Housing Poised to Recede From Peak Levels
Frustrated that steadily increasing the federal funds rate in quarter-percentage-point increments hasn’t driven up the low long-term mortgage rates that have helped fire up the housing market in recent years, the Federal Reserve will continue tightening into early 2006, when housing activity should start flattening out below this year’s torrid levels, according to economists at the NAHB Construction Forecast Conference in Washington, D.C. on Oct. 19.
“The housing market is seeking out a peak,” said NAHB Chief Economist David Seiders, and while it is still too early to conclude that it has found one — with housing starts increasing 3.4% in September and third-quarter performance exceeding expectations — there is growing evidence that the Fed has started to hit its mark and housing will begin losing some of its exuberance in the period ahead.
“The power of long-term interest rates for housing is incredible,” said Seiders, and key to the housing outlook is where those rates are headed. The rates on 30-year fixed-rate mortgages reported weekly by Freddie Mac have been moving up over the past month, he pointed out, and are now above 6%.
In his housing forecast, Seiders is predicting that long-term mortgage rates will rise by another 60 basis points by the third quarter of next year, bringing them to about 6.6%.
The Federal Reserve will decide to boost its federal funds rate by one-quarter of a percentage point at each of its next three meetings, he predicted, bringing it to 4.5% at the end of January when Fed Chairman Alan Greenspan's term runs out. Most likely, that will be the rate at which the central bank decides that its policies have reached neutrality, neither stimulating nor slowing down the economy.
Greenspan has discovered that it’s no longer as easy to slow down housing as it used to be, and the Fed has run into difficulty in taking some of the steam out of a boom that it believes has been running too hot and cannot be sustained.
The proliferation of “exotic” adjustable rate mortgages (ARMs) such as interest-only and payment-option loans, along with a rise in speculative buying that has been boosting home purchases and prices in hot markets, has strengthened the Fed’s determination to gain control over the housing sector, he said.
Monetary policy may already be starting to work. The Mortgage Bankers Association's weekly index of mortgage applications to buy homes has for the past 10 weeks shown “fundamental flatness hovering around a high level,” Seiders said. However, initial interest rates on ARMs have remained at attractive levels despite increasing market rates because lenders are discounting the initial rates, “holding the actual initial rate 2% below what could be charged."
NAHB is forecasting a decline in total housing starts from 2.032 million this year to 1.94 million in 2006 and a further drop to 1.883 million in 2007. After that, the annual production of new housing units (including manufactured homes) should settle around 2 million units, which is within the 1.9 million to 2.1 million rate that is sustainable on average for the 2003-2013 period, he said.
“We have been running a tad above that,” Seiders said, “but the comedown shouldn’t be all that dramatic.”
Single-family construction is projected by NAHB to decline from 1.683 million starts this year to 1.590 million in 2006 and 1.533 million in 2007. Multifamily output, however, should remain close to the 349,000 level expected for this year through 2007.
With rental vacancy rates falling and condominiums becoming oversupplied in some markets, the composition of the multifamily market should shift a bit away from condos and back to market-rate rentals, he said.
Oil Prices One of the Things That Can Go Wrong
In general agreement with his co-panelists about the outlook for the nation’s economy — with growth declining from about the 3.5%-3.6% range this year increasingly towards 3% in 2006 and 2007; unemployment leveling off at about 5%; and inflation moving up some but remaining mild — David Wyss, chief economist for Standard & Poor’s, cited a further spurt in oil prices as one of the things that could go wrong for the economy in the short run.
Oil prices are coming down in the medium term,” Wyss said. “There is a lot of oil that can be brought in at the $35-$45 range” once energy companies make the investment in increasing the supply, but that is a process that will take a few years.
However, as a result of a temporary shutdown of 20% of the country’s refining capacity from Hurricane Katrina, which was already running at 99% utilization before the storm, the availability of natural gas for heating could be a problem. “We can get by with existing supplies if this is a normal winter,” he said. “Otherwise, stock up on sweaters. They make a nice gift.”
Over the longer range, Wyss expressed pessimism about energy prices, with demand for fossil fuel expected to leap 50% over the next two decades, with 80% of the increase coming from China and India.
While the U.S. budget deficits should be heading back to balance at a time when the economy doesn’t need any fiscal stimulus, Wyss said that the deficits nevertheless “are not quite the disaster” that some economists say they are, with the 2004 deficit equivalent to less than 3% of GDP, the lowest among industrialized countries.
But there will be a crisis when baby boomers begin retiring and collecting Social Security and Medicare benefits, pushing U.S. debt from 65% of GDP this year to 239% by 2005 — unless Congress finds a way to address the problem.
Just short of 6% of GDP, the U.S. trade deficit is another potential problem, but foreign nations are relying on trade surpluses to help keep their economies growing and favor intervention by central banks to keep the value of the dollar propped up, and the U.S. is doing little to discourage this policy because it needs the money, he said.
“The U.S. is spending money like a drunken sailor, but fortunately we have this Japanese girlfriend who keeps slinging cash at us,” Wyss said.
Who’s Got the Bubble?
Wyss said that he foresees no housing bubble even though the ratio of the average home price is running at 3.2 times the average household disposable income, compared to a more normal ratio of 2.6 times.
Today’s home price would only be three times the housing price if homes were being built to the same size and with the same amenities as 10 years ago, he said.
“In the pure sense of the word, there is no housing bubble,” he said. Home owners measure the price of their house as the monthly payment, “and those are still low; housing is affordable.”
As mortgage rates head slowly upward, reaching 7% over the next couple of years, Wyss expects home prices to stabilize for four to five years, giving incomes a chance to catch up.
Looking at prospects for local bubbles, Wyss cited San Diego, with a 9.68 house price to income ratio, followed by San Francisco, 9.19; Los Angeles-Long Beach, 9.14; Orange County, Calif., 9.04; New York, 8.62; Honolulu, 7.78; Miami, 6.84; West Palm Beach-Boca Raton, Fla., 6.15; Boston, 6.11; and Providence-Warwick-Pawtucket, R.I., 6.05.
At the other end of the spectrum, the cost of a home is running at less than two times income in Wichita, Kan., he said, and beyond the West and East Coasts, there’s “not much evidence of excessive house prices elsewhere in the country.”
As interest rates do rise, the majority of mortgage borrowers won’t be affected in this country, he added, because 65% of all mortgages are fixed for terms of 15 years or more and only 10% are adjustable within two years.
More Rational Than Irrational
Low mortgage interest rates are responsible for today’s higher than normal home price to income ratio, said Maury Harris, chief U.S. economist and managing director for UBS, and the impact of rising mortgage interest rates in the period ahead will be largely offset by better growth in household income so that home prices are unlikely to decline on a national basis despite some regional weakness.
The market perception of the fair value of housing has changed, he noted, because of more favorable capital gains treatment in the tax act of the late 1990s, the ease of extracting equity and the public disaffection with the stock market.
The impact of speculation in the housing market has been overstated, Harris indicated. UBS research has found that investors have accounted for roughly 10% of mortgages to purchase homes in the current market, compared to 5% previously, a level that is significantly below a finding by the National Association of Realtors® that investors accounted for one in four homes sold last year.
By region, the investor share of purchases has been up in hot markets, he said, “but a lot of these have good population growth.”
“There’s a lot more rationality than irrationality behind what’s going on with home prices,” Harris said. “They’re going to slow down, but they aren’t going to crash.”
Photos by Morris Semiatin