Continuing Deterioration in Residential Construction Bodes Poorly for the Economy

The Commerce Department just released its April report on new residential construction. Housing starts fell to a 50-year record low of 458,000 units. That's 13% lower than the figure for March, and 54% lower than the figure for April of last year. The number of permits for new construction also fell to a record low of 494,000. That's 3% lower than the figure for March, and 50% lower than the figure for April of last year.

The recent declines in housing starts and permits are wholly the result of reduced activity in the multi-family (apartment) sector. Many writers have made much of the fact that single-family activity is actually picking up (however slowly). That seems like wishful thinking. Demand for housing won't recover as long as the economy is losing jobs at a rapid pace. And residential construction activity has actually been a very good leading indicator of overall economic activity. Continuing rapid deterioration in this sector suggests that the broader economy is still deteriorating, and that an upturn in housing demand is still some ways off.

Report Shows Continuing Weakness in City Economy

The San Francisco Controller's office just released the March edition of its Monthly Economic Barometer. It's a great place to find quick-and-dirty statistics about the City's economy. The latest batch of numbers are discouraging:

• The March unemployment rate was 9.0%. That's the highest rate since 1984. A year ago, the unemployment rate was 4.3%.
• The median home price fell 3.6% from February, and 19.3% from last year. (The current median price is $617,000. The record of $835,000 was achieved in May, 2007.)
• Apartment rents fell 1.6% from February, and 8.1% from last year.
• Commercial rents fell 13% from February, and 22% from last year.
• Hotel occupancies fell 5% from February, and 14% from last year.

Those are the highlights. The rest of the report is equally disheartening. You have to be dyed-in-the-wool optimist to find any good news in it.

If you want to read the next Monthly Economic Barometer when it comes out, you can find it here.

Deterioration of the High End Housing Market

The Chronicle ran a front page story about the Bay Area housing market in Sunday’s paper. The gist of the story was that the high end of the market is showing signs of distress, and is beginning to deteriorate.

The article was partially correct: there has indeed been a notable change in the high end of the market, but it’s premature to attribute that change to distress. And it’s inaccurate to claim that the high end of the market has only recently begun to deteriorate.

Let’s start with what’s happened recently. Take a look at the chart, below, which shows historical listing activity for single family homes in District 7 (which is a good proxy for the high end of the San Francisco market).

The blue bars indicate the number of new single family home listings in each year. (The figure for 2009 was obtained by annualizing year-to-date listings through the end of April and applying a minor correction for seasonality.) The purple line indicates the median asking price for those new listings. Together, these series provide a historical overview of the supply side of the market.

After several years of restrained activity, listings in District 7 bounced back strongly in the first four months of 2009. Meanwhile, asking prices continued their recent downward trend. The latter observation suggests that the sharp increase in listing activity is being driven at least partially by recent economic turmoil, rather than any renewed sense of opportunity. Keep in mind, however, that the number of listings is high only in comparison with the last few years. When compared to pre-2005 levels, listing activity is merely average. So it seems premature to conclude that owners of high-end homes are suffering from financial distress.

So much for the supply side of the market. What about demand? Contrary to what the Chronicle article suggested, demand for high end homes has been deteriorating for at least two years. Take a look at the chart, below, which shows historical sales volumes for single family homes in District 7.

Sales volumes in District 7 have fallen in every year since 2004. As long as prices were rising, declining sales could be attributed to higher asking prices (i.e., tighter supply). When prices began to decline in 2007, however, it became clear that demand was declining as well. (See this earlier posting for a cartoon picture that lays out the reasoning.) The rate of deterioration appears to have accelerated in 2009, but it’s incorrect to suggest that demand is only now beginning to suffer.

The inventory of high end for-sale homes in the Bay Area has climbed significantly in the last year, and now exceeds a year’s worth of supply. The Chronicle seems to have attributed the higher inventory entirely to the sharp increase in listing activity. If the rest of the Bay Area is like San Francisco, however, the increase in listing activity has merely returned listings to a level that would have been considered normal a few years ago. It therefore seems premature to conclude that high end sellers are ‘distressed’. And by ignoring the steady fall in demand over the last two years, the article reaches an overly dramatic conclusion, namely, that distress has suddenly overtaken the high end of the market. The reality is less exciting than that.

Rising Mortgage Defaults Put Continuing Pressure on Home Prices

Banks don’t like to own real estate, especially not when they’re fighting for survival. So when they acquire homes through the foreclosure process, they usually sell them fast.

