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Home Prices Going Higher This Spring?

Home prices look up this spring, but the longer-term indicators are more murky.

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In an August 2010 Stock Strategist, "Housing: A Tale of Two Time Periods," we surmised that home prices would be pressured for at least the remainder of 2010 but that the long-term outlook for at least stable prices was actually pretty good. Unfortunately, the first part of the forecast turned out to be spot on--home prices sank 3.5% between July and December according to the popular Case-Shiller 20-city index. The expiry of the federal homebuyer tax credit, combined with high levels of existing inventory, a weak economic recovery, and terrible consumer sentiment, made for difficult back half of 2010 in the housing market, to say the least.

Today, we're becoming more constructive on near-term prices. In fact, we wouldn't be surprised to see a decent upward move in the popular Case-Shiller indexes in the very near future. Figure 1 shows that listing prices in the index have already started a rebound after a horrendous December. While these median listing prices often suffer distortions from changing mix, they've proven to be a relatively reliable predictor of short-term movements in the popular Case-Shiller indexes.

As can be seen on the chart, median prices showed a very positive signal in spring 2009, an event that preceded a most unlikely multi-month period of increasing home prices. This year, we see good odds that the same dynamic will take place, with modestly increasing prices set to surprise all but the most contrarian observers. In fairness, prices generally enjoy seasonal strength starting in the spring and lasting through summer. We think there's something more at work here. Notwithstanding terrible February housing start numbers, recent talk from the builder community is that traffic has been a pleasant surprise so far this spring selling season. That dynamic, combined with other evidence, suggests to us that the market may finally be able to stand on its own in some markets. In addition, underlying Case-Shiller data suggest that several cities actually started to perk up in December, a full two months before this crucial period. San Francisco, Denver, Washington, D.C., Miami, Atlanta, Boston, Portland, and Dallas have all shown price trends improving in December from the prior couple of months (either lessening declines or outright sequential gains). Only Tampa, Detroit, and Seattle are showing demonstrably worse trends in December, in our opinion. Bottom line, we think home prices may pleasantly surprise some people in the not-so-distant future.

But the long term is where the real money is made, and unfortunately the above-mentioned analysis isn't going to much help outside six to eight months. Forecasting anything longer requires insight into household formation, interest rates, the availability of mortgage products, consumer confidence, inventories, and a host of other things. Even so, by looking at several factors we can get a decent sense as to whether the market is in some semblance of balance, a situation that generally yields at least stable prices in the intermediate term. Today, we think balance may be slowly returning after being tilted heavily in favor of weaker home prices for more than four years. Does this mean we are likely to enjoy uninterrupted increasing prices for years to come? No, but it does mean homeowners are unlikely to have to endure anything resembling the past five years anytime soon.

Over the Worst?
So what gives us hope the intermediate term may yield a more stable picture than the past several years? Mainly that new supply injected into the market over the past several years has been so constricted there's likely significantly fewer surplus homes in existence today. Sound absurd? Well, Figure 2 shows the degree to which actual new housing has been curtailed over the past several years. Traditionally about 17% of existing home sales, new home sales are currently more than 10 points below that level, illustrating the degree to which homebuyers are choosing existing homes over new.

This is good news. The most material way in which total housing supply is affected is through new construction and mother nature. And the fact that new building has been almost nonexistent for a long time (both primary and rental) is beneficial to the overall supply/demand picture. As we've mentioned many times before, foreclosure activity is not "new supply," as every single foreclosure processed over the past several years was already accounted for in the existing housing stock before the keys were mailed back to the bank. True, the surge in foreclosed units represents an excess of "available for sale" inventory units, a situation that has pressured prices for some time. But as prices have fallen more into line with prevailing rents, that pressure is subsiding. Several sources are indicating swiftly declining rental vacancy rates and firming rents throughout the country. This tilts the rent/buy decision in favor of the latter and also induces landlords into purchasing more primary housing and converting to rental properties. Both are beneficial to the primary housing market and likely to stem the widespread price pressure seen over the past four years.

Figure 3 shows the inventory of both existing and new homes for sale. As is clear, new-home inventory traditionally leads existing home inventory. And the good news is that new-home inventory can hardly go any lower. Already back to levels not seen since 1968 (a period that featured a bit more than half of today's households), it's clear there isn't much new-home inventory in the system. Existing homes are a different story, but even here the long-term trend now appears to be lower.

People talk a lot about foreclosures, as they have for several years. We believe the market has largely priced in the fact that many of these units are coming back onto the market. Many sit in poor locations, are too big, and feature amenities that are uncompetitive in today's market. For these reasons, we don't see any reason the market can't get back onto its feet well before the last foreclosure is processed.

To wrap it up, we think the short-term signals point to higher home prices over the next couple of months, but a longer-term stabilization is less certain. Even so, builders have been injecting new supply into the market at a rate well below normalized demand for years now, and the supply/demand balance may not be that far out of line as a result. If, somehow, buyers can make their way back into the market--and there are signs this is happening--longer-term stabilization may not be so far-fetched.

Stocks
Most of the large builders have rallied significantly from last summer, limiting margins of safety. However, we still believe there's some opportunity. The cheapest name in our housing/construction coverage is  Masco (MAS), which trades at a bit more than half our estimate of intrinsic worth. The company has seen sales dip to 40% from peak levels, with its cabinets, installation, and window businesses off significantly more. However, management has taken the company's fixed cost structure down significantly such that the business operates today at roughly break-even levels. A pickup in production levels, which would be aided by firming prices, would directly benefit these businesses. We think the company can make $1.50-$2.00 per share in a more normalized environment.

Of the homebuilders,  NVR (NVR),  Lennar (LEN),  KB Homes (KBH),  Pulte (PHM), and  Toll Brothers (TOL) are trading at varying discounts to our estimates of intrinsic value. Of the five, NVR, Lennar, and Toll and are the furthest along, with each operating at break-even to modestly profitable levels today. KB Home suffers from elevated overhead but would likely be able to scale this in a higher-volume environment. Pulte has significant work to do to attain profitability.

Eric Landry does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.