U.S. Housing's Inventory Problem

Not all of the news is bad. In June, the number of completed new one-family homes for sale fell for the 14^th straight month to 426,000. This represents substantial progress, although this number still needs to drop by at least 100,000 to reach normal levels. The number of completed new homes for sale is also trending down.

Inventories of existing homes, on the other hand, are near all-time highs, and may rise later this year. The National Association of Realtors (NAR) reported that the months' supply of existing single-family homes rose to a 23-year high of 11 months in June. This number is consistent with the Census Bureau's second-quarter estimate for the homeowner vacancy rate (the proportion of the homeowner inventory that is vacant for sale), which slipped 0.1% from a record-high first quarter.

The homeowner vacancy rate is now 1.1 percentage points above its normal rate of 1.7%. As 0.1 percentage point represents 75,000 homes, excess supply is about 825,000 units. How long would it take to sell off this excess? According to Harvard's Joint Center for Housing Studies, about 1.9-million housing units need to be built each year to satisfy the three sources of long-run housing demand—new household formation, demand for second homes, and replacement demand. This year, housing starts will drop below 1.0-million units (for the first time since 1945). Thus, on paper, it would take a year at current production levels to work off the excess supply. However, it will probably take longer than this because a rebound in housing starts over the next 12 months is likely.

Inventories may increase later this year because sales are dropping and foreclosures are rising. In June, the NAR reported the largest percentage drop in existing home sales in nine months. July and August's sales numbers also do not look promising, because of Fannie Mae and Freddie Mac's problems and because of recent drops in the Mortgage Bankers Association's weekly Purchase Index.

What this amounts to is that house prices will continue to fall. The decline in prices will likely to be greatest in the next few months. According to research by Professor Karl Case (co-creator of the Case-Shiller House Price index), prices are collapsing in a number of cities because banks are taking over foreclosed properties and are pricing them to sell. After the wave of foreclosures crests, banks will start dropping out as participants in the housing market and house prices will start to bottom out.

Our view is that prices are likely to drop another 10%, and that a rebound in prices will not take place until the middle of next year, if not later.