Introduction
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will see outsized benefits when the housing
recovery inevitably emerges, yet are well positioned to withstand a
protracted extension of the currently stagnant environment.
“A housing recovery will probably begin within a year or so. In any event, it is certain to
occur at some point.”
– Warren Buffett, 2010 Letter to Shareholders, February 26, 2011
Current Market Conditions – “Fear Sells”
If you believe the headlines of major news outlets, you would be convinced that there is absolutely no
potential for a housing recovery on the horizon. Clearly, the current housing supply is elevated, especially when you
factor in the so-called shadow inventory, which includes borrowers that are seriously delinquent, homeowners that
are in some stage of foreclosure and properties that have already been repossessed (REO). According to the
National Association of Realtors, the current supply (end of July) of homes on the market stands at 9.4 months, but
factoring in the shadow inventory (an additional 1.7 million units or an additional 5 months according to CoreLogic)
the total housing supply stands at ~14 months. With approximately 22.5% of all U.S. mortgages currently
underwater (note: this is a potential source of new housing supply that is not factored into the shadow inventory),
the shadow inventory will likely remain elevated for a few more years. Nevertheless, it should be noted that the
shadow inventory peaked in January 2010 at 2 million units or 8.5 months of supply. Absent a long term secular
decline in home prices, the shadow inventory represents a finite supply of inventory that should be worked off in an
orderly manner over the near/intermediate term.
While the headline grabbing news agencies like to instill fear in their readers by focusing on one
component of housing supply, it is worth noting that a traditional source of housing supply (new home construction)
has contracted meaningfully. New housing starts were just 447,000 in 2010, only slightly above 2009 levels, which
were the lowest levels since the Commerce Department began keeping records in 1959. It should be noted that
housing starts have been well below longer-term averages (1.2 million starts annually) over the past 3 years.
Source: bankstocks.com, “It’s Not Just Banks’ Inventory Overhang That Will Drive Housing Prices”, 8/4/2011
Although weak economic conditions have negatively impacted the demand side of the housing equation,
we believe that housing demand will likely pivot from a housing headwind to a tailwind in the not too distant future.
Specifically, household formation (or net new U.S. households as depicted in the following chart) has been
impacted in recent years by the economic malaise, but will likely spur an enormous demand for housing in the
coming years. Primary sources of increased household formation may include (1) The 20 million adult children
currently living with their parents, in large part due to the current economic/employment environment; and (2) A
reversal of recent declines in immigration as economic growth in the U.S. improves and attracts more job-seekers.
Introduction
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Source: bankstocks.com, “It’s Not Just Banks’ Inventory Overhang That Will Drive Housing Prices”, 8/4/2011
In our view, robust demand will help not only to absorb the current excess supply, but also to drive future
housing growth. Home affordability levels also give us optimism that healthier levels of demand will re-emerge in
the not-too-distant future. During the housing boom, housing became unaffordable, but the correction in prices
coupled with record low interest rates has dramatically powered home affordability levels up to record highs.
NAR Housing Affordability Index
50
70
90
110
130
150
170
190
210
19
70
197
2
19
74
19
76
19
78
198
0
19
82
19
84
19
86
198
8
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
20
10
Source: National Association of Realtors
A weak U.S. dollar coupled with attractive prices is already beginning to attract foreign investors to the U.S.
housing market. We note that a number of markets have experienced an inflow of foreign ownership, including
Miami, which was among the hardest hit housing markets. Finally, we believe the aging baby boom generation with
their rising pool of discretionary income will help absorb a large amount of the excess supply as they purchase
Introduction
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second homes for their retirement. While the baby boomers were certainly not immune to the hits taken to real
estate and investment portfolio values during the last decade, we would note that the most affordable housing
markets today are located in traditionally attractive retirement areas (Florida, Arizona, Southern California, Las
Vegas, etc.). Although we would expect boomers to remain in their current residences for a number of years given
lifestyle factors (healthier generation, desire to be closer to grandchildren, etc.) we would not be surprised if they
began to absorb a significant amount of the excess supply in the hard hit markets that would initially be utilized as
second homes.
A Closer Look at the Multiple Catalysts that Should Produce a Robust Housing Recovery
Below we provide a detailed review of the current housing supply/demand conditions and address what we
see as the powerful demand drivers for housing.
New Housing – Favorable Supply/Demand Conditions
Just as the pendulum swung from an equilibrium of housing starts in the early 2000s to a surplus in 2004
and 2005, we believe the pendulum has swung to the other extreme and there will be a shortage of supply when
housing demand normalizes. Using housing permits as a proxy for housing starts/construction (since this data is
widely available and has closely tracked new housing construction), median housing starts totaled approximately
1.5 million homes per year since 1960. This figure is more or less in line with long term housing demand which is
estimated to be roughly 1.35 million per year, consisting of household formations (750,000), obsolescence
(400,000), and second homes (200,000).
As a result of the bursting of the stock market bubble in March 2000, the subsequent lowering of interest
rates by the Federal Reserve (Fed Funds rate decreased from 6.5% in May 2000 to 3.0% in May 2005), the growth
of creative financing (no down payment, liar loans, interest-only loans, negative amortization), and the public’s
disenchantment with the stock market, individuals and investors (speculators or flippers) alike shifted an enormous
amount of capital to real estate. Between 2000 and 2006, sales of new and existing homes increased by 14% and
26%, respectively. Home builders responded in kind and actually overshot demand with increased production, to
the tune of a cumulative 2.4 million homes built in excess of estimated long-term demand between 2004 and 2006.
Excess Supply Being Reduced Through 4 Years of Significant Under-Building
Source: U.S. Census Bureau; NAHB via PulteGroup, Inc., Investor
Presentation, June 2011
Source: Moody’s Analytics, “Housing Hits Bottom in 2011”
The Federal Reserve began to raise interest rates in June 2004, effectively putting in motion the end of the
housing bubble. As interest rates on adjustable rate mortgages reset at higher rates, homeowners increasingly
began to default on their mortgages due to higher mortgage payments, spurring increased bank foreclosure activity.