By Joshua Steiner, Hedgeye
There has been some misguided housing buzz circulating around the idea that new
households will be sprouting up at a rapid clip this year. Some are even claiming that households will be cropping up at the fastest rate since 2007.
It’s true that household formation has been running below historical levels for the last several years. However, that doesn’t allow us to jump to the conclusion that we should be bullish on housing going forward.
Any prediction that household formation will pick up relies on the assumption that a strong increase in employment is on its way. And while last week’s jobs report, which said that non-farm payroll employment rose by 244,000 in April, is encouraging news, the job market is still very much recovering and by no means recovered.
We’re not suggesting that the employment situation can’t continue to get better — it can. But the employment situation must get a lot better for the optimistic household formation predictions to come to fruition.
A household is not a house
Newly formed households do not necessarily represent home buyers — in fact, it’s far more likely that people moving out of their parents’ basements will be renting an apartment, not buying a nice 3-bedroom.
Rather than looking solely at household formation, the relevant question for the housing market is how many households are moving from renting to buying (and vice versa), in addition to the number of new households being created. In other words, a new household doesn’t mean a new house, or even a house at all.
The national average of homeownership from 1967-1998 was 64.4%. Presidents Clinton and George W. Bush worked to encourage homeownership, and the rate got as high as 69.2% near the peak of the housing bubble.
Since then, the rate has gone back to 66.4%. Thus, returning to the long-term average (1967-1998) translates to 2.5 million households exiting homeownership. If the homeownership rate falls to 2 standard deviations below the long-term average — a rate of 63.1% — 4 million households would exit homeownership.
We estimate the total amount of “pent-up demand” in households — households that would have been created had the economy been stronger — at 4.8 million households. Applying the average homeownership rate to this group, the pent-up demand is made up of 3.1 million potential homeowners. So we’re looking at 3.1 million homeowners who should have entered the housing market against 2.5 – 4 million homeowners who have yet to leave it.
Another way of looking at this data is comparing the change in the number of homeowners to the change in number of households each year. As the following chart shows, there were more households entering ownership than new households being created during the bubble years, as might be expected.
Recently, households have been moving to renting; homeownership is in decline and will likely stay that way for some time.
Shadow inventory will create disenfranchised households
Shadow inventory, or foreclosed homes, is often referenced as a problem on the supply side of housing, and indeed it is. According to data from Lender Processing Services (LPS), there are 6.9 million houses in some stage of delinquency or default. Laurie Goodman of Amherst Securities has shown that the bulk of borrowers that have ever been delinquent are likely to liquidate.
But shadow inventory also represents a headwind to demand. Each of these 6.9 million homes contains a borrower in distress whose credit score is getting worse by the day. According to a recent report from the FICO banking analytics blog, a borrower’s FICO score falls 80-100 points as soon as they go beyond 30 days delinquency on a mortgage loan. If they liquidate, by foreclosure or short sale, or declare bankruptcy, their credit is hit a further 100+ points.
More to the point, if the borrower was considered creditworthy originally, their credit score won’t recover for 7 years or more. The bottom line is that a homeowner who goes through a foreclosure or short sale will be shut out of the mortgage market for many years. Keep in mind that the 6.9 million households in shadow inventory compares to just 3.1 million in “pent-up demand” for homeownership. If all of these households liquidate — and it’s likely that a great many of them will — the homeownership rate in America will fall to just 61%.
Pent up household demand won’t be enough
We understand the argument that household formation is pent up by weak economic conditions. We would agree that stronger employment statistics will likely be accompanied by a rebound in household formation. This will likely be a tailwind for the multifamily and rental markets, on the margin. However, we see several other headwinds for the housing market –particularly tightening mortgage credit and worsening creditworthiness among the borrower pool — more than offsetting the potential impact on homeownership.
