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New Home Sales: The Glass Half Empty, the Glass Half Full

The new home sales data for May, released in late June, are a tale of woe, hope and uncertainty.

The headlines were alarming. Bloomberg's was typical, "New Homes Sales Plunged in May to Record Low." The media pointed out that the level of monthly sales reached its lowest point since the government started collecting this data in 1963. On a population-adjusted basis, it was likely the lowest monthly sales rate since the home construction standstill during World War II. Moreover, this low point occurred notwithstanding the government's prodigious efforts to bolster the housing market and after three quarters of positive growth in Gross Domestic Product. The alarming report was only partially mitigated by the recognition that the low sales figure in May was in significant part due to the expiration of the home buyer's tax credit in April. Potential purchasers of newly constructed homes had already made their purchases and retreated to the sidelines.

Given the importance of housing to the macroeconomic investor, it is useful the look at the report's details from the perspective of the optimists and pessimists in order to get a balanced picture.

The Pessimists' Case

The drop in housing sales to this historically low point at a time when interest rates on 30 year fixed rate loans are at their lowest point in 60 years and the Federal Housing Administration's (FHA) down payment requirements are at historic lows demonstrates how intransigent the underlying problems are. Sales for the past three-months are comparable to the same period last year. This indicates that there is little fundamental upward demand in the market.

Pessimists argue the new home market now faces a period of three to six months of payback for sales that were advanced while the tax credit was available. The resulting housing reports will disappoint recovery expectations in the market and dampen consumer confidence for both housing and other purchases.

The supply of newly constructed homes at the current sales rate jumped to 8.5 months' worth from 5.8 months in April. A 6-month inventory is considered normal. New homes are taking a long time to sell, with more than half lingering on the market for at least 14 months.

However, the biggest problem, according to the pessimists, is not the new home inventory but competition from the excessive inventory of existing homes. Potential new home buyers can often get more home for the dollar in resale homes built during or prior to the boom years. Resale home are also often closer to work locations. The price of many resale homes, especially in exurbia, has fallen sharply as the result of mortgage defaults. The inventory of existing homes in May was 3,892,000 compared to an inventory of 213,000 newly constructed homes. New homes are now 5 percent of the total inventory compared to an historical average of 15 percent. Add to this a shadow inventory of homes taken back by financial institutions but not yet marketed, and homes yet to be taken back by foreclosure or short sale, and the existing home inventory overhang has been characterized as "extreme."

The Optimists' Case

Affordability for new homes has reached historically high levels. The respected housing analysts Hanley-Wood now rate affordability for new housing at an A+ level based on historical patterns. The median sales price in May was $200,900, down 9.6 percent from a year earlier and the lowest since December 2003. Homebuilders have reduced the size and price of new homes in an effort to lure more purchasers. Added to lower interest rates and lower FHA down payment requirements, more consumers are able to purchase homes. The result should be increased demand/sales for new homes going forward.

Inventory is at historically low level, which bodes well for future increases in residential construction. As noted above, the report for May indicated that the current inventory of new homes was 213,000, a level last seen in 1970. On a population- adjusted basis, this is likely the lowest inventory level in the post World War II period. Inventory has fallen for 33 straight months. At the recent housing boom's peak, the inventory was 575,000. Remarkably, even as new home sales dropped to record low levels in May, the inventory of new homes continued to fall. Further declines, if any, are likely to be small. As demand picks up, homebuilders will need to ramp up production.

How does it all add up? Yale economist Robert Shiller states that the housing market is in a period of "extraordinary uncertainty." Considering the surplus and shadow inventory of existing homes, how quickly will financial institutions unload their on-hand inventories? How soon will they complete further foreclosures given the increase in state mandated mediation requirements and resistance to foreclosure by uncooperative borrowers? How many additional defaults will take place in an era of high unemployment? While there are always unknowns and unknowables, the current level of uncertainty is higher than normal. For investors with an eye toward the influence of macroeconomic factors when making their decisions, this suggests a cautious and watchful approach. Neither "run for the hills," nor "jump right in" are wise strategies.


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