Why Housing Is Guaranteed to Recover

The housing market is a mess. Prices might look cheap, but probably aren't finished falling. They've basically fallen back to historic averages. The washing out process that happens after bubbles burst usually takes assets far below average. Euphoria doesn't just end. It turns to hatred. Fool me once ... you know.

Still, housing is going to recover. It might be years from now, but it's going to happen. You can guarantee it. Those are strong words, but the force that will drive recovery is even stronger.

A driver behind the housing bubble was that we built too many homes. For most of the last decade, new home construction grew far faster than population growth or household formation. This wasn't surprising. It didn't even matter that there weren't enough new households to fill all the new homes. Investors would happily purchase a new home -- or 10 -- and let it sit empty. The sole point was to let it appreciate and sell it at a profit.

But today we're in the exact opposite position. New home construction is comatose. It doesn't make any sense for contractors to keep building. "The construction industry is dead right now," Yale economist Robert Shiller said last month. "They don't see any profit in building homes at these prices." That's the strongest force you could ask for to keep new home construction glued to the floor, and it means homebuilding in relation to the size of the economy is nowhere near normal levels.

Here's a good way to visualize this:

Source: Federal Reserve.

The higher the line on this chart, the higher the odds are that we'll need to build more homes in the future. Obviously, we're in uncharted waters right now.

Some more figures to throw at you: In 2005, about 1 million new households were formed while more than 2 million new homes were built. That created an inventory glut. Today, about 1 million new households are still being formed, yet housing starts (new home construction) are running at about 560,000 per year. That's eating up excess inventory -- quickly.

That trend should stand, too, thanks to the U.S.' strong demographic and immigration trends. Household formation over the next decade should average nearly 1.5 million per year, according to the Joint Center for Housing Studies at Harvard University.

Simply put, the number of homes being built today cannot, and will not, support population growth. Excess from the housing bubble is being removed, and will likely be mostly cleared out in another year or two. After that, one of two things (or a combination of both) has to happen.

The first is home prices will rise. It's simple. At the rate we're going today, demand will not only catch up with, but surpass, supply in the future. And that's a fairly safe forecast to make. Unlike demand for stocks, gold, or bonds, a minimum level of demand for housing can be projected rather safely based off household formation -- itself a relatively safe forecast being based on demographics.

Once prices start rising after new households clear out excess inventory, homebuilders will regain the incentive to build. They'll have the demand to do it. I think that's the most important point to consider when looking at companies like Pulte (NYSE: PHM  ) , NVR (NYSE: NVR  ) , and KB Homes (NYSE: KBH  ) . If these companies can stick it out another two years or so, business is practically guaranteed to improve. Quite substantially, too. A lot of these companies are being priced based solely off of today's derelict housing market without respect for the inevitable construction rebound. Could be an interesting sector if you've got the patience. Most investors don't, and that's why these companies trade where they do.

More importantly, no modern U.S. recession has ever fully recovered without the help of housing. Even in non-bubble times, housing is one of biggest economy drivers for the simple reason that it's the largest investment most people ever make. Its downfall is a major reason our economy is still in a funk. And we'll probably stay there for a while. But if there's light at the end of the tunnel, it's from the chart above. The inevitable rebound in construction is one of the most positive future indicators we have today -- even if that future is a full two years away.

Again, the housing market is a mess and will probably get worse. Count on it. But everything is in place for a recovery. All markets are cyclical, and when you look at the numbers it's hard not to think we're near the bottom of this cycle.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (20) | Recommend This Article (40)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 30, 2011, at 11:43 PM, Estrogen wrote:

    So with interest rates at a low, would now be the time to invest in income properties? If one can put enough down (say 20-50%), take out a 15-20-30 yr mortgage, make the payments from rentals, looks like a nice dividend once home is paid off.

    Hmmmm. Perhaps I'll roll a bit of my IRA into a real estate IRA.

    Where is the flaw in my thinking?

    Estrogen

  • Report this Comment On July 01, 2011, at 10:31 AM, David369 wrote:

    Estrogen

    Only flaw I see is that you have to figure out the (probably high) interest rate you would pay for 2+ years vs how fast the property increases in value. My guess is that you would have to hold the rental properties for at least 4-5 years and that would be assuming that after 2 years property values begin climbing at a nice 5-7% per year. Then you would also get the write-offs on the rental properties while you held them. I guess the interest would be a write off too? This could get confusing. Good luck! I'll just stick to stocks, they are easier to evict when they don't pay the rent.

  • Report this Comment On July 01, 2011, at 11:06 AM, BMFPitt wrote:

    Estrogen -

    Owning rental properties is not like owning a dividend stock. There are many risks involved and you really have to look at the costs that you may incur when building a cash flow analysis. If you have a large amount to put down, then absurdly interest rates work against you, not for you. When rates rise, pricees will fall. That is when you will want to buy.

