Housing Market Recovery May Take Years

There seems to be a widely held assumption that home prices will bounce back quickly. That's silly. The housing market just went through a bubble, meaning that prices reached unsustainably high levels. So why should prices return to those same levels anytime soon?

Setting aside this logical inconsistency (or is it denial?), there is plenty of precedent for long declines in home prices. Take a look at the chart, below, which shows the Case Shiller home price index for Los Angeles.

Los Angeles prices peaked in 1990, and then fell for the next six years. The peak-to-trough decline was roughly 25%. Prices didn't return to their 1990 levels until 2000

Of course, this doesn't mean that we should expect the same course of events for Bay Area home prices. For starters, prices here have already fallen more than 25%. But it does highlight the fact that home prices tend to move in lengthy cycles. We shouldn't assume that they'll quickly adjust to the latest economic news, whether good or bad. And remember, most economists are expecting a long, grinding recovery from the current recession. Why should the housing market do any better?

Housing Market May Be Stabilizing

I can't decide if I'm skeptical or cautiously optimistic. But recent results suggest that the Nation's housing market may be stabilizing. Here's a summary:

1. Housing starts for June were up 4% (on a seasonally adjusted basis) compared to May. That's for all housing types; for single family homes, the one-month increase was 14%.

Housing starts have risen in each of the last two months. The data series are clearly volatile, however, so it's too early to announce a recovery. And if housing starts have in fact begun to recover, they’re starting from a very low level. The annualized rate of starts for June was 582,000 units. Before the crisis began, the rate had fallen below 800,000 units only once in the 45-year history of the data series.

Note: In an earlier blog entry, I mentioned that housing starts historically have been an important driver of overall economic activity. So stabilization in this sector would be encouraging news for the broader economy.

2. Sales of new single family homes for June were up 11% (on a seasonally adjusted basis) compared to May. That's the largest percentage increase in the last eight years. Sales have risen in each of the last three months, and are now 16% above their March lows.

Again, some historical perspective seems important here. The seasonally adjusted annual rate of sales for March was 332,000 units – a record low. The June rate of 384,000 units was nothing to shout about either. Before the crisis began, sales hadn’t been that slow since the 1981-82 recession.

Because sales are at such depressed levels, percentage increases can be misleading. June’s 11% improvement was an eight-year record for percentage increases, but the absolute increase in sales was a modest 38,000 units (on an annualized basis). Over the six-year period represented in the chart above, there were 14 months where sales increased by more than that.

3. Existing home prices for May were up 0.5% compared to April. That’s hardly worth mentioning on its own, but it’s the first increase in almost three years, following a cumulative decline of 32% from the peak.

The bigger news is that prices rose in 14 of the 20 markets represented by the Case Shiller indices. So May’s first hint of price stabilization is broad-based, and not simply the result of large increases in a few markets.

4. Existing home sales for June were up 3.6% (on a seasonally adjusted basis) compared to May. Monthly sales of existing homes have now increased for three months in a row.


The volatility of this series should encourage caution when extrapolating the last few months worth of data. Keep in mind, too, that until May, prices of existing homes had fallen for 32 months in a row. So while sales volumes may have stabilized, the stability has been fostered by continuous price reductions. It will be difficult to argue that the market for existing homes has stabilized until prices stabilize as well.

On the whole, it seems a little early to announce an end to the housing market downturn. Housing starts and new home sales may well have stabilized. But the tenuous stability in the market for existing homes has been paid for by continuous price reductions. There’s a good chance that demand is still falling in that segment of the market. We’ll want to see at least a few months of broad-based price stability before proclaiming that the housing market has finally bottomed.

Architecture Billings Index Falls Again

After recovering from record lows earlier in the year, the Achitecture Billings Index fell significantly in June. That's another indication that economic recovery may still be a ways off.

Source: American Institute of Architects (AIA), via Calculated Risk.

No Sign of Economic Recovery

In a recent posting, I said that the financial panic has subsided, but that the housing market is unlikely to recover soon. Paul Krugman made a similar point last week, about the broader economy. I won't reproduce his comments here, but I will borrow his chart (which he borrowed from Goldman Sachs, in any case).

Together, the four series included in the chart represent a sizable portion of overall economic activity. They all fell significantly during 2008, and they've all been flat since the beginning of 2009. Economic activity remains at depressed levels, with few signs of improvement.

