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Vacancies and Overextended Borrowers

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By RodgerRafter
February 7, 2006

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Rental Vacancies peaked at 8.1% in Q3 1987.
Homeowner Vacancies peaked at 1.9% in Q3 1989.

There was a huge stock market crash in 1987 but the economy didn't slow dramatically until the 1990 to 1992 period when the housing market slowed nationally.  There is a wealth effect that goes with stock market bubbles but housing bubbles involve far more real jobs and much more credit expansion.  When housing bubbles burst, they have a bigger impact on the greater economy and a slowing economy further suppresses housing prices.

Fast forward to the present situation.
Rental Vacancies peaked at 10.4% in Q1 2004.
Homeowner Vacancies set a record high of 2.0% in Q4 2005.
There are many reasons to fear an even greater economic slowdown starting in 2006 based on a more dramatic rise in home prices and extreme private and national debt levels.

Vacancy data can be found here.

From Q4 2004 to Q5 2004 the number of vacant homes increased by 427,000, with vacant for sale up 191,000 and seasonal vacancies up 245,000.  With speculation by property flippers, vacation home buyers, and retirement home buyers driving demand for new homes, it is not surprising that the nation produced far more homes than were needed for habitation in 2005.  All this is leading to a supply glut that finally is impacting prices.  Median prices for new home sales were down 8.39% from September to December (if the most recent government data is accurate).  Prices were up 13.61% y-o-y as of September, but were down 3.40% y-o-y as of December.

Builders loaded up on far too much land (and debt) in recent years and are rushing new developments onto the market in a futile race to unload it before prices fall too far.  New homes for sale that are under construction or finished:

July - 378,000
Aug - 390,000
Sep - 399,000
Oct - 405,000
Nov - 415,000

Preliminary December data showed 415,000 new homes under construction or finished, but this will probably see an upward revision with the next report, just as September, October and November all did with the last report.  The first estimate for new sales is always based largely on housing starts and historical patterns (assuming that most builders try to sell homes before they build them).  Times have changed, however, and builders are going ahead with production schedules even though the buyers aren't showing up like they used to.  Also, ARIMA seasonal adjustments assume continuations of trends.  The implication that the trend has changed shows up in the big downward revisions for October's data that we've seen so far:

Preliminary - 1st revision - 2nd revision
October New Sales:  111K - 110K - 106K
Sold before starting:  46K - 44K - 40K
Started/Finished 4Sale: 400K - 399K - 405K

The greatest rate of construction has been taking place in much of the South and overcapacity there is already extreme.  Searching newhomesource.com the areas I found with the most homes "Available now" were:

Houston.......1829
Dallas.........692
Austin.........431
Atlanta........311
Tampa..........221
Charlotte......216
San Antonio....209
Denver.........185
Phoenix........162
Chicago........157
Las Vegas......148
San Diego......132
Riverside......121
Orlando........119
Raleigh........117
Indianapolis...114
 
Those numbers aren't precise and not all builders use the site, but the numbers seem believable in their proportions. 

2005 Metro Area Vacancies won't be out until around February 17th, but 2004 rental and homeowner vacancy rates were:
Top Metro Areas.....10.2%..1.7%
Houston.............15.6...3.1
Dallas..............12.8...2.1
Austin..............12.8...1.9
Atlanta..............8.5...3.1
Tampa...............10.3...1.7
Charlotte...........12.2...2.6
San Antonio.........14.4...1.1
Denver..............14.4...2.9
Phoenix.............12.6...1.6
Chicago.............15.4...1.4
Las Vegas...........10.4...3.2
San Diego............6.5...1.5
Riverside............5.9...0.6
Orlando.............10.4...1.6
Raleigh.............18.6...2.1
Indianapolis........14.3...4.5
It isn't surprising that if you build a house where there is already overcapacity you might have a hard time selling it.  I expect most of those percentages to jump upwards in the soon-to-be-released 2005 data.

More than 15,000 new homes are listed for sale at NewHomeSource.com in the Houston area, with the most expensive "Available now" one being a 6,186 square foot home for $668,288 and the least expensive finished one being 1,164 sq. ft. for $89,721 (in contrast, $653,000 will get you a 1,225 ft. condo, spitting distance from the freeway near downtown Oakland from Pulte).  It is hard to imagine that the builders are making a profit at those prices, even with cheap land and financing.  More likely, the builders got carried away with their land purchases 2, 3 and 4 years ago in an area where cheap land was plentiful (Homeowner vacancies in Houston were only 1.1% in 2002).  Rather than letting land sit idle, builders pushed forward with development plans, capitalizing labor, material and interest expenses along the way and keeping profits high.  The losses won't hit the balance sheet until the homes are actually sold at a loss.