  • Report this Comment On July 01, 2011, at 2:10 PM, mikenpdx wrote:

    it's not as simple as that.

    perhaps only 560,00 are being built but there a glut of houses that will be back on the market by way of foreclosures over the next few years.

    combine stricter lending standards with higher interest rates which impact affordability and you have a significantly smaller base of people who can afford to buy a home.

    that slows the pace at which the glut of inventory can be sopped up. i'd love to see the housing market humming again but we're still years away from getting to that point.

  • Report this Comment On July 01, 2011, at 2:28 PM, davejh23 wrote:

    What do you mean by "recover"? As frogdog mentions, there's more to it than supply and demand. If mortgage rates jump 3-4%, affordability declines 30-40%. Some segments of the existing home market may start to look healthy again from a supply/demand perspective...home prices may start rising modestly, but they aren't going to "recover" pre-bust highs anytime soon...unless we see high inflation / wage inflation, it could be 20+ years. If mortgage rates rise and stay in that 7-8% range, and wages remain stagnant, I don't see a large segment of the boom market (3,500+ sq.ft. homes) "recovering"...with such a large oversupply and little demand, these large homes could continue selling below the cost of construction for decades. The building that I have been seeing recently are much smaller, more energy efficient homes that people can afford...that, and incomplete developments that were purchased from bankrupt private builders by large private builders at super low prices with units being sold close to existing home foreclosure prices.

  • Report this Comment On July 01, 2011, at 3:37 PM, sailrmac wrote:

    The author equates household formation with housing demand and construction as supply. What is missing is the % of household formation which typically results in home ownership demand. That was as high as 66%, every 1 million new households formed resulted in demand for another 660k new homes. However that % has been falling. 20 somethings waiting a few more years, potential retiree's deciding they don't need to buy and hold that second eventual retirement home now, existing retiree's downsizing, people being foreclosed on, people not qualifying, etc. etc. Lets say demand declines to 60% homeownership rate. Then every 1 million new household formations only results in demand of 600k purchased units. More importantly if we already had existing stock of 100 million homes that drop to 60% homeownership also free's up 6 million homes of supply. In this scenario even with 0 new homes being built, there would be 6 years worth of supply available.

    Change in homeownership rate (and the potential reasons that will happen) need to be factored into one's analysis.

  • Report this Comment On July 01, 2011, at 6:51 PM, xetn wrote:

    And you cannot overlook the 14 % of the work force that are out of work, plus thousands of others that are working part-time jobs. (Some estimates are approaching 25% when one figures in the number of people that have given up looking for work.

    Add to that the numbers of college grads that are now working for Starbucks, etc. and have huge education loans that they will have to spend many years paying off. Many of the recent grads are returning to the nest and living with their parents until they can find better opportunities.

    Then there is the fact that many of the previous high-pay manufacturing jobs have moved off-shore resulting in a larger portion of the the jobs are in the lower paying services sector.

    (Yeah I know that the "official unemployment rate" is about 9.1% but the government keeps changing the way they measure the rate).

  • Report this Comment On July 01, 2011, at 7:12 PM, DavesHere wrote:

    Don't get your chart at all.

  • Report this Comment On July 01, 2011, at 11:54 PM, Estrogen wrote:

    Brother Ben is going to keep rates low as long as he needs to in order to sustain a recovery. With QE3, 4, 5, 6 we'll eventually see inflation, which of course would impact housing on the positive side.

    Of course, we are probably many years away from that. But America is historically quite resilient and the entrepreneurial spirit will continue to push this country and the world forward (IMHO).

    Leveraged real estate (and equities) should do well.

    Thanks all for your insight.

  • Report this Comment On July 02, 2011, at 8:05 AM, kalho13 wrote:

    You cannot resilience your way out of debt or coming inflation. Do think we can keep printing money and not suffer the consequences of inflation? Add inflation to double or even triple the mortgage rate and see what happens to a housing recovery.

    But then we have this ridiculous national debt that we cannot pay as a nation. Taxes could be raised on anyone remotely successful so our politicians can make more self serving decisions, and that too will put significant downward pressure on the housing market.

    Don't ignore the fact that a large part of our economy is based on discretionary spending, and that will continue to put downward pressure on employment, which then puts more downward pressure on housing.

    Let's not forget to add that real wages have been stagnant over the last couple of decades while housing prices have exploded. When do we expect real wages to catch up with the increase in housing prices? I personally think housing will continue to fall or be stagnant at best over the next decade.

    In all there are so many looming factors that need to be addressed that this country is going to be in for a rough time over the next decade. This will show how resilient we are as a nation. I would even expect rioting by the government unions like we see in Greece as real changes are finally forced.

  • Report this Comment On July 02, 2011, at 11:30 PM, chicago103 wrote:

    Another point how many existing homes are going to come on the market once there's a recovery adding to the supply of homes. There are tons of home owners wanting to sell there homes but can't

    I see a slow boring recovery. I hope I'm wrong

  • Report this Comment On July 03, 2011, at 11:05 AM, David369 wrote:

    Yeah, it is going to be a long recovery because the recovery is tied to the housing market which is tied to the employment number both of which have to work together to make a recovery. As the housing market does better, more people will have work as not only new home building creates jobs but a seller of an existing home typically hires painters, installs carpet, etc to improve the property for the market. New buyers typically spend money at Home Depot type places to "personalize" their new property. But you won't have buyers at all unless employment goes up and people have a job (for at least a year to qual for a mortgage) or people feel secure they are not going to lose their job. Not to mention the large number of homeowners who are now upside down in their mortgage, that is they still owe more on their house than they could sell it for. They are "stuck" unless they walk away from it as many have. So the homeowners who want to retire and move to Florida or somewhere, can't because they would have to pay to sell their house.

