Housing in Canada: A Tale of Two Markets

Guest post by Norman Mogil


Canada’s housing market has diverged in recent years: Vancouver and Toronto joined other international real estate markets such as New York, London, and Sydney, while prices in other major cities remain subdued. Vancouver and Toronto housing now costs double that of comparable homes in Ottawa, Montreal and Calgary as the two most expensive cities continue to experience the fastest increase in prices and pull further away from all other regions in the country. Let’s look at the changes in buyers, housing stock, and credit creation that are behind this tale of two markets.

Table 1: Real Estate Prices in Canada 2014-2015

Source: Canadian Real Estate Assoc. July, 2015

Stable Housing Supply

Unlike the US, Canada has no recent history of overbuilding. The ratio of housing starts to household formation is roughly in balance at 1.2 starts per formation, which has allowed Canadian construction to avoid the boom/bust cycle often associated with housing. Furthermore, stable housing supply reduces the risk to lenders and has encourages continued orderly expansion of the housing stock. Since housing supply has not driven climbing prices in Vancouver and Toronto, we focus on housing demand below.


Population Changes

Canada is a "young" country. The working population is one of the most important components of housing demand. Chart 1 compares the working age population (ages 15-64) as a percentage of total population. Canada’s working age population is nearly 69% of the total population and exceeds the ratio in the US and the average for all OECD countries. Furthermore, the population aged 25-34 is growing at a rate of 2% y/y ; the age group of 30-34 is growing at even a faster rate of 2.6% y/y. These groups underpin the market of first-time buyers ^1.

Chart 1:  Working Age Population as a % of Total Population

Source: OECD

Immigration accounts for about 75% of the population growth in Canada . Over half of Canada’s 260,000 annual immigrants make their way to Vancouver and Toronto alone. Recent work by CIBC reveals that immigrants aged 25-45 years have dominated the estimated 770,000 non-permanent Canadian residents. Moreover, immigrants living in Canada for more than 10 years have a higher rate of home ownership than native Canadians, thereby exerting more demand pressure ².

Table 2: Housing Starts in Canada 2010-2014

Source : Statistics Canada

Credit-driven Growth

Total mortgage lending has increased by 30% since 2010, primarily attributable to commercial bank lending. In the past 6 months, the banks have eased off on this growth pattern, but levels remain relatively high. As non-bank funders also aggressively move into this market, both builders and buyers are finding easy financing.

Chart 2

Source : Statistics Canada

Credit growth has not been isolated to mortgages. Statistics Canada shows that household debt including mortgages, consumer credit, and non-mortgage loans reached 163 per cent of disposable income as of June 2015. The IMF warns that “although household debt levels appear to have stabilized recently, they have increased to historical highs in the past decade... one of the highest among countries of the OECD.” Just as easy credit allowed Canadian households to enter the housing market and push prices higher, there is now concern that high debt poses the risk of a major housing market correction. By way of comparison, US ratio of debt to real disposal income reached 172% in 2014. Canadians are less indebted than their American neighbours.

Debt should always be measured against assets to get a measure of the degree of risk assumed (Table 3). In real terms, the growth of household debt did accelerate to an annual average rate of 5.3% in 2000-2011, compared to 3.1% , in the 1980s, and 3.7%, in the 1990s. However, the ratio of debt to assets has barely changed. In the 1980s it stood at 16% and now it averages 17.6%. Overall, the accumulation of household debt has kept in line with the growth of household wealth . Put differently, Canadians have not increased their leverage from prior decades in any meaningful way. Finally, given that current interest rates are at a historical low, debt service is within a manageable range. And, with no anticipated interest rate increases, these debt levels do not pose a threat to the housing sector.

Table 3: The Growth of Household Debt and Assets 1980-2011, Canada *

The Influence of Foreign Capital

Canada continues to benefit from inflows of international capital. Investors from Hong Kong and mainland China have been buying up real estate in Vancouver and Toronto, contributing to the bidding wars in both cities. While there are no official data documenting purchases by non-residents, realtors have provided statistics and anecdotal evidence to support this argument. We must caution the reader that much better data and greater research are needed before any conclusions can be reached regarding the role of Asian investors in influencing housing costs in Canada.


