Housing outlook: Don't fly blind

D scexrr-y, AN rNDUsrRy ANALysr

I\asked me to address a simple but very important question: Why does every forecast for housing starts have them hitting 1.5 million units again?

The logic for the rebound was just not self-evident to him, given what is happening right now. Just as it is difficult to see a housing start decline during the boom, it is even more difficult to see a rebound from an extremely deep hole. The depth of the hole is evident in the chart below, which shows the history of conventional housing starts back to 1970.

Before answering the question, it is important to understand the unique character of this particular housing cycle. First, note that there is not a predictable cycle to housing starts. Housing cycles in the 1970s were about every three to five years, and we thought that was the rule. That rule was broken in the 1980s.

Then we entered a particularly prosperous period. Housing starts were relatively stable and trended up from l99l-2005, which led us to think housing cycles were a thing of the past. Second, unlike every other major housing cycle, the current one was not caused by tight monetary policy or high interest rates. Historically, when the Federal Reserve reversed course and lowered rates, housing rebounded quickly and dramatically. This clearly happened in 1983-1985 after the grim downturn in 1978-1982.

Obviously it is not happening this time. All the rules were broken this time. The economic recession in 20002001 was not caused by tight money either, but rather the popping of the stock market bubble. Fed actions to stabilize the economy in 2002-2004 helped promote easy credit and the boom in new creative financing instruments. This fueled the housing bubble. Between 2003 and 2006, the industry accrued two "hidden" inventories.

Many of us became concerned about the two types of buyers who were merely holding an ownership position, but would eventually be forced to sell-similar to building excess inventory. First, because of

lJ.S. Housing Starts Since { 97O

dramatic housing price increases, investors rushed into the market. Problem: they would liquidate their position when housing was no longer an attractive investment

Second, there was a rush of new "owners" who were not required to put up a down payment and/or who were not going to be able to sustain the payments over time and would eventually default on that mortgage. This would depress prices further and possibly depress housing starts for several years.

The illusion created in this period was the attractiveness of home ownership, which rose significantly and boosted single family share to a historic high. The correction is now underway as ownership rates decline. They are likely to fall further over the next few years, both because of the foreclosure process and the realization that housing is not a great investment.

So what do I mean that we are "flying blind?" Since this cycle is unique, there is no historical period that can be used to build a reliable econometric model. In fact, we now have to develop a different kind of model using variables we have never had to consider before. The old approach to forecasting starts was to look first at the fundamental drivers for housing demand over the long term, and then use interest rate variables to forecast the cycle or deviation from that trend. It worked in previous cycles.

But that brings us right back to the starting question. Those fundamental drivers for housing demand are what led most forecasts back to l 5 million or higher fairly quickly. There are three fundamental drivers for longterm housing demand:

Long-term demand = Net growth in househoWs + Net removal rates + Vacant unit demand

Net household growth is the major event and accounts for 10-807o of fundamental demand' Net household formations are estimated by taking the growth in population by age group and multiplying that iumber by a headship rate. A headship rate is the number of households in that age group historically divided by the size of the population in that age group.

Over long periods of time, headship rates are fairly stable. Plus, headship rates increase as the population ages as well. If headship rates were stable, household formations would currently be around 1.3-1.4 million per year' Removals average about 0.3-0.4 million per year. The need for vacant units (this includes second homes) is about 0'l0.2 million units per year' This logic leads to an underlying demand for housing, in trend' of about 1.7-1.8 million per year. Since current starts are way below that level, some Lelieve we are building pent-up demand for new units and starts will get back to 1.5 million units or more' If household growth was 1.4 million per year, then any excess inventory would be depleted quickly.

The problem is that there is currently no evidence of under-building. Vacancy rates are high despite low completion numbers. So th" really important question \s: When will starts get back to 1.5 million units? And, what will make that hippen? Another important question: What type of units will be demanded-single vs. multifamily starts?

The first thing that needs to be addressed is what is happening to headship rates and how many households are curientty-Ueing formed. The severe recession has eliminated n.utiy g mittion jobs, particularly for younger people' Headihip rates are not stable, but we have never had to estimate annual levels before.

A variety of recent studies are trying to estimate the impact ofjob losses on headship rates and therefore on current household growth. Unfortunately, the available data are not u.ry good. The annual household surveys by th9 U.S. Censui are the best we have and that data is a small sample-based estimate and therefore can be fairly noisy' Also, small changes in a headship rate can have a very large impact on annual household growth rates' It is possiUle-ttratiunent household formations are in the 200'000400,000 range vs. the long term trend of 1.4 million'

The next issue: How big is the current excess inventory of units? If you take the current vacancy rate of owner units and the vacancy rate for rentals compared to historical averages, there are 1.9 million units of excess inventory' SomJfinancial groups have estimated that banks are holding another 650,000 vacant units after foreclosure' In total, there could be nearly 2.5 million excess units'

But there are reasons to believe that number could be too high. If one looks at the annual estimate of stock' implied removals, and estimated completions, there is a ,t-ng "ut" to be made that this estimate is too high' After the la-st U.S. Census in 2000, there was a major revision in the stock and elimination of what appeared to be vacant stock at that time.

Unfortunately, the data available for both of these critical starting points is not perfect. So this is one of the times where a diCision-maker might consider using scenarioswhat if the recovery is like this, then what would be the best deployment of my strategy? So consider the two following plausible scenarios:

Scenario #1: "Huppy Days Are Here Again!"

If you believe economic growth will exceed 3Vo fot the next ihree years, driving employment growth up by nearly

2Vo per year, then household formations will quickly return to 1:3-l:4 million per year. If you also believe that the real vacant stock is oniy 1.2 million units, then the excess will be worked off quickly during the 2010-2011 period' Finally, if you believe the Fed will remain relatively accommodaiive until mid-2011, even with healthy growth, then you believe the recovery trajectory shoyl below' In this cise, starts shoot past 1.5 million units in 2013'

Happy Days Housing Forecast

Scenario #2: *rnePatient Heals Slowly."

If you believe that GDP growth will slip back to 2Vo or lower, this means employment will not improve much for the next few years. If so, household formations will remain below trend ihrougtr 20l2.It the vacant inventory is close to 2.5 million uniti, then the excess will be worked off very slowly. In this case, interest rates remain favorable because of slow economic growth. The primary mortgage lenders would remain government agencies, and lending standards would be another hurdle for the recovery' These assumptions would still support a recovery as shown below, but starts misht not hit 1.5 million units until 2015 or later'

Slow Healing Housing Forecast

At RISI, we are working to develop two products lor our clients. The first will use our experience and analysis skills to develop the best scenario for planning purposes given the extreme uncertainty of this period'

We are also developing a tracking system to inform clients as quickly as posiible if the outlook shifts up toward Scenario I or down to Scenario 2.The outlook we propose will lie between the two scenarios.

- Dr. Lynn Michaelis, former chief economist for Weyerhaeus-er, is a senior associate of RISI' Reach him via www.risi.com.