The months' supply of existing housing inventory has fallen to less
than 10 months in January and February after being in the double digits
for most of 2008. The months' supply of newly constructed homes, by
contrast, moved up past 12 months in January and February after
bouncing around in the 10 to 11 months range last year. In more normal
years inventory would be around a 6 to 7 months' supply. The months'
supply measure is widely cited and used to assess housing market
conditions. However, there is a lot of fuzziness in what exactly
constitutes excess housing inventory. Let's review in detail.

Raw Count

Let's start with how many homes are listed for sale. At the end of
February, there were 3.8 million homes listed for sale in the multiple
listing services (based on sample survey and extrapolations). Anyone
who has browsed through the Realtor.com web site in search for a home
knows that there are at times duplicate listings, so on occasion some
homes are getting double-counted. But as long as this double-counting
issue is roughly similar month after month, then the trend would
indicate a genuine shift in inventory changes. Some homes which may
have already attracted contracts should be listed off, but there could
be a delay in indicating as such. But again, as long as the frequency
of the occurrence is consistent then there will be no worries in
interpreting the trend. However, the recent rise in short-sales
activity, which only became prevalent in the past year, may be leading
to increases in delays in marking homes as under contract in cases
where a buyer has submitted a bid. REALTORS® say that short sale
process takes way too long for banks to give their decisions and so
REALTORS® continue to list some of the properties as available even
after receiving a buyer contract. In such cases, the inventory count is
being overstated.

Another source of error is the possibility of counting rental
inventory. Some multiple property owners, who in normal times would
like to sell a property, may in the current very difficult selling
environment decide to rent it out instead. Is the rental inventory
listed on the MLS being counted in the inventory of homes for sale?
After a data query of inventory, we found that less than one percent of
inventory had a price of under $10,000. That assures rental inventories
are getting filtered out when MLSs send the data to NAR. There are some
homes in Detroit and Cleveland where properties can be bought for less
than a price of a car and these homes are likely the ones showing up
with inventory price tag of less than $10,000.

The raw count again is at 3.8 million for existing homes, which is
down from 4.6 million in July of 2008. There is a normal upturn in
inventory count every spring and early summer, so expect some rise in
existing home inventory in the upcoming months; though the raw counts
should be consistently lower this year than from a comparable period
one year ago, if some turnaround in home sales occurs.

For new homes, the raw count was 325,000 in February. That is a
decline of 57 percent from a peak of 570,000 in mid-2006. Because
homebuilders have been cutting down on production, there are very few
new inventories being added. The months' supply remains high, however,
because the sales pace of new home is very low. But if the sales pace
picks up, then the months' supply will quickly shrink.

A big unknown is the shadow inventory. Some foreclosed properties
may not be listed in MLSs. We do not have good information about
properties for sale outside of MLSs. Also, some banks may be holding
off REO properties off the market in the hopes of getting a better
price later, or in the hopes of not flooding the market with REOs. I
cannot say if this strategy will pay off, but I have heard this is
taking place in some markets.

Vacant Units

When someone sells an existing home, that person will most likely be
a buyer of another home. Therefore, the home listing is not an increase
in supply, but rather a wash. The supply and demand is increased at the
same time. But a distressed homeowner needs to sell and cannot buy a
home. Therefore, the inventory addition is an increase in supply
without an increase in demand. Likewise if an investor property owner
wants to cash-out with funds going into the stock market or other
non-real estate investment vehicle. Given that we have increased
incidences of distressed sales, it is likely that we are getting supply
increases without an equal demand increase. This implies an increase in
vacant home inventory. The picture of investors is unclear at the
moment. Though investor home purchases fell by a larger amount than
primary residence buyers in 2008, there may be more investors entering
now than investors leaving. Home sales have been spiking in areas with
deep plunging home prices such that rental income generates a good
positive cash flow. In addition to rental investors who could be
raising demand without an increase in supply, first-time buyers with
their pure demand are eating into some vacant homes. A NAR survey of
REALTORS® about their most recent transaction indicated a larger
percentage of first-time buyers than in normal times.

