Is the Housing Market Rebound Sustainable?

By almost any measure – and as noted regularly in BuilderBytes’ MetroIntelligence Economic Update -- the housing market is not only on the mend, but rebounding much faster than most economists and housing analysts predicted.    Not only did the median price for existing homes rise by nearly 10% nationally over the past year, but they continued rising during the seasonally slow winter months, and already show signs of gaining altitude as the spring buying season continues.

Meanwhile, a combination of reduced new home construction, fewer foreclosures, investors paying cash for homes to rent out and owners still sitting on under-water homes means inventory levels that have fallen to 12-year lows.  So is the current scenario just an economic blip, or have we finally launched onto a sustained rebound that will last?

This answer is that this rebound may have some legs.  For one, home prices nationally are still below their long-run average compared to incomes, and affordability has rarely been higher.  Home builders, who have long struggled to gain traction with skittish buyers and had to compete against discounted foreclosures, are now facing shortages of labor, credit and finished lots to fulfill the rising demand for new housing, pushing NAHB’s Housing Market Index (HMI) in April down by two points to 42 (anything above 50 indicates more builders view conditions as good).  Consequently, whereas housing starts in March rose by nearly 47% over the past year, building permits rose by a much smaller 17% as builders must now address the rough edges of the rebound.

One reason that demand now exceeds supply is that while household formations were in hibernation as people doubled up with roommates, families or simply postponed divorce, population growth continued unabated.  Today, there are potentially millions of renters and households living in shared quarters who are ready to become home buyers given that they pass muster with today’s tougher credit standards.

Another reason for the supply imbalance is that investors -- large and small, foreign and domestic -- have increasingly funneled cash into what is now viewed as a safe investment:  U.S. real estate.  Currently, nearly one-third of all home sales are due to cash buyers, and it was this fairly consistent level of activity over the past two years which put that long-awaited floor under prices (which had foundered as federal and state tax credit gimmicks wore off.)

That fear of catching the falling knife, which froze the housing market for several years, has been replaced by the boom-era fear of missing out on the upside.  For these investors – which include brand-name private equity firms such as Blackstone Group and Colony Capital as well as smaller outfits issuing their own private placements for debt – they’ve managed to ignite a rental property boom, which has in turn put pressure on owners of traditional apartments.  What remains to be seen is what happens to these rentals when prices are no longer rising and rents have stalled, yet fund investors are still demanding the returns they were promised.  In contrast, traditional ‘mom and pop’ landlords can simply pay off the mortgage and then rely on the additional cash flow when they retire.

If there is one unknown which may derail the strength of this recovery, it is interest rates:  what happens when rates return to 5% or 6%, or even the 8.38% average noted over the last 49 years?  It’s hard to over-estimate the power that historically low interest rates have on affordability levels:  the same buyer whose $1,000 monthly payment would allow them to purchase a $165,000 mortgage at 6.1% (the rate in late 2008) could purchase a $222,000 mortgage at 3.5%, thereby boosting their purchasing power by a third.  This provides today’s buyers with a classic dilemma:  pay more today than they did a year ago, or pay even more in the future when interest rates may be higher.

In addition, home equity lines of credit are almost certain to rise as soon as the Federal Reserve ends its current policy of near-zero interest rates.  If the minutes from the most recent Federal Open Market Committee (FOMC) meetings are to be believed, then “QEIII” (the third round of quantitative easing) could end before the end of this year, and that could send variable rates higher – albeit slowly.  But for that to happen, the economy will have likely proven that it’s definitely on the mend, and that’s the sort of problem the federal government –and the yawning deficit – would almost certainly like to face.

