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98.6 Degrees

Chief Economist Frank E. NothaftThe U.S. housing market is healing, but how will we know when it's actually "healthy"? Let's use an analogy and say the patient – in this case, the housing market – was running an alarmingly high fever of 103 degrees in 2006, at the height of the boom. The patient collapsed and, after a difficult period of convalescence, now seems to be getting better. Housing starts, sales, and prices are rising, delinquencies and foreclosure inventories are trending down. The question is: What does a national housing market look like at a healthy 98.6 degrees?

To deliver the right prognosis, we need to compare the current housing market to the years before the housing peak, but not the peak itself. Let's start by reviewing the latest data on the market's condition.

Both the S&P/Case-Shiller 20-city and Federal Housing Finance Agency's purchase-only house price indexes have shown seven consecutive months of positive gains through August on a seasonally-adjusted basis. Freddie Mac's own house price index was up 4 percent in September over the same month in 2011. Residential construction was up over 26 percent in the first nine months of this year compared to the same time last year. Home sales were at a rate of almost five million units for the first nine months of 2012, a 9 percent increase from the same period a year ago, and the homeowner and rental vacancy rates have declined to 1.9 percent and 8.6 percent, respectively, in the third quarter of this year. On the surface, the housing numbers are looking better and trending in a healing direction.

Nonetheless, with the unemployment rate remaining in the high 7-percent area and family-income growth modest, housing demand has remained subdued, as has a principal driver: the pace of household formations. Household growth was running at an annual rate of 0.5 percent over 2007-2011, which was less than one-half the 1990-2006 average of 1.2 percent per year. However, over the past four quarters, it has returned to a 1 percent growth rate, or an increase of about 1.15 million households over the past year.

Our diagnosis of a healthy market will also have to take into account demographic shifts among both "Generation Y" and the "Baby Boomers" that are having a profound impact on the housing market. Generation Y's appear to be staying at their parents' homes longer and delaying both household formation and home purchase, based on a recent study by the Federal Reserve Bank of Cleveland. Baby Boomers are now looking at not only the younger generation living with them, but also their own retirement. Fewer are likely to be move-up buyers and may delay a move to a retirement home. Additionally, while the number of foreclosures continues to decline year over year, and the industry's seriously delinquent rate is down to 7.3 percent, both still remain elevated. If we put these additional factors into play, what a healthy housing market should look like will dismay those who keep comparing housing to its peak years of 2004-2006.

Our most recent Economic and Housing Market Outlook provides a near-term view; however, if we look at long-term trends, here's what a healthy housing market should look like in the next five years:

  • Housing starts increasing to about 1.8 million dwellings per year (compared with 2.1 million in 2005)
  • Home sales increasing to about 5 percent of the housing stock, or about 6.5 to 7.0 million homes per year (compared with sales of 7 percent of the stock in 2005)
  • U.S. house price appreciation rising gradually to about 3 percent per year (compared to 11 percent in 2005)
  • Vacancy rates easing further to about 1.7 percent on for-sale homes and 8 percent for rental homes (down from peaks of about 3 percent in 2008 and 11 percent in 2009, respectively)
  • Serious delinquency rates nearing 2 percent (down from a peak of 9.5 percent in early 2010)

To sum up: taking into account recent trends, key housing indicators, and the shifting demographic patterns that will define a new and realistic trajectory toward a healthy housing market, the long-term prognosis is promising. In the immediate future, however, the market's recovery will be tempered by continued high unemployment, modest income growth, and a subdued pace of household formations. In other words, the patient is on the way back to health, but don't expect the housing market to wake up to 98.6 degrees tomorrow morning.


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