The Independent Market Observer

2/25/14 – An Update on the Housing Market

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Feb 25, 2014 9:27:49 AM

and tagged Commentary

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Housing has been doing a back-and-forth over the past couple of days, with a number of stats down. Existing home sales were down 5.1 percent in January, with average home prices falling, and housing starts and homebuilder expectations also showing declines. At the same time, other stats, including price increases, remain very strong. In fact, in 2013, home prices rose the most since 2005. What’s going on?

The big picture here is that we should expect moderation in housing and understand that it’s actually a healthy thing. Within that big picture, we can look at several factors—weather, rising mortgage rates, and lower affordability—to decide whether the expected moderation in the housing recovery is going to turn into something worse.

First, the big picture. The chart below shows the relationship between house prices and the number of homes sold divided by those for sale—in other words, supply and demand.


What this tells us is that demand has dropped a bit relative to supply, so price growth should slow. But even slower growth is still growth, and the chart suggests growth could decelerate to around 5 percent per year, which is still above inflation.

This is a good thing. There’s a word for multiyear double-digit price increases, and that word is bubble. We have seen a recovery in housing prices, and if price increases were to continue at the current rate, it would mean another bubble. Having prices normalize, and then grow at the inflation rate or slightly above, is sustainable and healthy.

Second, let’s look at weather. Per Capital Economics, there are reasons to believe that weather was a significant contributor to the slowdown in housing. While starts got hit, the declines were greatest in the areas with the worst storms and actually rose in the West, where weather was better. In addition, building permits declined by less than starts—probably not a coincidence given that permits are done in indoor offices, rather than out in the elements. Nonetheless, the data suggests that weather had a real effect on housing, but this will pass as spring approaches.

Another factor is affordability, which relates to rising interest rates and property values, both of which make houses less affordable. Per the chart below, you can see that housing affordability has in fact declined.


Yet, despite the decline, it’s still more affordable than at any other time except for the past several years. Affordability continues to be quite strong overall.

The question remains, though, whether any moderation could turn into something worse. Here we need to look at effective demand and available supply. There are two components to effective demand for housing: household formation and affordability.

Looking at household formation, the run rate is around 1.375 million per year, according to David Rosenberg of Gluskin Sheff—well above the actual housing construction rate toward the end of last year—which suggests strong demand for the existing supply. Looking at affordability, per the chart above, the ability of the new households to afford a home remains strong. Effective demand is there.

From a supply standpoint, average months’ supply on the market is about five months, which is quite tight on a historical basis. Starts are running well below the usual level of around 1.5 million, so new houses are not going to swamp the market—quite the reverse.

Given strong effective demand combined with low supply and supply growth, the chances for the current moderation in housing values to turn into a sustained decline appear slim. Much more likely is sustained growth, once the weather improves.

Personally, after snowblowing my property too many times this winter, I can’t wait.

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