Everything You Need to Know About the Housing Market

This week, the Commerce Department released its December housing market report, and the numbers widely disappointed market observers. Newly constructed single-family home sales declined 7% from November, coming in at a seasonally adjusted 414,000 homes.

What does this report mean to you? As always, monthly reports should always be taken with a grain of salt; one month does not make a trend. But diving into these charts will help you read the tea leaves of where the housing market is, and more importantly, where it's going.

The 10-year trend: New home sales
Let's start by taking a step back and observing the performance of new-home sales over the past 10 years. The immediate observation is just how outrageous sales were back in 2004-2006. But looking at the trend over the past four to five years shows that December's numbers are not materially outside the pattern. The bullish trend beginning in 2011 still seems to be intact. 

US New Single Family Houses Sold Chart

Sales are relative. Let's look at inventory.
To evaluate the number of sales, we must also consider the inventory available on the market. Sales are an indicator of demand; inventory is supply.

In this chart, we can clearly see a strong seasonality to inventory in the housing market (this seasonality has been adjusted out of the preceding sales chart). But even with the cyclical gyrations, the long-term trend is still obvious. Supply is declining, but it could be nearing a stable level.

US Existing Home Inventory Chart

We have established that sales, from a trend perspective, are stable and slowly increasing. Inventory is declining but may be nearing a stable level. What does this mean for us as investors and market observers?

Understanding the intersection of supply and demand
When evaluating the real estate market, it's not enough to review sales and inventory independently. Understanding how these indicators interact is the best way to truly assess the direction of the market -- we need to find where supply and demand intersect. 

To do that, we can view a ratio called the "months' supply of inventory." If there is one ratio to understand in real estate, this is it.

In a stable market, this metric for new homes will be somewhere between four to nine months. This means that with current sales and current inventory, the market currently has enough houses to last four to nine months.

If this number moves lower, it indicates that inventory is low and that prices will likely rise unless there is an influx of new homes. If the number moves higher, it indicates there is an oversupply based on demand, and prices will fall. 

The real scale of the real estate meltdown can be seen in this chart, but what's more significant today is that the ratio of supply and demand remains in the range of a stable market. This is a great sign for builders -- it means prices will remain stable and that current market dynamics should continue. This is a great sign heading into the spring selling season.

US Months Supply of New Single Family Houses Chart

Recent history tells the story for homebuilder stocks
Bringing it all together, this final chart shows the stock price of two major homebuilders -- PulteGroup (NYSE: PHM  ) and Toll Brothers (NYSE: TOL  ) . 

US New Single Family Houses Sold Chart

Bringing these charts all together, we show that the long-term trends remain intact, supply and demand are still balanced, and homebuilder stock prices don't really correlate to short-term movements in the housing market. And so, we can conclude that for investors in residential single-family real estate or in homebuilders, the weak December numbers are, well, irrelevant.

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  • Report this Comment On January 29, 2014, at 1:23 PM, duuude1 wrote:

    Hey Jay,

    Feels nice and analytical and objective and all, with the graphs and ratios. But I notice one thing you never seem to address is housing affordability. The housing industry is always looking at supply and demand, but never probes beneath the covers of that "demand" to see if it is really sustainable. It's kind of like that saying, "never look a gift horse in the mouth" - as long as someone is buying, who cares if they can really afford the home or not - a sale is a sale. But I hope you see the problem with that mentality... We need to see if the demand is sustainable, so we need to know what that price:income ratio is.

    So median price to median income, both nationally and regionally, are the key numbers, and that ratio needs to be at 3. Near the peak of the bubble, that ratio was around 6. Prices are going up, but incomes are not (unless you are in that rarified 1% group).

    I've always believed Robert Shiller - and his contention is that today's housing market is very artificial with the Fed (still) buying huge amounts of mortgage debt, and with artificially suppressed interest rates. Without that support, where will home prices eventually go?

    Down.

    Duuude1

  • Report this Comment On January 30, 2014, at 9:59 AM, Schneidku40 wrote:

    duuuude,

    I've heard the argument many times that the fed is propping up the mortgage market by buying the debt, but I don't understand how an after-sale transaction could affect the initial sale? Somebody going in for a mortgage doesn't think about the Fed possibly backing that mortgage from the bank. The person is thinking about their down payment, monthly payments, and what house to buy. Correct me if I'm wrong, but all the Fed is doing is relieving some risk from the banks by backing the mortgages they provide. I understand this might make the banks take more risk by issuing mortgages to risky buyers, but from the data over the last 5 years it seems like banks have curtailed that practice quite a bit from the 2005-2007 bubble.

  • Report this Comment On January 30, 2014, at 10:42 AM, duuude1 wrote:

    Hey Schneidku50,

    Good point - I think you can consider the post-sale transaction in this manner:

    - let's say you go into a business contract to lend a stranger some money. It's a risk for you, so you charge a high interest rate to compensate for your risk.

    - Now say your parents promise to buy any loan contract you sign - in other words, your parents take on any risk that the stranger you loan money to cannot pay - and you have your money back from your parents (the Fed). Would you feel safer charging a lower interest rate to that stranger?

    The banks do that risk calculation. Since the Fed buys the bank's mortgages, the banks are not worried about charging lower interest rates for loans they don't have to keep on their books.

    And we don't see that risk calculation the banks make, we just see the low interest rates.

    When we see low interest rates, we can spend more per month on the principal, and so we can bid up prices of homes that we would not normally buy. Therefore, the market for homes is artificially inflated. People are paying more for homes due to the artificial environment that the Fed has imposed (the Fed had very good reasons for these moves - but the unintended effect is excessive home prices that must eventually come down).

    Best,

    Duuude1

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