    What a mess. To top it off mortgage companies are reluctant to lend money. I wouldn't want to lend either with the possibility that home prices could decline more, the collateral for the loan would decrease in value.

    What has our government done to fix this? I can't think of anything meaningful right off. Oh yeah they gave lots of money to the big mortgage companies going under who went and bought other mortgage companies. What's wrong with this picture!

  • Report this Comment On July 03, 2011, at 1:13 PM, Nolte808 wrote:

    I'll take the overwhelmingly negative comments on the article as a data point that optimism remains very low for housing and it may be a good time to go against the grain. I'll do some more digging and perhaps add to my position in SSD each quarter over the next year.

  • Report this Comment On July 05, 2011, at 10:24 AM, pondee619 wrote:

    " In 2005, about 1 million new households were formed ... Today, about 1 million new households are still being formed.."

    Is that 1 million new households net or just new households not considering those that ceased existing? Do "new Households" only buy new housing? What happens to existing homes?

    PS. Your "guarantee" with no time frame is worth less than nothing. You could "guarantee" that the Cubs will win the World Series, I wouldn't want to invest on it. But, "Why Housing Is Guaranteed to Recover" does make a sensational headline.

  • Report this Comment On July 05, 2011, at 2:15 PM, TicoHombre wrote:

    While the debate will continue to rage regarding the timing of the recovery, one significant point I take away from this article is that the demographic forces at work are powerful and will not be contained in the 'housing pressure cooker' forever.

    True, other economic forces (interest rates, shadow inventory, inflation/deflation, etc.) work In the interim to either heat or cool the "pot". However, population growth is guaranteed to add heat thus building pressure. When it finally explodes is still anyone's guess.

  • Report this Comment On July 05, 2011, at 2:32 PM, ERCOOP wrote:

    IMO housing has "recovered"! Its getting back in line with historical averages. I really dislike the way the term "Recovery" is used in the housing market. Recovery seems to only represent the high point of the bubble.

    The boring cookie cutter Mc Mansions were never worth the bubble high prices of 2006-2007. Therefore, the price is just regressing to the mean.

  • Report this Comment On July 05, 2011, at 5:02 PM, racchole wrote:

    I love people that read an article, and then post comments saying that the author is wrong, wrong, wrong. If you think you can write better than an author on the Fool.com, get your literary degree and start writing. But for god's sake, learn how to maturely add to a discussion without calling out the author on his faux pas. It makes you look foolish, and your points generally get ignored by the people who are looking to read a productive conversation. Maybe supply and demand isn't the only important factor when it comes to a housing recovery, but it sure as hell matters. The author is not wrong for leaving out information, he is simply writing an article based on his chosen facts. You want to add facts to the discussion, you can do it with demoralizing someone for not coming up with the same points as you. I take it that most of the negative posters are under the age of 25, at least I hope so.

  • Report this Comment On July 06, 2011, at 10:12 AM, ERCOOP wrote:

    @Racchole are you Morgan's Mom?

    At any rate, Morgan generally does have the best articles on Fool.

  • Report this Comment On July 09, 2011, at 6:23 AM, ltchoffman wrote:

    The time is coming soon when absolutely no one will buy US Gov Debt because they will all loose faith in our Governments ability to pay back not only the debt principle, which we are not doing now, but also the GOV will cease being able to pay back interest payments. (We are borrowing money to pay our interest payment now). Inflation will continue to rise and Big Ben will not forever be able to keep interest rates down once enough investors choose not to buy US Gov Securities any more because they feel it is too risky. Oh, Uncle Sam will keep printing money anyway but that coupled with no one buying our debt will set off inflation that will only fly sky high. How long do you think that will take to turn around?

    Then I wonder who will be buying houses and who will keep their jobs so they could if they even wanted to? Sounds pessimistic, I know but politicians say what they need to to get elected because we the represented public want to believe good things are in store for us in the future. The truth that ignoring the economic reality that we cannot forever create money out of nothing more than paper and continue to live in excess without destroying our economy and our way of living will not get any politician elected...we don't want to hear it.

    Before housing values go up they will come down, way down even more. But it is true housing values will move up again...., maybe in 10-20 years from now. Just my take on it.

  • Report this Comment On December 26, 2011, at 1:16 PM, kathlee101 wrote:

    ..what I don't understand is the following: if a person like me with a little undergrad degree could see that housing prices were way too high and must be destined to fall.. why could others not see it as well....this is not to say the the greedy real estate people didnt know what they were doing...but as far as people who bought houses just to let the value go up....what goes up must come down

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