“There is no sector of America’s economy that is more cyclical than housing. If it is pushed down far enough and long enough, as it was in the post-2008 housing depression, it will eventually snap back to levels that exceed historical norms. That turn in the market is occurring now and it should become a boom by 2015. It will be powerful enough, together with rising oil and gas production and other factors, to lift the entire US economy. Indeed, the resultant US economic growth rate may be higher than the Federal Reserve’s long-term forecast of 2-2.5%.
This surge will be driven by a combination of improving house prices, a lower inventory of homes for sale, rising rates of household formation and population growth, and improving access to mortgage credit. Together, they should push residential investment, which includes both new construction and remodellings, to annual growth of 15-20 per cent during the next five years. This alone may contribute 1-2 percentage points to annual growth in gross domestic product and up to 4m jobs over that period.
It is the depth of housing’s fall that has laid the foundation for this. And it is hard to exaggerate how deep that was. Single family housing starts, for example, averaged 1.4m annually during the 2000-04 period, before the bubble. After it, they plunged to an average annual rate of 500,000 and stayed there. New home sales, which previously averaged 900,000 a year, fell to a third of that. And residential investment, which averaged 4 per cent of US GDP over the 25 years ending in 2005, has accounted for only 2.5 per cent of it since 2008.
Now, however, the cycle is upward, starting with prices. The S&P/Case-Shiller Composite 20 City Home Price index has risen 8 per cent since March. Indeed, Barclays has projected that, by 2015, nominal home prices will exceed their 2006 peak. Home affordability is also way up, as the ratio of mortgage payments to both income and rents has never been more favorable. Moreover, the relationship of home prices to household income is back to the level of 30 years ago. Rising prices and affordability, of course, lead directly to the buying and building of homes.
Second, the levels of relevant supply have fallen sharply. The number of homes for sale has fallen back to its long-term average of 2m. Yes, there is a larger “shadow inventory” of homes that are in foreclosure or carry delinquent or defaulted mortgages. However, many of these are distressed, in that they have not been physically maintained. This means that the supply has become two-tiered – quality homes and distressed homes. For most buyers, only the first of these two markets is relevant and the supply there is approaching its lowest level since 1992.
Third, housing demand is going to be strong, driven by demographics. The International Monetary Fund forecasts that the US population will increase by 15m during the 2012-17 period, more than the increase of the past five years. The two groups of the population that are growing fastest are the over-55s and the so-called echo boomers, the grandchildren of the baby-boom generation. The first group has the highest rate of home ownership. The second has been renting disproportionately, and is primed to start buying. JPMorgan estimates that 6m new units of housing are needed by 2017 just to serve the bigger population.
Then there is the coming recovery in household formation. According to JPMorgan, this rate was steady at about 1.4m annually from 1958 up to 2007. But, it plunged below 500,000 for the three years following the financial crisis, as young people moved in together or lived with parents. Now it has doubled from that level and estimates of pent-up households are at an all-time high. Most expect formation rates to rise much further still, exceeding the 50-year average for a few years.
Finally, the availability of mortgage credit is starting to improve. Underwriting standards tightened sharply following 2008 and the proportion of home sales that are financed by new mortgages is now at a 10-year low. However, household finances have improved sharply, with debt service ratios returning to pre-crisis levels. Moreover, banks also need the income from originating mortgages. Mortgage credit availability is therefore opening up, which also boosts home sales.
For now, the stubborn economic headwinds that began in 2008 continue to suppress US growth, which crawled along at a rate of only 1.7 per cent rate for the first half of 2012. While it may take the best part of two years for these headwinds to die, the stage is being set for a strong economic recovery beyond that. And the housing boom will be its biggest driver.”