The key to a quick sale is to set a low asking price, which is why foreclosed homes are usually the cheapest ones on the market. There is only so much demand for homes, so when banks are sitting on a large stock of foreclosed homes, they quickly come to dominate the supply side of the market.

That’s a pretty good description of what’s going on in the Bay Area right now. While fewer than 1% of Bay Area homeowners defaulted on their loans during the first quarter of 2009, more than half of the homes that were resold during the same period had been foreclosed on during the previous year.

Take a look at the chart, below, which shows the recent history of mortgage defaults in the Bay Area.

A default is said to occur when a borrower misses a scheduled loan payment. When that happens, the lender may issue a Notice of Default, which is the first step in the foreclosure process. According to Dataquick (which provided the data for the chart), 80% of borrowers who default on their loans ultimately lose their homes to foreclosure.

After falling for six months (due to changes in California law and a temporary moratorium on foreclosures), default activity resumed its upward trend in the first quarter of 2009. Lenders issued a record 19,438 default notices to Bay Area homeowners.

There is anecdotal evidence that housing demand is recovering in the Bay Area, perhaps due to the recent performance of the stock market. On the other hand, unemployment is still rising sharply, so I wouldn't be surprised if the recent surge of optimism turns out to be a flash in the pan. In that event, prices will be mainly driven by supply-side factors. Considering the recent trend in mortgage defaults, Bay Are home prices are likely to be under pressure for some time to come.

(In case you're curious, default notices were issued on roughly 0.2% of San Francisco homes during the first quarter. Meanwhile, previously foreclosed homes accounted for roughly 12% of resale activity.)

Apartment Rents Trending Down in Bay Area

Bay Area apartment rents have been falling for the last six months, and are now about 4% below their Q3 2008 peak. That's according to Novato apartment research firm Real Facts, via the San Francisco Chronicle. Real Facts surveys apartment complexes with 50 or more units, and includes everything from studios to four-bedroom apartments in their numbers. Their estimate for the average rent in the nine-county Bay Area was $1,556 for the first quarter of 2009. That's 1.4% lower than their estimate for the first quarter of 2008, and represents the first year-on-year rent decrease in the last four years. Rents in the City were essentially flat on a year-on-year basis -- Real Facts estimates that they fell 0.1%.

My guess is that apartment rents will continue falling for the next several months. The Bay Area is still losing jobs at a rapid pace, and increasing numbers of foreclosed homes are being bought by investors and converted to rentals.

Inventory of Unsold Homes Suggests that San Francisco Market Will Remain Weak

The inventory of unsold homes has historically been a good predicter of near term housing market performance. I addressed this topic in an earlier blog posting. For California as a whole, the historical relationship seems to have broken down recently. The breakdown probably resulted from banks dumping foreclosed homes onto the market. (I'll address this shortly, in another blog posting.) San Francisco has had relatively few foreclosures, however, so the historical relationship has held up pretty well.

Take a look at the chart, below, which compares the beginning-of-year inventory of unsold homes in San Francisco to the change in median price during that same year.

Inventory is stated as the number of months required to sell the current stock of for-sale housing, assuming that selling activity remains at current levels. I plotted it using an inverted scale in order to highlight the correlation with price changes.

Real estate practitioners often assert that the housing market is "in balance" when there is six months worth of inventory. The chart suggests, however, that the equilibrium level of inventory for San Francisco may be less than six months. Since 1997 (the beginning of my data series), the average inventory in San Francisco has been only 3.6 months, compared to 5.0 months for California as a whole. And although San Francisco began 2008 with just over six months worth of inventory, prices fell almost 20% during the year.

The San Francisco market had 5.8 months worth of inventory at the beginning 2009. That represents only a modest improvement over 2008. If I had to make a prediction based on this indicator alone, I'd say that 2009 is shaping up to be another weak year for the San Francisco housing market.

Unemployment Still Increasing Sharply

The national unemployment rate reached 8.5% in March. That's almost a full percentage point higher than the January reading of 7.6%. Ben Bernanke said at the time that unemployment would climb to 8.0% "for sure." Presumably, he felt that a higher figure would have sounded outlandish. In retrospect, he was being overly cautious.

The Bay Area unemployment rate has been climbing rapidly as well. It hit 9.9% in March, compared to 8.8% in January and only 5.1% in March of 2008.

It's hard to see home prices stabilizing when the job market is deteriorating so rapidly.