Renters gaining upper hand as vacancies rise

Although the rental market in Southern California started weakening over a year ago, the recession is now giving tenants the upper hand to renegotiate lease agreements -- even mid-stream -- in various markets around the country. In some areas such as downtown L.A. and Long Beach, previous conversion projects re-converted back into rentals and new condos dumped onto the marketplace at once can easily spike vacancy rates and require landlords to offer concessions they would've found previously unnecessary. From a Wall Street Journal story:

As the housing downturn deepens, rental rates are falling in many major U.S. cities, including New York and Los Angeles, and tenants are finding they have greater leeway to renegotiate their leases.

Early in the housing crisis, former homeowners were starting to rent again, supporting demand for rentals. Now, with more newly constructed condos being converted into rental units, landlords are struggling to keep buildings occupied. Apartment rents nationwide fell 0.4% in the fourth quarter from the third quarter -- the first drop since 2003, according to Reis Inc., a New York City-based real-estate research company. Apartment vacancies rose to 6.6% in the quarter from 5.7% a year earlier.

In some major cities, the declines have been far steeper. In Manhattan, rents fell on almost all kinds of apartments in 2008. Rents of studio apartments fell 7.4%, and rents of one-bedrooms and two-bedrooms in buildings without a doorman fell 5.5% and 5.6%, respectively, according to a report released Tuesday by the Real Estate Group of New York, a Manhattan-based brokerage firm. In Miami, 60% of rents decreased in the fourth quarter, and 45% of rents in Los Angeles declined. Rents did buck the trend in a few cities. During 2008, rents increased 2.3% in Pittsburgh and 4.2% in Houston...'

Some landlords and property managers say they have never encountered so many tenants looking to bargain. Mitchell Rattner, president of Home Equity Savers in Riverwoods, Ill., owns 50 condo complexes and homes around Chicago with a partner and says that requests by tenants to negotiate were almost unheard of until fairly recently. In the past 10 months, he's discounted two of his tenants' rents midlease to keep them from moving out. "If they're good payers, we will give them a discount," he says...

It may be easiest to negotiate in cities like Miami and Las Vegas that have been hit hard by home foreclosures. There, renters are getting a boost from a "shadow supply" of rental units: Investors who have scooped up foreclosed homes are renting them out so they don't have to sell into a declining market. Such investors "are undercutting a lot of the normal rental rates so they can attract tenants quicker," says Elizabeth Olds, real-estate economist with Boston-based Property & Portfolio Research Inc.

In some California cities, vacancy rates are being boosted by the conversion of new condo projects into rentals, says Patrick S. Duffy, principal of MetroIntelligence Real Estate Advisors, a real-estate consulting firm based in Los Angeles. In downtown L.A., where there are a lot of new condos, the vacancy rate was almost 10% in the fourth quarter, compared with an L.A.-wide vacancy rate of 4.5%...

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As stocks and home prices crater, apartment market remains strong

I'd imagine that some apartment investors with long-term bets on the rental market are feeling somewhat vindicated by the news that, at least according to data tracker RealFacts (an alliance partner to MetroIntelligence and Beacon Economics), rents and occupancy levels continued to hold up during the third quarter of 2008. From an AP story via the L.A. Times:

Apartment rents, as well as apartment occupancy, across the country were virtually unchanged in the third quarter of 2008, according to RealFacts, a San Francisco-based apartment data research firm.

And while more than a million homes have been lost to foreclosure in the last two years and with banks readying for another 1.5 million repossessions, apartment buildings have remained solvent. To date, there have been virtually no foreclosures on large apartment buildings, according to RealFacts...

In the San Francisco Bay area, with one of the highest housing prices in the country, average rents for the third quarter were $1,637, or 1.2 percent higher than the $1,618 they cost per month in the second quarter.

In the Riverside-San Bernardino area of southern California, which has one of the highest foreclosure rates in the country, rents were $1,157 in the third quarter, slightly down from $1,162 in the second.

And in the Las Vegas area, also hit hard by foreclosures, rents were $887 in the third quarter and $886 in the second...

The data collected by RealFacts comes from more than 3 million apartments in complexes of 100 units or greater.

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