To be clear, that number of “distressed” homes is still daunting, to say the least: According to the “The State of the Nation’s Housing 2012,” a study from Harvard University, this includes roughly 2 million foreclosures, and another 11 million homeowners who are underwater (owe more on their mortgages than what their homes are worth). However, when I read Altman’s piece, I felt a sense of enthusiasm (albeit reserved) for what that means for one company as we look onto the years ahead: Berkshire Hathaway (BRK.A)( BRK.B). While he was early with his prediction, here’s what Warren Buffett had to say about housing in the 2011 shareholder letter:
"Last year, I told you that 'a housing recovery will probably begin within a year or so.' I was dead wrong. We have five businesses whose results are significantly influenced by housing activity. The connection is direct at Clayton Homes, which is the largest producer of homes in the country, accounting for about 7% of those constructed during 2011.
Additionally, Acme Brick, Shaw (carpet), Johns Manville (insulation) and MiTek (building products, primarily connector plates used in roofing) are all materially affected by construction activity. In aggregate, our five housing-related companies had pre-tax profits of $513 million in 2011. That’s similar to 2010 but down from $1.8 billion in 2006.
Housing will come back – you can be sure of that. Over time, the number of housing units necessarily matches the number of households (after allowing for a normal level of vacancies). For a period of years prior to 2008, however, America added more housing units than households. Inevitably, we ended up with far too many units and the bubble popped with a violence that shook the entire economy. That created still another problem for housing: Early in a recession, household formations slow, and in 2009 the decrease was dramatic.
That devastating supply/demand equation is now reversed: Every day we are creating more households than housing units. People may postpone hitching up during uncertain times, but eventually hormones take over. And while 'doubling-up' may be the initial reaction of some during a recession, living with in-laws can quickly lose its allure. At our current annual pace of 600,000 housing starts – considerably less than the number of new households being formed – buyers and renters are sopping up what’s left of the old oversupply. (This process will run its course at different rates around the country; the supply-demand situation varies widely by locale.) While this healing takes place, however, our housing-related companies sputter, employing only 43,315 people compared to 58,769 in 2006. This hugely important sector of the economy, which includes not only construction but everything that feeds off of it, remains in a depression of its own. I believe this is the major reason a recovery in employment has so severely lagged the steady and substantial comeback we have seen in almost all other sectors of our economy.
Wise monetary and fiscal policies play an important role in tempering recessions, but these tools don’t create households nor eliminate excess housing units. Fortunately, demographics and our market system will restore the needed balance – probably before long. When that day comes, we will again build one million or more residential units annually. I believe pundits will be surprised at how far unemployment drops once that happens. They will then reawake to what has been true since 1776: America’s best days lie ahead.”
To put this discussion into some context, Berkshire Hathaway’s operating businesses collectively earned $15.3 billion in pre-tax income in 2011; as such, the $1.3 billion drop off in pre-tax profits from the housing-related companies mentioned over the past five years actually appears quite material to underlying profitability at Berkshire.
While far from perfect (due to the slew of other businesses that fall under this heading), a look at Manufacturing, Service and Retailing net earnings provides an interesting look at how this piece of the businesses has been affected by the housing collapse:
The year 2011 includes about $291 million of earnings from Lubrizol, which affects comparability; after backing that out, 2011 earnings were roughly $2.75 billion – resulting in a five-year CAGR of 5.2%. The mid-single-digit growth rate despite the weakness in housing is due to solid results at McLane, Iscar and Marmon (to name a few), summed up by Buffett in the shareholder letter:
“The four housing-related companies in this section (a group that excludes Clayton, which is carried under Finance and Financial Products) had aggregate pre-tax earnings of $227 million in 2009, $362 million in 2010 and $359 million in 2011. If you subtract these earnings from those in the combined statement, you will see that our multiple and diverse non-housing operations earned $1,831 million in 2009, $3,912 million in 2010 and $4,678 million [pre-tax] in 2011.”
Weakness in itself isn’t a reason to become optimistic but as made clear by Altman and noted by Buffett, “Housing will come back – you can be sure of that.” And when it does, Berkshire will benefit in a material way, further boosting a company that’s already firing on all cylinders and prepared for continued growth for years beyond the era of Buffett and Munger (though I certainly hope they both stay with us for a long, long time).
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About the author:
I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.