More Fuel is Added

The pressure on the housing market in both Vancouver and Toronto contradicts Canada’s oil-driven economic slowdown over the past six months and has complicated the Bank of Canada’s recent monetary policy decisions . The central bank has cut rates twice this year. In its latest move, the BoC stated:

“Of particular note are the vulnerabilities associated with household debt and rising housing prices. And we must acknowledge that today’s action could exacerbate these vulnerabilities.”

The Bank recognized that, although its policy moves were necessary to stimulate overall growth, it runs the risk of further inflating Vancouver and Toronto housing markets.


Is There is a Correction Coming?

The rise in house prices has prompted many analysts to say that a correction is inevitable. Simply put, they argue that growth in market demand is unsustainable and thus a major correction must follow. Before arriving at that conclusion, it is important to bear in mind that both cities feature:

1. Diversity in employment and industrial makeup, so that they can weather a downturn in oil and other commodities , as they did in the oil crash of mid-1980s;
2. Population growth will continue at the current rates and there is no sign of change in government policy regarding immigration flows;
3. Interest rates not only remain low, but show no sign of increasing given the current economic environment, eg 5 year mortgage rates are 2.50%;
4. And, both cities face land scarcity, especially in the core areas.

Conclusions 

1. Canada has a split housing market; Vancouver and Toronto, overwhelming skewed the average home price in the Canada; looking at the rest of Canada, prices are stable and values remain relatively low.

2. The growth in housing stock has risen to match the growth in population and household formations; there is a relatively good demand/supply balance in place.

3. Household debt measured against the growth in assets indicates that the ratios today are within the historical averages.

4. There is concern, however, should the Canadian economy weaken further and employment and growth deteriorate that housing prices and values could be at risk.


 _____________________
¹ Robert Kavic, Business in Canada, April 14, 2014
² Benjamin Tal and Andrew Grantham CIBC, “Many Faces of the Canadian Housing Market” June, 2015

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Some thoughts on slowing house price appreciation in the US

As discussed earlier (see post), home price increases in the US are slowing. One of the reasons for the slowdown is the continuing weakness in wage growth. The latest data seem to indicate that in spite of the overall improvements in job creation, wage growth remains subdued - hovering around 2% per year over the past 3 years or so.

And wage growth is a key determinant in home price valuation. Merrill Lynch for example shows that current home prices may already be above where they should be, based on Merrill's "fair value" index (that is driven to a large extent by wages).

Source: BofA

The other issue holding back home prices from accelerating is credit. Credit conditions for mortgages remain relatively tight and in fact have worsened for non-traditional mortgages.

That's why it remains challenging for the housing sector to maintain momentum, as we see residential construction spending stall.

Of course this is the situation for the nation as a whole. Underneath all this we have quite a bit of variability. Skilled workers are more likely to have higher paying jobs, are able to get mortgages, and are buying homes. House prices in certain areas are rising much faster than what we see in the national averages. In many cases there are simply not enough homes. Yet in other areas, the situation remains stagnant in terms of wages, credit, and the housing market. This divergence, although not visible at the national level, is growing.

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Slower home price increases in the US

A quick note on home price appreciation in the US. Prices are now rising at less than 6% per year and the pace is slowing.

That’s a good thing - we want to avoid the affordability collapse taking place in the UK or France. In fact US home prices are still rising faster than homeowners’ expectations. The long-term housing price increases should be in line with wages. And we all know where that is.

Shiller likes the slower price increase:

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Rental home shortage is America's next housing crisis

The US is facing a new housing crisis. No, it has nothing to do with subprime mortgages or bloated home equity balances. This time the nation is dealing with shortages of rental housing, a problem that will become increasingly acute in years to come and may result in a material drag on economic growth.

Americans are simply not building enough homes to accommodate the population's needs. The number of housing units completed per capita in the United States remains a fraction of historical averages. The slight improvements from the lows of 2011 have barely scratched the surface.

Similarly, in spite of recent increases, residential construction spending as a fraction of the GDP remains at the lowest levels than at any time since WWII.

