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The Housing Recovery Explained: What World War II Can Teach Us About Our Current Housing Prices and Real Estate Markets

Oct. 19, 2012
The Housing Recovery Explained
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We’re seeing a lot of mixed messages when it comes to the American housing market: is a housing recovery being seen, and when will house prices and investor confidence reflect that?

The Battle is Joined: A Long, Slow Road to Victory

Let us set the scene: It was November, 1942. The British were able to fight to a stalemate over the channel, but had not seen a battlefield victory against the Nazis on the ground in over two years of war. The forces of the Empire of Japan had overrun their colonies in the Pacific, with entire divisions of precious troops taken prisoner and forced into inhuman captivity and slavery.

But then, Montgomery’s 8th Army managed to lure the enemy to the heart of the Egyptian desert and smash the Afrika Korps and their Italian allies at El Alamein. The victory came just two days after the American, British and French landing in Morocco and Algiers, threatening the Axis base at Tobruk.

Churchill reported news of the victory to Parliament on the 10th, saying “Now, this is not the end. This is not even the beginning of the end. It is, perhaps, the end of the beginning.”

There were to be many setbacks between Operation Torch and ultimate victory, but the Allies battled back, and kept the pressure on all the way to Berlin.

I mention this because we’ve been through far tougher times before this – bruised and battered, but unbowed. And just as Montgomery was able to strike when Rommel was at the very limit of a 700-mile supply line from his base to find an opportunity for a decisive victory, real estate investors have also begun to reap profits from a real estate market that has for the most part become rife with fear. And fear drives prices below value.

Here Comes the Cavalry: Ultra Low Interest Rates Both Help and Hurt Housing Markets

Well, Chairman Bernanke isn’t riding a horse and blowing a bugle – his banners fluttering gaily in the breeze. In the capital markets, the cavalry doesn’t come with the thundering of hooves and the blowing of horns. Instead, it comes with QE3 (quantitative easing) and a silent Treasury auction, with the Fed buying treasuries on the open market, and flooding the economy with liquidity. Only this time, the Fed isn’t just buying Treasuries, but saving bankers by purchasing all kinds of financial assets. As I type this, QE3 – the quantitative easing policy of the Federal Reserve, is thundering across the capital markets like the Mongolian Horde.

The money is there to lend. In fact, there is so much money to lend that lenders are cutting each other’s throats to lend it. They’ve bid interest rates down to record low levels.

Normally, low mortgage rates help the housing market. Cheap loans make homes more affordable for young families, retirees and real estate investors alike.

But now, rates are so low that there’s a sort of perverse effect: The rates are so low that lenders aren’t being compensated for the risk of default on loans to weaker applicants.  Despite the flood of easy money in the capital markets, lenders have actually tightened their underwriting standards substantially, just in the last year. So while it’s very cheap to get a mortgage, it’s also very difficult to qualify for one in today’s market. And that holds back any kind of full housing recovery.

Signs of Life: Housing Rebounds

That said, there have been some solid indications of progress lately.  According to the Commerce Department, housing starts have risen to their highest level since July of 2008. New housing permit numbers were up 15 percent over August’s figures, seasonally adjusted. But the real movement is in the year-over-year figures: Septembers’ numbers, just reported on October 17th, were actually up nearly 45 percent over the prior year.

In addition, home construction is in surge mode:

Builders last month started construction on single-family houses and apartments at the fastest rate in more than four years, the Commerce Department said Wednesday. And they laid plans to build homes at an even faster pace in coming months — a signal of their confidence that the housing rebound will last.

The pace of construction has grown steadily in the past year, and analysts expect it to keep rising. The increase has been fueled by record-low mortgage rates, more stable home prices and a shortage of previously occupied homes for sale.

This last point is particularly telling: It indicates that in some markets, at least, the overhang of unsold homes has largely vanished. In theory, the increase in construction means more employed construction workers and contractors – who may want to buy homes themselves – are going back to work. This is a necessary grassroots improvement on the demand side that was a necessary precondition for a sustained recovery that has a chance of helping beleaguered homeowners with negative equity break even so they have some choices when it comes time to sell.

When market reversals happen, they can happen very quickly.   But is this the recovery? As Han Solo might say, “Nice new building permits, kid! Now don’t get cocky!”

While empty housing inventories are slowly being worked through, there remains a lot of downward pressure in backed-up foreclosures. Foreclosures all but came to a halt for a year as state attorney generals worked their way through allegations that banks had so screwed up the foreclosure process thanks to Robo-signing and sloppy procedures that homeowners could not be sure what lenders truly had the right to foreclose.

Well, earlier this year, mortgage lenders and the state attorneys general struck a deal – clearing the way for a backlog of foreclosures to wind their way through the system – a process that can take longer than a year.  Still, foreclosures are down 16 percent now compared with a year ago, despite the settlement: good news.

Fundamentals are Key: At What Point Are We Really In Recovery Mode?

These are all backward-looking indicators, though. What happened in foreclosures yesterday doesn’t tell us much about prices tomorrow. And a big increase in housing starts is a sign of optimism on the part of builders, but no one’s yet repealed the law of supply and demand.

The problem with the real estate bubble is that housing prices got way ahead of any figure that could be justified from their rental income streams. The bulls can’t even walk – much less run – until rental streams and ownership costs come into closer equilibrium.

The good news: We seem to be getting there.

You can see that we had a mine real estate bubble in the late 1980s, but prices moderated to let rents catch up. Then houses fell slightly out of favor during the Internet craze, when everyone wanted tech stocks, rather than houses. Then, when Internet stocks fell out of favor, investors went looking to other places to invest their money. They deflated the Internet bubble and blew the same air into housing prices.

You can see how far out of whack the market became. But you can also see that the owner-equivalent rent index provides a useful support for housing prices. And no one’s going to repeal the need for a place to live. You can see the explosion, deflation, and a couple of dead-cat bounces – but we’re getting close to equilibrium.

When the blue line falls below the pink line, you should see a lot of cash-flow positive properties out there…which will itself provide a price floor, as investors compete with one another to buy them. Much more information – and links to data from several individual major metropolitan areas – is at the link.  In addition, the backlog of unsold inventory has also reached a state of relative normalcy, with between four and five month’s worth of housing demand in unsold inventory.

The takeaway?  Things are much better than they were, and positive signs abound. On a more individual scale, if you can get approved then now is a good time to buy, refinance, or do what you’ve got to do to get your finances in shape.