San Francisco Housing Market Recovering Strongly - For How Long?

The San Francisco housing market has strengthened significantly since the beginning of the year. Prices are still 10% to 15% lower than they were last summer, but that represents a marked improvement from January, when they were down by roughly 25%. Take a look at the chart, below, which shows the recent history of home prices in the City.

The solid blue line shows median sale prices for 2-4 bedroom single family homes in San Francisco. The dashed purple line shows median sale prices for 1-3 bedroom condos. I smoothed both series slightly, using a trailing two-month average.

In January, San Francisco home prices were roughly 25% lower than they had been just six months earlier. And they were on a trajectory that seemed to imply disaster. Since then, the economy appears to have stabilized. The recession isn't over yet, but the panic has subsided. Not surprisingly, home prices have bounced back somewhat, rising by about 10% since January.

Is the recent price trajectory sustainable? I'll save that for a future blog entry. Meanwhile, the chart below seems worth considering.

The solid blue line shows median sale prices for 2-4 bedroom single family homes in San Francisco. The dashed purple line shows the S&P 500 stock price index.

It seems clear that over the last couple of years, the housing market and the stock market both have been driven by the same underlying factors. That's hardly surprising, given the dramatic events of the last 18 months. The recent close correlation is unusual, however. Over longer time horizons, houses and stocks generally don't track each other very closely. Stock prices respond rapidly to economic news, limited only by investors' imaginations. In contrast, home prices are sharply constrained by the ability of consumers to pay for them. So while expectations of improvement in corporate profits may drive stock prices higher, continuing deterioration in the job market is likely to put a ceiling on home prices.

Note: You can find additional price charts for San Francisco and the Bay Area in the Market Stats section of my website.

The Panic Is Over but Don't Expect Quick Recovery in Housing

The World panicked when Lehman Brothers collapsed. Credit markets froze and stock markets nosedived as investors fretted about the risk of a second Great Depression. Inevitably, the housing market got caught up in the crisis of confidence. Starting from already low levels, most indicators of housing activity fell to record lows in the opening months of 2009.

Several months later, it appears that disaster has been averted. The direst indicators of distress have returned to levels that are merely concerning, and not terrifying. It shouldn’t come as a surprise, therefore, that housing market indicators have bounced back from recent lows. But stepping back from the brink of disaster isn’t the same thing as recovery. The housing market downturn was well underway before the panic started, and may still have some ways to go now that the panic is over.

Consider the following series of charts, which illustrate the spike in panic levels. The first chart, below, shows the so-called TED spread.

The TED spread is the difference between the interest rates on 3-month interbank loans and 3-month Treasury bills. The former is the interest rate that (non-US) banks pay when they borrow from each other; it’s commonly known as LIBOR. The difference between LIBOR and the Treasury rate is an indicator of the perceived riskiness of lending money to commercial banks.

By September of 2008, the TED spread had already widened significantly from pre-crisis levels. When Lehman Brothers collapsed, however, the spread spiked to more than ten times its pre-crisis levels. Evidently, major banks suddenly became concerned that if Lehman could fail, so could any other major bank. Indeed, almost every bank in the country has since received federal bailout money to keep it afloat.

The TED spread has fallen steadily over the last several months. It’s still at elevated levels – suggesting that banks aren’t out of the woods yet – but the worst of the crisis has subsided. Some of the larger banks have actually begun returning their bailout money.

The stock market also went into a panic in September. Take a look at the chart, below, which shows the VIX volatility index.

Volatility is a measure of stock price fluctuations. High volatility indicates that stock prices are changing rapidly. When Lehman Brothers collapsed, the VIX index went from around 20 to a record of over 60. The index has declined significantly since then, to its current level of around 25. That’s still higher than the levels that prevailed immediately before the crisis, but it’s not much higher than the long-run average of around 19.

It’s instructive to make a quick detour into option theory. Options can be thought of as insurance against big stock price movements. When volatility rises, the insurance gets more expensive. What the VIX index actually measures is not current volatility, but the volatility that’s implied by option prices. In other words, the VIX index is essentially measuring the cost of insuring against big stock price movements. Immediately before the crisis, insurance was much cheaper than it had been historically, suggesting that investors may have been overly complacent about risk. When the crisis was in full swing, the cost of insurance hit record levels.

