Sharp decline in home prices, increase in backlog/inventory of homebuilders, reduction in housing starts, leading listed players posing losses or reduction in profits. None of this is new, as this has been the case in the US housing market over the past three quarters. The question is, will this continue? And if yes, when will the prices reach the rock bottom? What can a typical retail investor expect in the near future?
First, let me try to explain what appears to have caused this. The growth in the new home markets between 2000 and 2005, were fuelled to a large extent by speculative buyers and to a lesser extent by baby-boomers buying their second houses. Driven by this demand, the average selling prices of leading homebuilders grew at a double digit rate over the past five years. Concurrently, sub-prime loans (high risk loans provided at a higher interest rate for people who have poor/relative less credit history) witnessed a sharp increase. According to Industry estimates, sub-prime loans accounted for a fifth of the 32 billion mortgage loan market in 2006. The availability of sub-prime loans also induced individuals with poor credit history to buy new homes. In the worst case scenario, these individuals were able to sell their homes and repay their debt. However, a steady increase in the interest rates (17 times in a row from 1% in June 2004 to 5.25% in August 2006) also in turn propelled the mortgage rates and the monthly installments. This slowly started increasing the defaults and delinquencies, as swelling mortgage payments hit the borrowers with spotty credit. In addition, the skyrocketing home prices slowly pushed the genuine homebuyers out of the market. By mid 2006, signs were pretty apparent that the homebuilding industry is going to witness a rough ride. And what followed suit is what we are seeing now – sub-prime fears sending the Dow spiraling down during the last few weeks, leading sub-prime home loan companies such as New Century Financial Corp. filing Chapter 11 (bankruptcy protection), and homebuilders missing earnings targets.
What's next?
Last week, the Federal Reserve lefts its benchmark short-term interest rate unchanged at 5.25%. In addition, Fed also indicated that it is not likely to lower the interest rates, given the ‘uncomfortably high’ core inflation (core inflation excludes volatile energy and food prices). If housing continues to remain week, Fed will be forced to ease the interest rates, as housing accounts for a sizeable portion of the GDP. Nonetheless, the probability of reduction in mortgage rates appears remote at the current juncture, given the Fed's stance. The sub-prime market crisis is expected to have a negative impact on the consumer spending and prolong the housing downturn. Further, home loan providers are also expected to tighten the loan standards, which in turn may result in a credit crunch for first time homebuyers.
Given this scenario, a genuine homebuyer should expect the housing prices to fall further in the next two quarters, as homebuilders will try to reduce their inventory levels. With home prices dropping 25% to 40% in the last three quarters, the reduction in housing prices may not be substantial, but can anywhere range between 5 to 10%. Additionally, he/she can also expect to get additional goodies such as kitchen upgrades. A typical retail level investor in homes should take advantage of the reduction in interest rates, if any, and lock themselves up at a fixed mortgage rate, instead of a variable (adjustable) rate. This will also help him/her to plan the finances betters, as the cash outflows will remain constant in this case.
The Indian Scenario – Prices will continue to surge
The Indian housing sector, unlike the American homebuilders industry, is fragmented, with unorganized segment accounting for over 90% of the industry. The supply-demand gap in the Indian housing industry is estimated at about 20 million homes. To a large extent, this is fueled by a young population (demographically), a steady surge in the per capita income levels, availability of financing, and attractive interest rates (despite a 3-4 percentage point increase in the interest rates over the past two years). This in turn continues to propel the property prices across India, particularly in the metropolitan cities such as Chennai, Mumbai and Delhi. Cities such as Hyderabad witnessed ballooning property prices (over 100% increases) during the past two years. The relaxation in FDI norms for the real estate segment also appears to have aided this growth, to an extent. Given the scenario, the probability of reduction in home prices in India, except in pockets (if there are any), appears to be remote at least for the next few years.
Madhan Gopalan
The author, based at Louisville, Kentucky, is a Global Equity Research Manager with Ness IBS, USA. The views expressed in this article are his and not that of his employer's. He can be reached at gmadhan72@yahoo.com