At the same time demand has been on the rise. As an indicator, the chart below shows Google search frequency for rent related phrases.

Apartments & Residential Rentals - related searches (Source: Google Insights)

The myth out there is that this problem is somehow limited to some of the coastal areas of the United States - NY, Florida, California, etc. It is not. Just take a look at the rental vacancy trend in the Midwest.

The last point represents Q1, 2014

This shortage is of course translating into rising costs of shelter across the country. The overall shelter CPI is headed toward 3% and the rate of just rental cost increases is even higher. It is materially above the overall CPI rate and expected to rise further.

This trend, combined with massive amounts of student debt (see discussion) will be increasingly taking a bite out of consumer spending. The percentage of "housing cost burdened" households (those who spend more than 30% of their income on shelter) has been rising rapidly.

JCHS (Harvard) - The recent deterioration in rental affordability comes after a decade of lost ground. The share of cost-burdened renters increased by a stunning 12 percentage points between 2000 and 2010, the largest jump in any decade dating back at least to 1960. The cumulative increase in the incidence of housing cost burdens is astounding. In 1960, about one in four renters paid more than 30 percent of income for housing. Today, one in two are cost burdened. Even in 1980, following two decades of worsening affordability, the cost-burdened share of renters was just above a third.

Given such demand, why does residential construction remain so tepid? Since 2008 the acquisition, development and construction (AD&C) lending has been too restrictive to accommodate the rising demand. That in turn has led to insufficient numbers of developed lots for construction.

US News: - According to a recent National Association of Home Builders industry survey, 59 percent of builders reported the supply of developed lots on their areas was low or very low. This is a significant increase from a similar survey undertaken in September 2012. In fact, the 59 percent response is the highest rate recorded since 1997, when this first survey question was first posed.

Other reasons include highly restrictive zoning rules, as existing homeowners limit new construction in order to boost their property prices. Whatever the case, residential construction is running at half the level of longer term housing demand. And while the nation can get by for now, consider the situation 5-10 years down the road.

Economists, politicians, and the media continue to focus on slow home sales as an indication of weak housing markets. But they are simply "fighting the last war". The looming crisis is not about how often homes change hands, but about the shortage of rentals and the rising cost of shelter that the new generations of Americans will increasingly face.

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The UK housing sector: fighting the last war

The media and the blogosphere continues to buzz about the risks building in the UK residential housing sector. Just look at this housing price index - we are way above the pre-recession peak. Compare it to home prices in Spain to see this massive divergence (see chart). It's a bubble and it's about to burst...

UK housing price index (source: Office for National Statistics)

Hogwash. As discussed before (see post), the UK is struggling with a housing shortage. Unlike the US and Spain who overbuilt prior to the financial crisis, the UK started the recession with an insufficient housing inventory. And the new supply of homes entering the market remains inadequate. Here is a chart of UK housing starts...

Source: Department for Communities and Local Government

... and here is the UK population over the same period.

Furthermore, there is little evidence of any material speculative investing activity in resi property markets that we saw in the US prior to the crisis. And most importantly there is no evidence of aggressive mortgage lending. In fact the amount of new mortgages approved in the UK is declining this year after last year's increase.

Source: Investing.com

So for all of your folks who are looking for financial bubbles across the globe, this is not one of them. And yes, you hear regulators, IMF officials, and politicians talk about this as being the next scary problem for the UK. In reality however these people are just "fighting the last war".


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US housing sector stalling

The US housing recovery continues to face headwinds. Here are the key factors contributing to weakness in the sector.

1. We've had a sharp decline in housing affordability due to higher prices and higher mortgage rates. The decline in mortgage rates recently should help somewhat, but buyers remain cautious.

Source: Deutsche Bank

2. Banks have tightened lending standards. The important trend here is the tightening in the "nontraditional" mortgages (ignore the "subprime" component - it's not a meaningful portion of the market). If you don't fit into the traditional mortgage "box", getting a loan is now more difficult.

Senior Loan Officer Opinion Survey on Bank Lending Practices (Federal Reserve Board)

3. Household formations have stalled. It will be difficult to get the demand going until growth in households picks up again.

