Business Outlook: Housing Demand Stabilizes

Just as the housing collapse has played an outsize role in the recession, a housing turnaround will be crucial to a recovery in the broader economy. In both 2007 and 2008 the direct effect of the housing slump subtracted about one percentage point from overall economic growth, and the drag in the first quarter of 2009 was 1.4 points. That doesn't include the indirect losses of housing-related jobs, spending, and consumer wealth. Recent signs that housing activity is at least stabilizing are a milestone. Just removing the heavy downward pull on growth will be an important first step toward an upturn in the overall economy.

Any housing revival will follow the typical path of past recoveries: Improving sales will lift new construction, followed by a firming in prices. This process is finally starting, but the headwinds are still fierce. Record affordability is offset by tight credit and rising unemployment. Builders see demand improving, but not fast enough to unload the bulk of their inventories. And foreclosures continue to put homes back on the market, keeping intense downward pressure on prices.

The three-year drop-off in demand has clearly bottomed out. Sales of existing homes rose 2.9% in April and have been close to stable since November. But the National Association of Realtors (NAR) says about 45% of sales are "distressed" properties, including foreclosures and short sales. As these sales taper off, traditional buying will come under more pressure to take up the slack. Sales in the first quarter are up 117% from the previous year in Nevada, 81% in California, 50% in Arizona, and 25% in Florida. Overall purchases are down 7%, but excluding those four states, sales are off 19%.

The benefit of these distressed sales is that they reduce inventory in the areas that account for much of the overhang of unsold homes. In April, NAR said the total number of homes for sale had fallen 12.8% from the year before, although weak sales have kept supply at a high 10.2 months. If a home is not listed, however, it is not included in NAR's inventory. Economists at UBS (UBS) note that U.S. Census Dept. data through the first quarter show a rising number of vacant homes being held off the market, which could imply that inventories are higher than measured. Although there are no hard data, lenders might be bringing their problem properties to market slowly to control prices.

While conditions remain tough, first-time home buyers are doing well. Given low prices and mortgage rates and Washington's $8,000 tax credit, first timers accounted for about 40% of all April sales, says NAR. These buyers aren't chained to an existing home whose value is falling, and they have not suffered big losses in their net worth.

Firmer home prices will be the last stage of the housing recovery. Through March, Standard & Poor's Case Shiller Home Price Index was down 32% from its 2006 peak. Economists at Capital Economics say the index shows prices are now 18% undervalued based on the long-term relationship between prices and per-capita income and 9% undervalued relative to rents. But it's not unusual for prices to keep falling well below fair value after a period of overvaluation.

Indeed, rising foreclosures will keep downward pressure on home values. Washington's $75 billion effort to stem foreclosures by helping some 9 million "at risk" homeowners to modify their mortgages is off to a slow start. As of mid-May only 55,000 have received modifications, while in April alone lenders issued a record 342,000 foreclosure notices, according to RealtyTrac. As the program picks up speed, it will help to limit the foreclosures when more homeowners are pushed into default by the recession's effect on jobs and incomes.

The good news is that, despite the recession, housing demand is managing to stabilize. Clearly, stiff headwinds will limit any upturn, but just taking away housing's minus will be a plus for overall growth.

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