Over the past several years, the executives of homebuilding companies were handsomely rewarded for taking large risks and building at the fastest possible rate.  It is a structural flaw of our financial system where executives get most of the benefits of risk taking and aggressive accounting while investors are exposed to most of the downside risks when companies overproduce.  Being pessimistic on housing doesn't help your stock price or boost the size of your bonus checks if you are the CEO of a publicly traded homebuilder.

Listening to the Standard Pacific conference call yesterday, I heard an analyst ask about the troubled Tampa market where many builders are resorting to large discounts and incentives to unload homes.  The executive who answered simply said that they didn't see a need to discount homes in that region and quoted some unspecific numbers about backlog.  Looking at NewHomeSource.com, however reveals that 114 of the 221 "Available now" homes are theirs, with more listed as under construction.  Perhaps they are reluctant to discount those homes and take a loss right now.  Inventories for Standard Pacific are up sharply over the last year and their debt level is up sharply as well.  If they don't take the losses and hang on to too many homes, interest expense will eat away at their equity over time.

Meanwhile, many new homeowners are facing more acute pressures from interest expenses.  Mortgage payments were up to a record 10.76% of income for all homeowners in Q3, and buried within that number are legions of bubble homebuyers and investors who've bought far more home than they can afford.  With perhaps $1 trillion worth of adjustable rate mortgages resetting in 2006, pressure on many at the margin will push them into solvency.  Defaults and foreclosures are already rising.  As many single-family homeowners are converted into apartment renters through the bankruptcy and foreclosure processes, housing oversupply problems for single-family homes should escalate.

NAR estimated inventory of 2,796,000 existing homes for sale, or a 5.1-month supply in December, which is up by 582,000 (26.3%) year over year.  Distressed borrowers will have a very hard time unloading their homes in a hurry if they decide they can no longer afford high mortgage payments.

Easy credit and temporarily low interest rates made it possible for people to buy more home than they could afford.  It also allowed many others to extract imaginary equity out of their appreciating homes as prices soared.  The result was rising debt levels, a trade gap and a housing boom.  Far too many homes were built and the homes built were larger than the economy could support.  Now that the homes have been built, median prices will probably spend a few years falling to a level that people can actually afford in most markets regardless of the size of the median home.  A vacant home is a large cash drain on whoever is stuck holding it.  Exactly what that level will be is hard to guess, but I'm expecting that we'll see greater than 50% declines (adjusted for inflation) in some of the most overbuilt and overextended markets.

The biggest bag holders for all of this are the ones who made it possible, the investors in mortgage backed securities, including:


-foreign investors and central banks, looking for a place to park Trillions in trade gap proceeds


-pension funds and hedge funds, seeking to generate short term yield regardless of long term risk

Investors in homebuilders, with too much debt and land on their books, and investors in lenders, with too many high risk loans on their books, will also be left with substantial losses.

How deeply the shakeout will strike and which investors will be left holding the bag for falling home prices remains to be seen. Another round of easy credit could fuel a rise in prices and bail out distressed borrowers with another round of cash-out refinancing. I don't see one coming, however, because the Fed seems determined to definitively kill off the bubble by taking the profit out of mortgage lending. It appears that the Fed has finally burst the bubble it created with ultra-low rates a mere two years ago, but you won't get an admission of this before it becomes so obvious that most investors have figured it out for themselves. I expect tightening to continue at the March meeting unless the inflation numbers and economic numbers both come down significantly.

Eventually I expect the Fed will try to stop the bleeding before its main constituents, the member banks, are too badly damaged. But just as bursting the bubble took a very long time to accomplish in the face of high levels of public greed, ensuring a gradual or shallow decline will be very difficult once high levels of fear come into play. On top of this, the US economy faces additional challenges in the form of unsustainably high government deficits and a $700 billion trade gap. Simply easing credit would likely lead to a rapidly falling dollar and rising inflation. That may happen anyway, if foreign investors decide that roughly $10 trillion in US debt is more than they want to hold. In the end, inflation may be what ends the cycle of falling home prices.


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