Source: U.S. Census Bureau

This weakness in housing is already reflected in the equity markets as shares of homebuilders underperform.

Orange=S&P500 ETF, Blue=Homebuilder index ETF (source: Ycharts)

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From our sponsor:

A UK housing bubble or something else?

Home prices in the UK continue to rise to new highs, exceeding the pre-recession peak. The price increases started in London and have now spread nationally. Many families are quickly being priced out of the housing market. Some are calling it a bubble.

The Guardian: - UK house prices continued to accelerate in February, rising by 1.9% during the month and pushing the annual rate of inflation to more than 9%, according to the latest data from the Office for National Statistics.

Commentators warned of a "superbubble" and said the market was "out of control" as the official figures reported year-on-year prices rises of 17.7% in London and said first-time buyers had experienced double-digit price growth.

Just to put this in perspective, US home prices are now roughly at the levels they were a decade ago. UK home prices have risen over 40% over the same period.

Many are blaming the Bank of England's so-called FLS (the Funding for Lending Scheme - see overview) for flooding the market with cheap mortgages. Indeed the program has resulted in lower bank financing costs and lower mortgage rates.

Source: BOE

But is all this cheap credit creating a speculative housing bubble in the UK or is there another factor at play? If you speak with British realtors, they tend to have one major complaint in common. The UK is facing a housing shortage as the post-recession home construction activity remains subdued.

Source:  Department for Communities and Local Government

Homes are being built at about half the rate needed to meet the pace of British households creation. But that is also partially the case in the US - so why such a divergence in house price trajectories between the two nations? The answer, according to Goldman, is that unlike the US and some other nations that went on a building spree during the bubble years, the UK was facing a housing shortage even before the financial crisis. The UK housing "bust" happened without the "boom".

GS: - And, while the shortfall in house building has become more acute in the years since the financial crisis, the rate of house building was also inadequate before the crisis. Unlike countries such as the US, Ireland and Spain – where house building rose sharply in the years leading up to the crisis – the UK has experienced a post-crisis bust in housing supply, without having experienced a pre-crisis boom.

But with housing prices rising faster than wages, doesn't it mean that this rally should be ending soon? Not necessarily. The acute housing shortage has put a similar upward pressure on rents as well, limiting housing options.

Source: GS

And while fewer people can purchase a home after the recession, those who can end up paying materially less on their mortgage than they would be paying in rent (thanks to FLS). They are jumping into the housing market and driving up prices.

Of course if the Bank of England pulls the plug on stimulus by raising rates or by imposing a more stringent lending requirement on banks, home price increases are likely to slow. The housing shortage however will still remain, resulting in higher demand for rentals. Whether paying more for home purchases or dealing with higher rents, one thing is clear: UK residents will be paying increasingly more for shelter in the years to come.

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Two potential headwinds for the US housing market

While the US housing market remains relatively robust, it is likely to face a couple of headwinds going forward. One is the lower affordability index, which is declining due to higher prices and higher mortgage rates (see discussion). On a year-over-year basis the declines have been quite steep.

The second trend that will detract from demand for homes is the recent slowdown in net household formation. The chart below shows the year-over-year change in total number of US households. This decline in the "formation rate" is likely to be transient (simply because of population growth), but it is not helpful for the housing market nevertheless.

Estimate by the United States Census Bureau

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From our sponsor:

The dark side of rising rental costs in the US

One factor that may continue to provide tailwinds to US housing recovery is the rental market. Rents are rising faster than inflation, widening the spread between housing costs and wages.

Bloomberg: - For households with children, rising housing costs, elevated unemployment and stagnant earnings are increasingly placing rent beyond reach. The housing slump made matters worse as former homeowners turned into renters, increasing competition for available apartments.
...
Nationally, the average hourly wage among renters is $14.32 this year compared with the $18.79 needed to afford an apartment at a fair-market rent, as defined by the U.S. Department of Housing and Urban Development, without spending more than 30 percent of income on housing, a National Low Income Housing Coalition report found in March. The $4.47 gap this year is wider than the $4.10 differential in 2012.
...
Median household income has fallen every year for the past five after adjusting for inflation, with Americans earning no more than they did in 1996, according to data from the Census Bureau. The share of people making less than $15,000 climbed to 13 percent of the population in 2012, from 10.9 percent in 2000, and the share making less than $35,000 expanded to 35.4 percent from 31.4 percent.

