The residential real estate market is likely to experience another year of pain and weakness but at some point during the year a recovery may surface. Although correctly predicting when a market bottoms and heads upward—a turning point—is nearly impossible, there are signs to look for that reveals when the market could be near bottom.
Here are some signs that are likely to signal a market turnaround for the housing market. We define a turnaround as a steady increase in home sales from a trough.
The months’ supply represents the number of months it would take to deplete the inventory of homes at the current sales pace. Under normal market conditions, the months’ supply is expected to hover in the 5 to 7 months range. However, today the months’ supply is hovering around 11 months because demand for homes is at cyclical lows, causing the supply of homes to build to excessive levels. An inventory surplus of homes available for sale in the marketplace exerts downward pressure on home prices. A market signal that the housing sector could be bottoming would be a steady downward trend in the months’ supply numbers, say from 11 months to 9 months. Although 9 months’ supply is still excessive, a steady downward trend suggests that home demand is picking up and/or the inventory of homes for sale is decreasing, both positive developments for the housing sector.
Days on Market
Days-on-market is the number of days that a property is available for sale and is a reliable indicator of conditions in the housing market. Under normal conditions days-on-market could range from 20 days to 60 days, depending on the conditions in the local marketplace. Today, days-on-market range between 60 days and 120 days in many local markets across the nation. A market signal that the housing sector could be bottoming would be a steady decline in the days-on-market numbers, say from 120 days to 60 days; or from 60 days to 30 days, again, depending on the local conditions.
Housing starts (new residential construction) has been a reliable leading indicator for the direction of the economy. Historically, housing starts decline before an economic recession and starts rise before an economic recovery. Housing starts have fallen over 45 percent from peak to trough so far in this recession. Excess supply and weak demand conditions have kept builders from digging holes in the ground (a literal picture of a housing start). Starts fell by 19 percent to 625,000 in November, the lowest level of starts since World War II. Today, starts are weak because foreclosed homes are being sold at deep discounts, taking away business from the new home marketplace. In addition, builders are having a difficult time obtaining financing for their projects. As a result, housing starts may not be as reliable a leading indicator it once was. Even with an increase in housing demand, builders may postpone planning new projects until inventory levels come down. So look for the months’ supply number to come down first, followed by some steady increases in housing start numbers.
As measured by the Case-Shiller home price index for twenty cities, home prices have fallen about 25 percent from their peak in 2006. In this deflationary marketplace, it is not unusual for households to postpone home purchases in anticipation of further price declines. And that is what has occurred during the past two years. A market signal that the housing sector could be bottoming is a steady deceleration of year over year home price changes. We would expect a deceleration to coincide with a meaningful reduction in home inventory numbers.
One of the primary reasons for the real estate downturn is that home prices soared, creating an affordability problem which sharply reduced the demand for homes in high cost areas. Affordability measures have improved markedly during the past year, but that has not led to a corresponding increase in home buying. That is because households continue to expect further price decreases. In addition, households are less confident today due to the recession which has generated several million job losses. Continued improvement in affordability measures will eventually influence households to purchase homes. We recommend monitoring two affordability measures—the National Association of Realtors, NAR, affordability index and the mortgage debt/income ratio. A steady rise in the NAR affordability index combined with a deceleration in job losses (as a proxy for an improving economy) would be a market signal that the housing sector could be bottoming. We also recommend monitoring the mortgage debt servicing (on the median priced home with 20 percent down payment) as a percentage of the median income household in a local marketplace. In normal affordable conditions, the mortgage debt/income ratio hovers between 20 and 23 percent. During the height of the real estate boom, for some metros like Miami and Las Vegas, the ratio exceeded well over 30 percent. Look for this ratio to head towards a more normal range.
Tighter underwriting restrictions on mortgage products have significantly increased the fallout of mortgage applications to home closings. There are many instances where a household applies for a mortgage to purchase a home, but then is denied a mortgage because he or she did not qualify due to more stringent underwriting criteria. Today’s high fallout rate is evident in recent increases in the Mortgage Bankers Association’s purchase index which did not result in a corresponding increase in home sales. Thus, the relationship between the purchase application index and future home sales is no longer a reliable one. A steady decline in fallout rates on mortgage applications signals that households are now qualifying for mortgage products to purchase homes. This would be a positive sign for an eventual housing recovery.