Reply #30: Assessing the Demand for Residential Real Estate

[54anickel]

http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=44901

Recently the CEOs of some residential construction companies have been on television’s “financial news” networks taking about their companies and emphasizing the following two points.

1. This time, the housing market is not as sensitive to increases in interest rates as in the past, especially since the rates are at historically low levels. The point being emphasized is that the rates can go higher (another 200 basis points?) before having a significant impact on home sales.
2. The housing market is all about SUPPLY and DEMAND.


Point 1 is related, in part, to the “Greenspan’s Conundrum” that writers on this site and elsewhere have explained using a “supply and demand” scenario for dollar denominated debt, with contribution from foreign buying of the intermediate-to-long end of the yield curve. This article examines the second point made above, especially the demand side of the housing market. Demand For Residential Housing can be classified into two categories. The first covers houses (or condos) purchased for buyer-occupancy as primary residence (PFR). All other purchases can be categorized as Purchases for Investment (PFI). Vacation homes which are not the primary residence of the owner will be included in the PFI bucket. The next two sections examine the demand in these two groups. Only net demand is considered here- someone selling a house to buy another does not create net incremental demand.

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House Purchases for Investment


Recent reports indicate that in certain areas more than ten percent of house purchases are being made purely for investmen purposes, with the buyer not residing in the house. Part of this is being attributed to foreign buying of American housing. While the demand in this foreign-ownership category is hard to assess, it can be inferred that a further weakness in the dollar vis-à-vis other major currencies will be positive for incremental demand. If the Yuan strengthens by nearly 40% relative to the dollar, as many China-critics want, this will enable greater purchases of American real estate by the Chinese. One point to note about real-estate investment is that unlike paper investments such as equities or bonds, there is a “real” outflow of money during the time of ownership of real-estate. This includes taxes and maintenance costs. A house purchased as an investment can be rented out for income, but there may be downward pressure on rents if the rate of homeownership among the “renters” goes up relative to the rate of conversion of apartment units into condos or other units meant for sale.


In summary, the magnitude of the unfulfilled demand for housing combined with financial “new product development” can keep the current housing boom going for a few more years. However these new financial products have yet to stand the test of the vagaries of the environment- an economic downturn or an interest rate spike or other events that may cause lenders to pull in the reins. To understand the magnitude of the impact of a constrained lending environment it is useful to look at the sharp decline in prices of telecommunications stocks in 2001-2002 when investors became more risk-averse. Some companies went bankrupt and those left holding the bag (like the author) did not receive any bailout from the government. Others like Lucent and Nortel are currently trading at less than 5% of their peak values. The expectation with the housing market now is quite different. Despite the new bankruptcy law that makes filing Chapter 7 more difficult, house buyers are purchasing financial products with greater risk on the downside. Investors are pouring more money into the homebuilders and the lenders. Part of the bet is that with the scale of liabilities of the mortgage industry, especially the GSEs, the Fed and the government will bail out the financial sector from any disasters, shifting the burden to the public. As alluded to by others, ‘character’ is being tested- that of buyers, lenders, builders, investors, and the public at large.

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