According to the Fed, the ratio of rental obligations to disposable income is now at post-recession high. Growing rental costs are driven by declining vacancies and lower housing inventory in the US. Of course the recent rise in interest rates has not helped matters either. Higher rates raise the break-even rent level for landlords who finance their properties.

Source: CIBC

While this development is encouraging some renters to plunge into homeownership, giving a boost to home prices, it is also displacing low income families. This trend is quite troubling.

Bloomberg: - The number of children without a home increased by an estimated 2 percent, according to NAEH, a Washington-based non-profit focused on policy and research on the needs of homeless people.
...
The share of Americans experiencing “deep poverty,” living at less than 50 percent of the $23,492 poverty line for a family of four, climbed to 6.6 percent in 2012 from 4.5 percent in 2000, based on Census Bureau data released last month.

That may increase the pipeline of Americans heading toward homelessness. There was a 9.4 percent increase in the number of poor people “doubled up,” or living with friends or family due to economic need, between 2010 and 2011, based on the NAEH 2013 report. Crowley said 2011 is the latest year for which usable data on doubling up is available.

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A housing affordability index scenario caps housing prices and mortgage rates

We've had a great deal of movement in the NAR US Housing Affordability Index recently. The index is meant to measure homebuyers' ability to finance house purchases (discussed here back in 2011) and given some recent events, it's worth taking a look at what the index is telling now.

First of all, there has been a great deal of criticism of this index (for example here). The index clearly doesn't take into account factors such as credit conditions, while making some (over)simplifying assumptions (see description). It is certainly a blunt tool that uses the median house price, median household income and the latest mortgage rates. But its simplicity makes it relatively easy to get a picture of "affordability" over time (the absolute level of the index is not very meaningful - just the relative moves). More importantly it's quite easy to stress-test.

The Affordability index had peaked in early 2012 and has been declining rather sharply since, as home prices began to recover. Along the way however the declines were offset by falling mortgage rates - until recently.

The latest value available from NAR is as of July of this year, when the average mortgage rate used in the calculation was 4.13%. Things have changed since then (see chart). Based on the analysis performed by Deutsche Bank, the chart below shows where the index would be if:
1. we use current mortgage rates (rather than from July) and house prices remain unchanged;
2. 1% increase in mortgage rates and house prices remain unchanged;
3. 1% increase in mortgage rates and house prices increase another 10%.

Source: DB

Scenario #3 shows how sensitive affordability is to these adjustments. It takes use below the pre-recession affordability average - a shock that would be quite difficult to for the current economy to absorb. Some would say this scenario is unrealistic. Perhaps. But mortgage rates are up some 1.5% from the lows in just a few months and house prices (based on the S&P Case-Shiller Index) are up 12% from a year ago. Was such a scenario realistic last year?

The conclusion we can draw from this exercise is that with household income growth remaining weak (see post), there is a natural cap on this combination of rates and house prices. Another 1% jump in rates and a 10% increase in home prices and a significant portion of the US population gets priced out of the housing market, forcing prices to stall or even correct.

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From our sponsor:

For many Americans rising home prices are no cause for celebration

Economists and the markets have been cheering the jump in housing prices and improving construction statistics. But for many Americans rising demand and higher house prices bring more bad news. Based on the latest data (report below) from the Joint Center for Housing Studies, Harvard University (JCHS), here are some sad facts about the housing situation in the US.

1. The number of homes for sale is still near record lows. That is driving up costs and quickly pricing many households out of the market.

2. The US actually has a large number of vacant homes that are not making it into the market. Vacant homes are often in areas with few job opportunities, making it impossible to renovate, sell, or rent.  Many are in places like Detroit and simply will never be sold.

