Housing Recovery: Not Yet, but When?

Standard & Poor's believes markets will stabilize and then recover in 2010

It looks like the U.S. homebuilding story entering 2009 may be much like 2008, with weak demand, high cancellations, lower pricing, and industry inactivity. Current housing market conditions remain weak, with a deepening recession keeping many qualified homebuyers on the sidelines and the financial system still in a crisis situation.

S&P economists are forecasting new housing starts in 2009 to reach only 650,000 units, a 29% decline from 2008's estimated level of 910,000 units, and a 65% drop from the 1.8 million units posted in 2006. Starts are expected to jump to 980,000 units in 2010. As a percentage of U.S. real gross domestic product, residential construction may decline 19.5% in 2009, following year-over-year decreases of 18.1% in 2007 and 21.3% seen for 2008. However, S&P economists are forecasting a 13.3% pickup in 2010.

For long-term recovery, we believe a more positive view of the industry is dependent on the housing market's ability to reduce home inventory, which stands at 10.4 months compared to six months on average in healthier markets. In our opinion, home inventories may begin to decline when the pace and level of foreclosed homes eases. Normalized levels of six months may not occur until sometime in late 2010, in our view. We should point out that some of the more troubled markets in California, Florida, and other Sunbelt states have metropolitan areas with more than a 30-month inventory supply.

Pricing trends are not much better, as the "peak to trough" decline from the boom period of late 2005 to perhaps June 2009 is expected to be 30% to 35% for the national average. Again, select metropolitan areas in overbuilt Sunbelt states and Midwest states with above-average unemployment may experience pricing declines in the 40% to 50% range.

What will drive a housing turnaround?

Standard & Poor's thinks the housing market may bounce along the bottom for the next nine to 12 months, but we believe the foundation for a market recovery will take hold. In our opinion, the key drivers for a housing rebound are as follows:

1. Buyers' confidence in their jobs and income levels;

2. Ease of housing price declines to market stability;

3. Affordable housing in relation to household income;

4. Access to mortgage financing with low interest rates;

5. Ability to sell one's own home in order to move into a new one.

We would first watch the existing housing market, which has high inventories and many potential sellers on the sidelines. Seven out of every eight home sales are tied to existing residences. In market downturns, homebuilders are typically the first to lower prices, as unsold home inventories tie up companies' working capital and reduce their return on investment. In our opinion, we are now seeing homeowners capitulate and lower their prices to sell their homes. So, existing home sales may be the first to recover in the second half of 2009.

Building permits and housing starts are key indicators of future new building activity. These two measures, which are signs of homebuilders' confidence, closely correlate with six-month contract closings and home deliveries. Right now, we believe a decline in building permits and housing starts may prove to be a good thing for the long term as homebuilders work off excess inventory and do what they can to stabilize the market's supply and demand balance.

Future household growth may look different

So much attention has focused on the baby boom generation in the last three decades, because this age group represented about 77 million Americans born between 1946 and 1964. The Harvard University's Joint Center for Housing 2008 Report showed this age bracket gaining around 4.7 million households (about an 11% increase) between 2005 and 2010, and as this group ages, many will trade up from single-family homes to "empty nest" and active adult segments.

Future household growth should come from the changing age composition of the population, the strength of ongoing immigration, and social trends such as divorce and remarriage rates that influence the size of households.

This will likely mean smaller homes per square feet that may be closer to work or near urban areas to avoid long commutes.

If immigration remains near its current pace and as echo boomers (ages 25 to 34 years old) age, household growth could average 1.2 million to 1.4 million per year in 2010 to 2020, according to the Joint Center for Housing study. Even if immigration slows down by 30%, household growth should still be positive and exceed its 1995 to 2000 average annual levels.

Because people who immigrate to the United States tend to do so when they are young, they are candidates for the entry-level home market. Immigrants now account for 11.7% of the U.S. population, according to the Census Bureau.

Including immigration, the share of minority households as a percentage of the population is likely to reach about 35% by 2020, with Hispanics having the largest gain. The Joint Center for Housing study stated that minorities accounted for about 25% of all households in 2000, up from 17% in 1980.

During 2000-2006, minorities contributed to more than 60% of household growth and were near 50% ownership levels of either all African Americans or all Hispanic Americans and about 60% of other minority groups, according to the U.S. Department of Housing and Urban Development.

Is it too early to be buying homebuilder stocks?

Since the beginning of 2006, the top 13 builders have written off approximately $29 billion in land inventory and land option contracts, lowered outstanding debt, and raised cash.

We believe there will be many more bankruptcies for smaller and privately-owned operators, which make up 70% to 75% of the U.S. homebuilding industry.

However, we expect the largest builders to endure the worst U.S. recession since the Depression, but contact backlog orders have collapsed to 15% to 20% of their operating level from the peak of the housing cycle in 2005. In the year ahead, we see an easing in the rate of decline in order cancellations, net contracts, backlog, and asset write-offs, which brings us to our neutral fundamental outlook on the sub-industry.

In 2008, the S&P Homebuilding index declined 32% versus a 38% decrease by the S&P 1500 index. This subindustry is viewed as an early cyclical group, but there have been many false starts in the past 12 months. Therefore, we recommend homebuilders that have conservative management, strong balance sheets with ample liquidity, and a geographic presence that we believe is diversified for their home communities.

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