Investment Strategies

Why housing deserves another look

With supply leveling and demand buoyed by bargains,the American dream still has some life

Mar 18, 2012 @ 12:01 am

By Brad McMillan

It appears that the housing market is emerging from its hole. For advisers and investors, this means it might be time to consider what portfolios should look like from a higher level.

Why is the market starting to recover? Let's look first at supply and demand. In the case of housing, supply consists of existing homes for sale and newly built homes.

The supply of existing homes for sale has dropped substantially. In fact, it now rests close to the 30-year average, when expressed as months of supply. For existing homes, then, the market is approaching balance, suggesting that price declines may be nearing an end. Mind you, this is the visible supply. There are still a large number of homes in the “shadow” inventory (such as those awaiting foreclosure), and they can be expected to push supply back up in the short term. Nonetheless, that could be the last wave of excess supply, and then the market can normalize. We are much closer to the end than to the beginning.

The supply of new homes also has started to bottom. After a significant decline, residential investment has stabilized over the past year. The National Association of Home Builders Index has increased three months in a row, signifying increasing optimism on the part of investors that new construction has bottomed. Supply for new homes is at a low.

Overall, the supply situation for both existing homes and new construction supports a stabilized market in the reasonably near future.

What about demand? It's showing support, as well. Despite the well-known economic problems in the market, significantly lower prices and record-low mortgage rates have contributed to housing affordability's being at an all-time high. In some markets, it is now cheaper to buy than to rent. The greater affordability of housing has started to rekindle demand. Sales of existing homes have rebounded, while sales of new homes have been flat — a condition in some markets, according to reports, that results from limited supply. Even the homeownership rate has shown an uptick after several years of decline, suggesting that the American dream still has some life left.

PRICE APPRECIATION

The best illustration of supply and demand, though, is price. Prices are still dropping overall, which seems to make the above arguments somewhat irrelevant. Even here, though, there are signs of a bottom.

First, if we break out distressed sales from nondistressed sales, we find that prices of nondistressed sales have been increasing, suggesting that the overall declines can be attributed to price cuts on distressed properties. Many distressed properties remain in the shadow inventory, so the declines may not be over. But again, this suggests that once those properties clear, the stage will be set for price appreciation. Second, there now are five cities across the country reporting overall price appreciation. Clearly, real estate is becoming more market-dependent, an indication that the national crisis is fading. Location is reasserting itself.

Another way to look at overall pricing is to compare it with income levels and rents. By both methods, houses are now slightly undervalued by historical standards. Again, it's certainly possible that values can continue to decline for a while, but declines from an already undervalued starting point are necessarily limited.

So while housing still may be in a hole, that hole is getting shallower.

What will the end of the housing crisis mean to investors and advisers?

There are two principal ways a housing recovery could affect investor portfolios. The first is via the wealth effect. If housing values stabilize, and even start to recover, existing homeowners will feel and be wealthier, and they may be more willing to spend. In addition, home buying often has a large multiplier effect, as homeowners purchase the many items (furniture, appliances and other home goods) that a new home often requires. The second is a potential increase in employment. As buyers re-enter the space, new- home construction should facilitate more housing-related hiring. The aggregate effect on the economy could be substantial. The effect on consumer confidence also should not be discounted.

The key question is the time frame. While recovery is not imminent, it is within sight, and the time to plan is now. For young investors, who may now be more willing to take the plunge, and older investors, who should start considering what this will mean to their financial plans, the future is looking somewhat brighter.

Brad McMillan (bmcmillan @commonwealth.com), a chartered financial analyst, is vice president and chief investment officer at Commonwealth Financial Network.

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