The bond market provided what was perhaps the most alarming indicator of panic. Take a look at the chart, below, which shows the difference between the yields on ordinary 10-year Treasury notes and 10-year inflation-indexed Treasurys.

When investors lend money to the Government, they usually demand a certain base rate of return (the so-called ‘real return’) and then add something extra to compensate for expected inflation. For instance, if investors normally require a 3% real return, they’ll demand a yield of 5% on Treasury notes if they’re expecting an inflation rate of 2%. That’s because inflation will erode the purchasing power of their loan principal by 2% per year. The extra 2% interest is compensation for the 2% annual erosion of the purchasing power of their principal.

Inflation-indexed Treasurys are designed to compensate investors directly for the eroding effect of inflation. If inflation runs at 2%, the Government automatically increases the loan principal at the same rate of 2%. Since the purchasing power of the loan principal is protected from inflation, the regular interest payments don’t need to include any extra compensation. The yield on inflation-indexed Treasurys can therefore be taken as a direct measure of the real return that investors require on loans to the Government.

The difference between the yields on ordinary 10-year Treasury notes and 10-year inflation-indexed Treasurys provides an indication of the inflation rate that’s expected to prevail over the next ten years. Before the crisis began, expected inflation was running at around 2.5%. That was in line with the historical average for (expected) inflation. It was also consistent with the 2%-3% inflation range that the Federal Reserve seems to have targeted in the past.

When the crisis began, expected inflation fell essentially to zero, reflecting investor concerns that the US might experience a ‘lost decade’ similar to what Japan went through in the 1990’s. As with the TED spread and the VIX index, however, inflation expectations have reverted toward normal levels lately, and are now only somewhat lower than they were before the crisis. Presumably, investors are no longer concerned about the possibility of a protracted recession (although many economists believe that there is still a substantial risk that the US will experience a lost decade).

What does all of this have to do with housing? Much has been made of the recent upturn in housing market activity. Housing starts have increased for several months in a row, as have sales and even, in some markets, prices. Take a look at the chart, below, which shows the Housing Market Index, published by the National Association of Home Builders.

The Housing Market Index (HMI) is a measure of builder confidence. It’s a good proxy for residential construction activity.

The HMI index fell significantly when Lehman Brothers collapsed. From a level of 17 in September, it fell to a record low of 8 in January. Unlike the other distress indicators above, however, the HMI index had begun deteriorating long before the panic began. It bounced back to 15 in the latest survey, but the bounce is mainly attributable to the end of widespread panic, not a general recovery in the housing market. The index is still far below the neutral level of 50, which would indicate an even balance of optimism and pessimism among builders.

Bay Area home prices have risen from their recent lows. Is that an indication that demand is finally turning around, or is it a one-time bounce, resulting from the end of the panic? My money is on the latter hypothesis. Considering the severity of the panic, it would be surprising if home prices didn’t bounce back when the panic subsided. The recession is still in full swing, however, and jobs are still being lost at a rapid pace. (Unemployment rose by 0.5% in May alone.) People who are banking on a continuing recovery in home prices are likely to be disappointed.

KPIX Story about Multiple Offers - Tying Up Loose Ends

KPIX ran a story in March about a house that received 42 offers. I said at the time that the house was severely underpriced. Out of curiosity, I decided to see what happened to it.

The house in question was 555 Edinburg. It was listed at $459,000, which is equivalent to $367 per square foot. By way of comparison, the median price-per-square-foot multiple for the 16 comparable houses that I identified was $451. In other words, the house on Edinburg was priced at a large discount relative to the comps, so it should have received multiple offers.

The sale closed on April 22nd, at a price of $570,000. That's equivalent to $456 per square foot -- right in line with the comps. Take a look at the chart, below, which shows the distribution of price-per-square-foot multiples for the comps.

555 Edinburg landed almost precisely in the middle of the distribution. Keep in mind that the comps were sold over a five-month period between October, 2008 and February, 2009. Those were the darkest months of the financial panic that ensued following the collapse of Lehman Brothers. In other words, far from signaling a recovery in the San Francisco housing market, the sale of 555 Edinburg signaled continuing softness.

The good news, if there is any, is that the market clearly did its job. Despite what was no doubt a bidding frenzy, 555 Edinburg sold right where it should have.