Source: JCHS

3. We are seeing the confluence of tight housing conditions and weak household incomes. As JCHS points out "most types of households have seen their real incomes decline over the past decade". This is particularly true for growing households.

Source: JCHS

4. As a result, "the total number of households paying more than half their incomes for housing soared by 6.7 million from 2001 to 2011, a jump of 49 percent". Note that this is a problem for both homeowners and renters.

Source: JCHS

5. Housing shortages (discussed here) and rapid renter household growth are driving up rents. At the same time, millions of federal rental subsidies for low income renters are set to expire in the next decade.

Source: JCHS

6. On top of all this is the fact that households are now forming at a rate of about a million per year. The market is demanding a million new residential units each year. Unless construction can keep up and prices decline or incomes rise (neither seems likely right now), this trend will drive up the number of households with "housing cost burdens" (already over 40 million; see #4 above) - for both homeowners and renters.

JCHS housing report

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From our sponsor:

Is the US facing a housing shortage?

Homes available for sale as well as the housing supplies measured in months are now at pre-recession levels, while household formation continues to recover (see post). This development was predicted by William Wheaton back in 2009.

Source: JPMorgan

Forbes: - Most striking however is the fact that inventory has contracted to its lowest level since December 1999, more than 13 years ago. The number of available homes, which is not seasonally adjusted, fell 4.9% from December and is 25.3% lower than a year ago. With 1.74 million homes on the market, at the current sales pace, supply will be exhausted in just over four months. It represents the lowest housing supply since April 2005. In a normal market, a healthy supply level is about six months.

A number of economists continue to talk about the shadow inventory - the millions of homes that are "about to hit the market" as homeowners have or shortly will fail on their mortgages. Some evidence suggests that in the more depressed housing areas banks are indeed sitting on foreclosed properties, unwilling to sell. But a number of banks have also been aggressively modifying mortgages, reducing principal and interest, and therefore cutting delinquencies.

Clearly many more homes will be hitting the markets this year. But it really doesn't make much difference if people who move out of these homes end up buying or renting - they need to live somewhere. And according to the Census Bureau, rental vacancies are near a 10-year low.

Ironically, the relatively tight credit conditions are (at least partially) restricting new home construction. Completion of new housing units has improved recently but remains at historically depressed levels - certainly not enough to keep up with the population growth and family formation. The danger of course is that with spring approaching (generally a period of increased demand for homes), some markets could overheat due to tight supplies, worsening home affordability and dampening sales numbers.

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From our sponsor:

US housing prices revert to long-term per capita income growth

Over a long period, home prices tend to follow growth in per capita income. After bouncing off the recent lows, home prices have once again reverted to their long-run growth trend.

Source: JPMorgan

Historically, incomes (total incomes of everyone over 15 years of age divided by the population size) have grown at roughly 5% per annum (although this growth has been more modes recently). In the next few years house price appreciation (HPA) will likely stay in that range as well (or lower). In fact the CME Case-Shiller futures are forecasting the average HPA to be just above 3% per year in the next three years. And unless incomes in the US somehow experience a dramatic upturn, HPA should stay subdued.

Source: JPMorgan

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From our sponsor:

US housing supply demand curve still bullish

Guest post by Lee Adler (The Wall Street Examiner)


CoreLogic reported today that existing home sales prices officially recorded in October (probable contract average August) rose 6.3% year over year. Corelogic also collects MLS data on contract prices from which it calculates a pending home sales price index. That index portends that closed sales in November will be up 7.1% year over year. These numbers are within the range of other recently reported US national housing price trend indicators.

The following is an excerpt from the Wall Street Examiner Professional Edition Housing Report. In the current issue, I looked at a new indicator from the NAR that appears to be a decent proxy measure for supply and demand.

Falling homeownership rate and the housing market

Some readers have been asking how one can reconcile positive signs in the housing market with declining rates of homeownership. Indeed, homeownership is falling at an even faster pace than during the 08-10 period (chart below).

Source: JPMorgan

The explanation is that so far a great deal of net demand growth in housing has been in rental units. Households are putting a premium on mobility. This demand for rentals is in fact one of the factors supporting the housing market - for every renter there is a landlord who buys a home.

