By Peter Coy
Every rosy housing stat that comes out hardens the battle lines between the housing-bubble crowd and the everything's-O.K. crowd. On Oct. 19, the government announced strong numbers for home construction in September, showing that Hurricanes Katrina and Rita didn't derail the housing juggernaut. Optimists seized on the data as evidence that the conditions are still in place for a healthy housing market, while bubble theorists saw signs of overbuilding that will produce a glut and falling prices.
The numbers were certainly impressive. New building permits were up 2.4% from one month earlier and 7.4% from a year earlier, going by the seasonally adjusted annual rate, according to the Census Bureau and the Housing & Urban Development Dept. And housing starts were up 3.4% from August and 10.3% from September '04, at a seasonally adjusted annual rate.
RUNNING FLAT OUT.
But what do the numbers really mean? First, the case for optimism, from Brian A. Bethune, a U.S. economist at Global Insight, an economic research firm in Lexington, Mass. He says housing is being propelled by healthy employment growth (never mind the hurricane-related downward jag in September) and by immigration -- legal and otherwise -- which is stimulating the rate of household formation. Mortgage rates are also still attractive, Bethune says. But even if rates rise, he argues, favorable economics and demographics will continue to keep housing strong (see BW, 10/3/05, "Shelter After The Storm").
How strong? He estimates that at the current pace -- building began in September on 2.1 million privately owned housing units -- the construction industry is running pretty much flat out. He thinks it might soften more than a seasonal norm over the winter but will bounce back next summer as rebuilding from Katrina and Rita gets seriously under way (see BW, 10/24/05, "Where A Slump Would Hurt Most") .
According to Bethune, builders are "operating on a very conservative level," working in response to proven demand rather than on speculation, so the risk of excess inventory is slight. He says while certain regional markets have gotten bubbly, "the core market is going to remain healthy even with higher rates.... The housing market only takes a real hit when the economy goes into recession."
Now for the pessimists, among whom is Ian Shepherdson, chief U.S. economist of High Frequency Economics in Valhalla, N.Y. In a piece Shepherdson published on Oct. 17, before the latest housing-starts data, he argued that "the housing market will finally fall apart, beginning next spring." He said the decline could be so bad that it could pull the whole U.S. economy into recession.
The nub of his argument is that housing demand has been fueled by expectations of rising prices, more so than by economics or demographics. If people start losing faith that prices will keep going up, their appetite for more housing will abruptly be sated, he argued. He pointed out that rates for 30-year fixed mortgages are around 6%, and home prices have gone up around 16% in the last year alone. If you expect prices to keep rising at that rate, it's a no-brainer to borrow as much as you can at 6% and invest it for a return of 16% for a big, fat margin of 10 percentage points.
But let's say Federal Reserve rate hikes cause mortgage rates to go up to 7%. Demand for housing would cool slightly, and if builders didn't react quickly enough, a modest oversupply would result. Houses would sit on the market longer. And people would revise downward their expectations of annual price increases to, say, 6%. The combination of slightly higher mortgage rates and sharply lower expectations for capital gains would be "enough to push down home sales by 40% or more," Shepherdson argued (see BW Online, 10/5/05, Housing: Less Bang Than Whimper).
"Nothing terrible will happen in the housing market immediately," Shepherdson wrote. "But if Treasury yields continue their upward creep for another few months, things will take a very serious turn for the worse." Shepherdson didn't immediately respond to a call seeking comment on today's housing start numbers.
Who's right? Will home sales continue at the current record pace for the indefinite future -- or will they plummet by 40% in the next year or so? It's impossible to say for sure, of course, but the pessimistic case does have one thing going for it. It explicitly takes into account human nature. People tend to base their expectations for the future on their most recent experiences. That's why they're so optimistic right now (see BW Online, "If Housing Slumps, How Safe Are You?").
But even a slight softening of prices could rapidly turn them into pessimists. That's how bubbles pop. Even if housing starts don't actually plunge 40%, chances are good that today's frenetic activity won't last a whole lot longer.
Coy is BusinessWeek's Economics editor
Edited by Patricia O'Connell