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Housing's modest recovery: down but not out.


AFTER DECLINING steadily during 1989 and 1990, housing market activity finally bottomed out in January 1991 and a recovery began. By June, combined new and existing home sales were 24 percent above the January trough. But then the recovery fizzled out, with total home sales declining in July, August and September. October saw a modest improvement, but the October level of sales was just 11 percent above the weak January level.

At this writing in early December, it looks as though this will be the weakest recovery of housing markets in decades and that 1991 levels of housing sales will be the lowest since 1984. Moreover, at about 890,000 units, starts of new, one- to four-family homes will be the lowest since the recession year of 1982.

With mortgage interest rates at their lowest level in 14 years, one would think that housing markets would be going gangbusters. "What's going on?" is the question asked by consumers, home builders, real estate brokers, mortgage lenders and policy makers.

Along with most other forecasters, the Mortgage Bankers Association of America (MBA) has for some time expected this to be a relatively modest recovery for the housing sector. For example, during the first 12 months of the three previous housing recoveries, sales of existing, single-family homes increased an average of 43 percent. During the current recovery, we expect an increase of just 15 to 16 percent. Similarly, sales of new single-family homes are expected to increase substantially less than the average of those previous three recoveries.

A major reason the current recovery of the housing markets has been so sluggish is that the recovery of the overall economy has been relatively weak. Extensive overbuilding of commercial real estate, the fiscal problems of federal, state and local governments and overleveraged balance sheets of businesses and consumers represent serious structural problems that will impede economic growth for some time. Indeed, while the economy did manage to grow in the third quarter of 1991, by October, employment and per-capita, real disposable income were still below year-earlier levels. The unemployment rate remained stuck near 7 percent.

Furthermore, this poor overall economic performance took a serious toll on consumer confidence. Following a steep plunge and equally steep rebound associated with the Gulf War, consumer confidence faltered and then plunged again due to widespread concern about job security and seeming political disarray. As shown in Chart 1, there is a close correlation between the level of confidence and the level of home sales. When confidence is low, fewer people are willing to reduce their cash reserves and increase their indebtedness in order to purchase a home.

The demographic dropoff

On the other side of the coin, there are both long-term and short-term forces that are more directly weakening the housing sector. Over the long-term, the underlying demographic demand for net additions to the stock of housing is gradually declining as the population ages. In the late 1970s, the baby-boom generation swelled the ranks of 25-to-34 year olds. It is during this period of their lives that most people establish independent households, and so roughly 2 million new households were being formed each year. As we enter the 1990s, the number of 25-to-34 year olds is actually declining while the 35-to-44 and 45-to-54 age groups are growing rapidly. As a result, the annual increase in the number of new households is estimated to be only about 1.3 million currently and is expected to decline to about 1.1 million per year by the end of this decade.

Another important fact about these demographic changes is that first-time homebuyers are becoming relatively less important in the housing market, while repeat or move-up buyers are becoming relatively more important. For many repeat buyers, moving up to a more expensive home is as much a portfolio decision as it is a shelter-consumption decision. The extra money put into a more expensive home each month could just as well be put into stocks, bonds, insurance policies and so forth. The question with which many of these potential buyers are struggling is: which of these alternative investments will provide the highest rate of return? Keep in mind these are people who hope to be in a position to fund their children's college educations and their own retirement.

Appreciation declines

At this time, the attractiveness of housing as an investment is relatively low, because in real terms, the cost of financing a home purchase is currently quite high. While nominal or market mortgage interest rates have declined to 14-year lows, the rate of appreciation of home prices has declined even more. As shown in Chart 2, starting from around 6 percent per year in 1986, the average rate of appreciation of a constant-quality, new, single-family home has declined rapidly during the past several years and is now essentially zero. In some areas of the country, home prices have actually fallen during the past two years.

If past rates of appreciation determine households' expectations of future appreciation, at this point, the typical household likely expects that a home it purchases today will appreciate at somewhere around 2 percent per year in the future. Inflation expectations have largely been wrung out of the housing sector. I can think of no better way to verify this fact than to point to the increased interest among consumers in 15-year mortgages.

Subtracting this expected rate of appreciation from nominal interest rates on fixed-rate mortgages, (see Chart 3) reveals that real mortgage interest rates are currently in the range of 7 1/2 to 8 percent compared to 5 1/2 to 6 percent in late 1986 and early 1987, the previous peak level of housing market activity. It is true that real mortgage interest rates were even higher back in 1983 and 1984, when we experienced a relatively strong recovery of housing markets. But at that time, we were experiencing rapid growth of employment and income, and there was a great deal of pent-up demographic demand. To make matters worse, since 1986, federal tax policy has been changed in several ways to increase those real mortgage interest rates on an after-tax basis.