JPMorgan: - There is no contradiction between increased demand for housing and reduced homeownership rates. Demand for housing is mainly dependent on the increase in the number of households, whether these households choose to own or to rent the housing units they live in. Growth of household formation had been stifled during the expansion to date by high unemployment and subdued job growth. Young people have had an especially tough time in the labor market, and many who could not find jobs or could not find good jobs are living with their parents or are doubling or tripling up in apartments with friends. In addition, tough labor market conditions have discouraged immigration.

But labor markets are gradually improving, and the period of maximum weakness in household formation is behind us. And the increase in the number of households has accelerated over the past year, to growth of 1.01% or 1.15 million, the largest annual increase since 2Q06 if still somewhat below the norms prior to the recession. The decline in homeownership rates implies that virtually all the increase in demand for housing units associated with increased household formation consists of increased demand for rental units. Indeed current estimates indicate that over the past year the number of occupied rental units increased 1.32 million and the number of owneroccupied housing units actually declined 175,000 (although the number of reported owner-occupied units was up in the latest quarter).

With household formation on the rise (see discussion) and mortgage to rent ratio at 0.63 (record low), the homeownership rate should stabilize in the near future. It is unlikely however that the rate will ever return to levels we saw in the early part of the last decade. The "American dream" propaganda associated with homeownership is no longer part of the culture - the concept that every household should own a home is simply flawed. Labor mobility has become an important dynamic of the US economy, both in terms of skills and geography. This adjustment is vital in order to address the rapidly changing labor demand (see discussion). And high levels of homeownership tend to hinder labor mobility, particularly when house price appreciation rates stay subdued.

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Some positive news for US housing

Recent data continues to favor the US housing market. Here are three data points.

1. Household formation has picked up pace in Q3 to 1.2 million. It seems family formation has stabilized from the weak growth trend in the past few years (see discussion; the US Census should have more details in January).

Source: JPMorgan

2. Homeowner vacancies showed a sharp decline in the third quarter.

Source: US Census Bureau

3. REIS reported that the ratio of mortgage payments (based on the median house price) to apartment rents is at 0.63 - near record lows.

We could be looking at a surge in housing starts in 2013, potentially leading to a nice rise in construction payrolls (according to some estimates we could see over 250K new resi construction jobs plus all the jobs created in supporting industries).

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9 million mortgages still underwater

As we finally begin to see improvements in the US housing market (see discussion), it is important to note that we still have roughly 9 million mortgages that are "underwater" (the mortgage balance is higher than the value of the home). That's almost one fifth of the overall market. Furthermore if home prices for some reason begin to decline again, that number of underwater mortgages increases quickly. The chart below from JPMorgan shows the impact of increases or declines (in 5% increments) in home prices ("house price appreciation" or HPA). The housing recovery has a long way to go and substantial downside risks remain.

Source: JPMorgan

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Update on the Goldman housing index

Back in April, we discussed a very simple US housing market index developed by Goldman. The index basically looks at the percentage of US zipcodes that have experienced housing price appreciation (see discussion). Here is an update. Currently roughly 50% of zipcodes in the US are reporting price appreciation - which is still below the lows of the 1982 and the 1992 recessions. However as a comparison, the index was at 20% at the end of Q1. Note that the temporary spike in 2010 has to do with First-Time Homebuyer Credit program.

Source: GS

As expected, housing price appreciation is held back by distressed sales. The bifurcation of the distressed and the non-distressed markets (discussed here) is slowing the overall market improvement. Those areas with the largest declines in distressed sales saw the largest increases in prices.

Source: GS

This tells us that as we work through the distressed home inventory - which is happening fairly quickly (see discussion), prices should stabilize further.

