(Bradley Hunter is an economist with MetroStudy. This column was provided by the Florida Homes Builders Association.)
In 2005, the saying was, “if the house doesn’t sell, raise the price.” This year, and in 2007, that strategy won’t work. Normal price sensitivity (“elasticity,” for those of you who remember Econ 101) has returned to the market, meaning that high prices mean slow sales.
As you all prepare budgets and plan for next year, you will need to determine things about absorption pace - for the market as a whole, for your submarket, and for your key competitors.
There are various ways to measure absorption. You can look at:
1) Contracts,
2) Closings, or
3) actual Move-ins
Last year, the pace of monthly contracts led to an exaggerated estimate of actual demand. That is because investor purchases do not reflect actual user demand, but in fact represent a form of spec inventory supply.
Closings, the measure favored by appraisers, is normally a very good indicator of actual demand, but in the present real estate cycle, it suffers from the same problem as contracts: it includes investor purchases, overstating market demand.
The pace of move-ins represents the best measure of true user demand. This is because it is the only measure of absorption that deals exclusively with users. Until the unit shows signs of occupancy (there is a list of definite clues we watch for), it is part of finished/vacant inventory. The only problem with this measure is that it is very labor-intensive to collect.
Metrostudy’s method is to drive every street of every active subdivision and take note of the occupancy status of each housing unit, and then to compare that to the status of that unit in the prior quarter. This takes a team of several hundred people about 15 solid days for the southeastern U.S., and necessitates driving 50,000 miles. The data are then entered into the GIS-driven database, ready for analysis in any target market area.
The move-ins can be viewed alongside the finished vacant housing stock (which, when high, reflects the number of speculator-owned units with no user living within).
In the uncharted waters that the market is now entering, it is crucial to have an accurate way of measuring actual demand for every type of housing in every project.
Many developments are seeing significantly slower absorption now. The environment is changing. As the housing market moves into uncharted waters, it is important to analyze the medium-term economic trends that will drive the market in 2006/2007. Interest rates become a key element of such a forecast.
The new Fed chairman has a tough job ahead of him. He has to do the equivalent of driving a car while only looking in the rearview mirror. The Federal Reserve Board is going to be making decisions on 2006 policy that will affect the economy in 2007, based on data that shows what occurred in 2005.
The questions that the Fed faces include:
Will the housing slowdown bring about a recession? One third to one-half of the economy’s growth is being driven by the housing industry. When housing slows, this will impact the economy, and when the economy softens, housing demand may weaken further. This cycle could expose Achilles’ heel.
What does the yield curve tell us? It is flat now, and may have inverted by the time this article comes out. This condition typically suggests that the bond market expects interest rates to decline, and that usually reflects an expected recession. Inversions are less predictive than they used to be, having predicted eight of the past six recessions. That’s not a typo; there were two false alarms.
How will the current account deficit affect the dollar, and how will that in turn affect interest rates? Foreign investors have been buying U.S. Treasuries at a faster rate than we have been issuing them! This is what has kept interest rates so low. This pattern is very unusual, and cannot be sustained. Hence, once these foreign investors cut back on buying our Treasuries, rates will rise.
And the housing industry has to then translate all of that into:
Will the 30 year fixed mortgage rate rise rapidly, or slowly? And even more importantly:
How will the increase in ARM rates impact new housing demand? And, will there be massive foreclosures as people find themselves in over their heads? The coming increases will impact demand, but the massive foreclosure scenario is not likely. As rates are adjusted upward, people who have experienced gains in value will be able to refinance easily, keeping their monthly payment low (using their equity gains to reduce their loan amount). This will keep most people from being forced into foreclosure.
Will investors start a bidding war (a downward spiral)? As I have noted before, investors are driven by the dual emotions of fear and greed, and if fear starts to take over, then those speculators who are marketing the same product as a dozen or more neighbors might sense mark down their price a bit to get out first. Then another neighbor might push the price down a smidge further, and so on. Although this risk exists here in South Florida, our fundamentals are much stronger than those in Vegas, and although prices fell there for a year, they are now heading back upward.
Will home prices go down in some areas/product types, and what will that affect? Some people have a bizarre definition of a loss on an investment. Back when Vegas had its correction in 2004, I heard about some speculators lamenting that they had “lost $80,000,” when the reality was that they were still up $100,000, instead of the $180,000 they had perceived a few months earlier. That will almost certainly become a common story around here at this season’s Christmas parties.
“Opportunities to Make Colossal Mistakes” In mid-2005, I warned in one of my articles and in several speeches that some land purchases that were being made then were going to come back to haunt people. I still think this is the case, and the homebuilding business is going to require a great deal of attention to facts and data. Success is going to require realistic market planning based upon fundamental market research.
The upshot of all this is that there are going to be some trouble spots as we go forward in 2006. The market is going to feel much different than it did for the past few years. Developers will have to shed the fallback plan of passing on the increased costs of construction and land to consumers, because consumers will not be able to absorb those costs. Margins are going to be much lower than they were. That is the reality. Demand will still be there, but only for homes that are priced according to what the market can bear. The only way to avoid colossal mistakes (which will no longer be covered up by the market) is to stay informed. There is a lot of dis-information and mis-information out there, and that can lead to poor decisions. The way to stay ahead is to have the best information on the market and on the competition that you can have.