Some transactions are a wash, while others raise or decrease
inventory. So what is the situation of vacant homes? The Census Bureau
collects information on vacant property on a quarterly basis. The most
recent data is as of fourth quarter 2008, and there were 2.23 million
vacant homes listed for sale. Prior to 2000, when most people would say
the housing market was normal and not that interesting, the figure had
been bouncing around close to 1.1 million units. Therefore, one can
deduce that we have an oversupply of vacant homes - in excess of one
million units. Be mindful that the Census sampling for vacant home
count is quite limited so it is subject to a larger sampling error.
Still, the one million excess vacant homes plus-or-minus sampling
errors imply continuing large supply conditions. One comforting point
is that the vacant home count has been leveling off in 2007 and 2008,
essentially stuck at the 2.2 million mark. It had dramatically
increased in 2005 and 2006. A decline is needed in 2009 to get us into
home price stabilization.

New Home Construction

Another way to judge how close we are to reaching housing inventory
equilibrium is to examine whether or not we are producing enough
housing units to keep up with new household formation. It is a given
that the U.S. population grows by about 3 million each year. At 2.4
persons per household, the population growth translates into about 1.25
million new household formations (those needing a housing unit - be it
a rental or owner occupied) each year. In fact, household formation
averaged 1.24 million a year from 1960 to 2008.

In order to house the new people the country needs to add at least
by the number of new households. Historically, housing starts averaged
1.5 million each year from 1960 to 2000. (I purposely am not counting
the post-2000 period of abnormal boom and bust years.) The country
consistently added more housing units than households by 250,000 each
year. That is not a surplus. Rather, that extra production is to
account for demolitions and demand for second homes. Assuming there is
no second home demand, the 250,000 would be the new production needed
just to replace old demolished units and keep the housing stock steady.
The 250,000 demolition rate is in fact quite conservative, because
given the nation's 130 million housing stock, the demolition rate
implies a depreciation rate of 0.2 percent. The IRS permits a property
depreciation rate of about 3 percent, which translates into property
obsolescence in about 30 years. The point is only to illustrate that
the demolition rate assumption of 250,000 per year is quite
conservative. It could in fact be closer to 500,000, but no data on
demolition is available, at least to my knowledge.

Assuming 250,000 in demolition activity, then how much of an
overhang in overproduction during the boom years still remains? Here's
the math:

 

Housing Starts

(million units)

Demolition

(million units)

Household formation

(historical average in millions)

Cumulative Surplus from 2000

(million units)

2000

1.570

0.25

1.25

0.70

2001

1.601

0.25

1.25

0.171

2002

1.710

0.25

1.25

0.381

2003

1.854

0.25

1.25

0.735

2004

1.950

0.25

1.25

1.185

2005

2.073

0.25

1.25

1.758

2006

1.812

0.25

1.25

2.070

2007

1.341

0.25

1.25

1.911

2008

.903

0.25

1.25

1.314

2009

.500

0.25

1.25

0.314

 

The table above shows that over-production of new homes during the
boom years led to too many homes in relation to household formation.
For example, the cumulative surplus from 2000 to 2006 was 2 million. In
other words, we had 2 million too many homes in 2006. A rise in second
home purchases, which is a rise in housing demand without a household
formation, can lead to absorption of those over supplied homes. That in
fact happened during the boom years when second home purchases went
through the roof, but those same second homes may be reaching the
inventory as evidenced by sharp rises in foreclosures on investor
homes. So the second home demand could have been a wash over the boom
and bust cycle - neither adding nor subtracting in cumulative sense
over these years, which then says that the above table analysis is
meaningful.

Builders have pulled back sharply from 2007. That is helping to trim
away the surplus homes. If the projection of housing starts of 500,000
holds for 2009, then we will be in essence returning to equilibrium by
the year's end. If production continues to remain low in 2010, then we
could be encountering a shortage situation once the economy gets back
on track.

If we assume less conservative demolition activity of 350,000 each year, then we have the following situation.

 

Housing Starts

(million units)

Demolition

(million units)

Household formation

(historical average in millions)

Cumulative Surplus from 2000

(million units)

2000

1.570

0.35

1.25

-0.030

2001

1.601

0.35

1.25

-0.029

2002

1.710

0.35

1.25

0.081

2003

1.854

0.35

1.25

0.335

2004

1.950

0.35

1.25

0.685

2005

2.073

0.35

1.25

1.158

2006

1.812

0.35

1.25

1370

2007

1.341

0.35

1.25

1.111

2008

.903

0.35

1.25

0.414

2009

.500

0.35