GS: - ... distressed transactions, including bank real estate owned (REO) sales and short sales, play an important role in the current housing market. In earlier research, we estimated that the declining fraction of distressed sales during the recovery process has contributed materially to recent national house price movements. ... we confirm this finding using regional data. Among the Case-Shiller 20 cities, areas that had severe housing downturns but saw significant declines in the number of distressed sales over the past year -- Detroit, Las Vegas, and Phoenix -- also experienced higher price appreciation this year. Once the housing market fully recovers and the fraction of distressed sales returns to historical normal levels, the impact of the distressed/non-distressed mix on house price growth rate will dissipate. In the near-term, however, we still face a large distressed sales pipeline. This, coupled with investors bidding up REO properties in REO-to-rental programs and banks increasingly resorting to short sales (which has a smaller price discount) rather than REO sales to dispose distressed properties, suggests that house prices will continue to increase even with little improvement in the fundamental economic underpinnings.
...
... the recent strength observed in the housing market could also be related to "pent-up" demand coming back to the market. From 2007 to 2011, falling home prices and subsequent deterioration in the economic outlook may have caused many potential homebuyers to wait on the sideline.  [see this discussion on house price appreciation no longer strongly tied to the economy]

And once again, this has little to do with QE3 and low mortgage rates - the market is driven by completely different dynamics.

SoberLook.com

How much will lower mortgage rates help the US economy?

As mortgage rates in the US hit new lows, the US consumer should benefit. The question is how much difference does the mortgage rate make in improving economic growth. We should see the impact on the economy from two sources: higher home sales due to improved "affordability" as well as more money in consumers' pockets due to refinancings at lower rates.

30y average US mortgage rate (Bankrate.com)

1. We know that as mortgage rates declined, home affordability improved. It is important to note however that the rate is not the only component of affordability. Factors like home prices and disposable income must be included as well. Let's take a look the Housing Affordability Composite Index from the NAR. Here is how it is defined.

When the index measures 100, a family earning the median income has exactly the amount needed to purchase a median-price resale home using conventional financing. An increase in the home affordability index means that a family is more likely to be able to afford the median priced house.

As homes become more "affordable", we should see increased sales. What's particularly important is to see higher sales of new homes because that stimulates the construction sector and should create jobs. The chart below compares the affordability index, which indeed has been on the rise, with existing home sales. Except for the First-Time Homebuyer Credit spike and drop, sales have not been responsive to improvements in affordability.

Affordability Index: White; Existing Home Sales: Yellow (Bloomberg)

Now we make the same comparison with new single family home sales.

Affordability Index: White; New Home Sales: Green (Bloomberg)

New home sales have been on the rise slightly, which is gradually improving new home construction.  But so far this trend in construction has not contributed to better employment conditions. This is evidenced by poor US employment-population ratio (discussed here) below. The jobs created in construction are not enough to offset growing labor force due to increasing US population as well as jobs lost elsewhere.

New Privately Owned Housing Starts: White;
Employment-population ratio Yellow

To significantly impact hiring in the US, one needs a far larger increase in new home sales - something that may take years, in spite of improved housing affordability.

To be sure, the US housing picture is improving and home prices are on the rise. But as discussed earlier, at this stage it has less to do with "affordability" (which has been high for some time now) and more with the demographics of growing US population (discussed here).

If mortgage rates suddenly decline from 3.50 to 3.25 or 3.00 and the affordability index goes up further (although as home prices improve, affordability could stall), there is no evidence that home sales (and therefore construction) would all of a sudden begin to grow at rates beyond their existing trend. It certainly hasn't happened as rates dropped from 5% to 3.5%.

2. Now let's take a look at the impact on consumer spending from additional refinancings due to lower mortgage rates. The data here speaks for itself.

Every 25bp improvement in primary mortgage rate is worth only about $5bn in the US consumers' pockets. That's in part due to limitations of borrowers' ability to refinance because of insufficient equity in their homes or poor credit history. Let's say we improve mortgage rates by 50bp (to 3%), translating into $10bn in savings per year. Consumers in the US spend about $11 trillion annually. The savings from the reduced mortgage rates therefore constitute 0.09% in incremental consumer spending (assuming consumers spend it all). Sadly increased gasoline and food prices will more than offset this improvement.

It is quite clear that even though lower mortgage rates are helpful to economic growth, another 50bp (or even larger) reduction in rates will have only a marginal impact on hiring and growth.

SoberLook.com