuyers still must make
payments on their loans. Obviously the higher your average income, the easier it
is for you to afford a home. And as more people find employment, the pool of
potential homebuyers increases.
While the economy has cooled somewhat over the past year, data on this front
remains encouraging. In fact, recent wage growth has been at its fastest pace in
close to five years. Meanwhile, the unemployment rate in the U.S. remains near
historic lows.
Economic Growth
Finally, as you might imagine, when the economy is growing, this serves to
strengthen the housing market. Most of the big real estate busts of the past
several decades have occurred in the context of a recession -- the 1990-91 bust
is a classic example.
While the U.S. economy has clearly slowed, it's still growing. And recent data,
such as the employment statistic highlighted above, suggests that growth may
actually be picking up again. That too should shore up
the real estate market.