Cloudy, but clearing

With such a gloomy picture, is there any hope for 1992? We think there is. First, the overall economy is skating perilously close to a double-dip recession. While we believe that scenario will be avoided, through mid-1992 economic growth will remain sluggish, unemployment will remain relatively high, and inflation will continue to decelerate. Under these circumstances, the Federal Reserve (the Fed) is likely to ease further while the bond market is likely to drive long-term interest rates down. We suspect that mortgage rates will fall at least another 50 basis points between now and mid-year. This decline in nominal mortgage rates will help to qualify many more potential buyers and drive down real mortgage rates, boosting the attractiveness of housing as an investment.

Perhaps more important, the continued increase of home sales will act to further reduce inventories of unsold new homes, which should cause home prices to rise and, thereby, cause consumers' expectations of future price appreciation to improve. At the national level, the inventory/sales ratio for new, single-family homes, shown in Chart 4, reached relatively high levels by late 1990. However, over the course of 1991, that ratio has fallen back into a range suggesting reasonable balance and an end to extreme downward pressure on prices. In fact, given the constraints on financing faced by many home builders, it is possible that this inventory/sales ratio will continue to fall. That would further strengthen the case that home price appreciation will accelerate as demand strengthens during 1992.

At the regional level, the inventory picture remains mixed. In the South and Midwest, inventories were kept pretty well in line with sales throughout 1989 and 1990, so only a minor correction was required that now appears to be over. However, in the Northeast, and to a lesser extent, in the West, the inventory/sales ratio remains above normal levels, indicating a continued excess supply. Home prices in these regions may continue to be subject to some downward pressure until this excess supply is worked off.

Our expectation that the housing recovery will gain further momentum is supported by recent movements in the MBA Mortgage Applications Index. The current low level of mortgage interest rates have set off a surge of refinancing activity reminiscent of 1986 and early 1987. Applications for a home purchase, which provide a reasonably good leading indication of home sales, have risen modestly since August and are signaling increases in home sales in the fourth quarter of 1991 and early 1992.

In summary, we believe there are several reasons for expecting the recovery of the housing markets to continue through 1992, but to remain of moderate dimensions, overall. During 1992, total housing starts are expected to increase by 21 percent to 1,250,000 units. Most of this increase will occur in the one- to four-unit category, although some increase in multifamily starts is also expected. Sales of existing single-family homes should rise about 8 percent, to 3.5 million in 1992, while sales of new homes should increase about 20 percent to 600,000 units.

Due to the surge of refinancings, one- to four-family mortgage originations are expected to total $540 billion in 1991, a 19 percent increase over 1990. For the year as a whole, refinancings should represent about 30 percent of total originations, just slightly less than in 1986. For 1992, we expect originations to range from $580 billion to $620 billion; the main source of uncertainty being how long the current refinancing boom will last. If mortgage rates do, indeed, decline another 50 basis points, an even larger portion of the mortgages written from 1986 through 1990 become candidates for refinancing, and so total originations would likely be closer to the $620 billion figure.

In addition to a larger total market, mortgage bankers are enjoying a major surge in market share. From about 36 percent in 1990, data for the first quarter suggest that mortgage bankers' market share will be about 46 percent in 1991, if not higher. (See Table 1.) Total originations for the mortgage banking industry in 1991 should be about $250 billion - the highest on record. [Tabular Data Omitted]

However, the industry may lose some market share in 1992 as ARMs gain in popularity. The spread between FRMs and ARMs has widened this year and will likely widen further in the months ahead as the Fed takes further steps to ease credit conditions. Thus we expect the ARMs share of conventional loans closed to rise to about one-third in 1992 from about one-fourth in 1991, causing the mortgage banking industry market share to slip to 43 percent. But even with a slightly lower market share, the origination volume for the industry should range between $250 and $270 billion.

PHOTO : CHART 1 Consumer Confidence and Existing Home Sales

PHOTO : CHART 2 Expected Home Price Appreciation

PHOTO : CHART 3 Nominal Versus Real Mortgage Interest Rates

PHOTO : CHART 4 Inventory-Sales Ratio for New Single-Family Homes

Richard W. Peach is staff vice president and deputy chief economist for the Mortgage Bankers Association of America in Washington, D.C.
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Author:Peach, Richard W.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jan 1, 1992
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