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| Defining a Normal Housing Environment |
| Written by Jonathan Smoke | |
| 01.29.2008 | |
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Discuss this article on the forums. (0 posts) The S&P/Case-Shiller price indices for November were released today. More of the same. Home prices in the main 10-market composite were down 8.4% from a year earlier. The 20-market composite recorded a 7.7% year-over-year decline. Let me be the first to tell you to expect more of the same next month when December is reported. I’ve written before that this series is closely followed and is very good if you are focused on one of these 20 markets, but it isn’t representative of all markets in the country. Are home price declines normal? No. Regardless of measure, nominal home price declines have rarely occurred in the past; and we don’t have much experience with home price declines being as severe and widespread as we saw in 2007. But what we had in 2007 was the perfect storm for housing bears to come out of hibernation and revel in some schadenfreude. And since bears are highly entertaining, they’ve captured our attention for months now. I like to think of housing bears as cave dwellers—they prefer dark places to rest. And as bears, they view caves as merely shelter from the elements. Hence, bears can’t fathom a cave having any value that isn’t explained by rents as there would be  no value in ownership—no investment value, no luxury value. I mean, they are just caves and apparently they are perfectly fungible and exist in great supply wherever you need to hibernate. So why own or dream of owning one?The bears were right that the bubble markets were out of control earlier this decade. 2002 – 2005 were not normal years either. The level of home price appreciation in bubble markets coupled with massive increases in new home construction created the environment that led to the nasty experience of 2006 and 2007. So what is a normal view of housing? Much ink has been spilled in the last six months on defining a normal range of home prices. I don’t like the bearish view that prices are tethered to rents or incomes, so I wanted to find a way to look at the level of new home sales to define what a normal range may be and just how far out of kilter we have been this decade, both good and bad. Here’s a different way to look at the size of the housing market using ratios of new home sales to household growth (in blue) and sales of single-family existing homes to existing housing stock (in red) along with a simple linear trend line for each over the 27-year period that data were available on all four underlying series. The logical basis for looking at each of these ratios is simple. Existing homes turn over or change hands because of migrations of households and life changes (marriage, divorce, children, retirement, death, etc). We would expect some stability in this ratio but it also wouldn’t be abnormal in a vibrant and growing economy like the United States to see gradual growth in that ratio in non-recessionary periods. Likewise, the demand for new homes is principally driven by new household formations. In other words, if no new households were ever created (and no housing stock ever destroyed) and no second homes ever purchased, we wouldn’t need new homes—we’d simply exchange our caves to fit our changing circumstances. So it’s rational to look at new home sales against the growth in households. We’d expect stability in this ratio as well as growth since ownership is considered a key measure of success, and as wealth and ages grow, we can expect more second home purchases. Looking at the two ratios together we see that both move in a similar pattern. They both declined in 1982 and again in 1990-1991, during recessionary periods. Otherwise they showed similar gradual growth until 2001. It would not be irrational to expect both to grow during the 1992-2000 period as the economy experienced consistent growth and as financing was readily available, interest rates were low to moderate, and as mortgage financing options began to proliferate. But in 2002 to 2005, a spike occurred and new homes climbed much further than existing homes. If the prior two declines were normal in recessionary periods, then these two ratios should have declined somewhat in 2001. Therefore, the spike likely started in 2002. Then both ratios began falling towards their longer-term averages starting in 2006. New homes have already given up all of their post 1998 gains. The existing home turnover ratio hasn’t hit its 27-year average yet, but it is about where it likely would have been without the bubble. There’s not enough history to this to say the decline is over, but it at least provides a way to frame what is normal and where we’ve been this decade, which has not been normal at all. 
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