Hot Topics

Log the housing industry's extraordinary performance in 2005 ahead of 2004. Then put your record books away. Economists' projections for much of the past decade have underestimated home building activity, but most are certain that 2006 will mark a change of pace for the industry.

What's more, builders agree. They're not going so far as to lend credibility to the bubble theories, but they acknowledge that pricing power will diminish in the face of rising interest rates and energy prices, and they know they'll have to work to preserve margins while adjusting for higher materials costs.

Despite these near-certain challenges, 2006 looks to be a strong year for housing. Just how strong, though, will depend on questions that surface during almost every conversation about home building. Here, economists and builders share their thoughts on the hottest topics of the year.

Bottom line: The waves from “the three ugly sisters” will ripple through the economy throughout 2006.

The hurricanes hit months ago, but it's still too soon to accurately forecast how rebuilding will take shape. What's sure, though, is that the effort will increase pricing pressure on building materials—the costs of which already jumped in the immediate aftermath of the storms. Frank Nothaft, Freddie Mac's chief economist, estimates increases of 5 percent to 10 percent across all types of building materials.

Many of his peers agree. “Reconstruction efforts throughout the Gulf Coast area will increase demand for all the components of the building industry,” says Richard DeKaser, chief economist for National City Corp. He anticipates delays in getting products, followed by price declines later in the year as companies ramp up their production to meet demand.

NO MORE CHEAP MONEY: Nearly all economists believe after averaging 5.8 percent for three years running—2003, 2004, and 2005—for the first time since the mid-1960s, rates will continue to increase gradually, as seen toward the end of 2005. More buyers are opting for fixed-rate loans as the yield curve between fixed and adjustable rates narrows.

It might be difficult to believe after the price increases of wood products just after Katrina, but Henry Spelter of the U.S. Forest Service says there's good pricing news ahead. In the short term, lumber prices will come down as companies harvest the 19 billion board feet of timber knocked down in the hurricanes. Longer term, panel prices will stabilize as more than a dozen new OSB plants come on line by 2010.

“Prices will be less volatile, but don't kiss volatility goodbye,” says Spelter, who adds that prices will likely move within a $100 band, rather than the $200 or $300 of recent years.

The hurricanes' effect also will be felt through the year in building materials made from petroleum, including PVC pipe, asphalt shingles, and vinyl siding. In fact, that's the only group of products where Michele Halickman, a building materials analyst at Global Insight, doesn't expect price declines in 2006. She's forecasting a 15 percent price increase in 2006, after an 18 percent jump in 2005.

For other commodities, though, she says, “the worst is over.” Among the winners: steel, which saw prices fall sharply in 2005 as domestic production increased to meet demand. (For more information about other materials, see “Friendly Neighbors?” at right.)

It hasn't taken long for builders to feel the recent pinch. Kyle Dempsey, president of Alpharetta, Ga.–based Sivica Homes, says his OSB prices were up as much as 40 percent a month after Katrina, pricing for shingles and PVC has “gone crazy,” and he's being assessed fuel surcharges by vendors. “I'm concerned with pricing because I am committed to value,” he says. “As long as I can keep pumping out the volume, I can afford the margin pressure to ride this out.”

Bigger builders are relying on long-term relationships with their subcontractors and vendors to smooth any bumps. “We're in this together,” explains Antonio Mon, president of Technical Olympic USA. “The suppliers know we're there for the long run, and we take care of them by throwing all the business their way.” He credits those relationships with enabling his company, based in Hollywood, Fla., to receive cement even when other builders struggled in 2005.

Of course, the energy constraints that are sending materials prices higher are pinching consumers' wallets, too. Higher energy prices—including natural gas rates, which may be triple their levels of last winter—have the same effect on consumer spending as higher tax rates: They leave consumers with less money in their pockets. As Freddie Mac's Nothaft points out, consumer spending constitutes two-thirds of gross domestic product.

BUYER'S MARKET?: In some markets, 2006 may be a better time to buy as price appreciation slows. New-home sales were expected to set another record in 2005, and economists aren't projecting much of a drop-off in 2006.

Similar calculations have led most economists to bump up their projections of GDP growth for the first half of 2006. They're anticipating greater growth toward the middle of the year as rebuilding efforts gear up.

Bottom line: Not until after winter, unless gasoline prices continue to decline.

Consumers won't spend, because many feel pessimistic about their current and future financial health. But they were expressing those opinions in the late summer, even before Katrina.

Consumer confidence surveys by The Conference Board and the University of Michigan registered significant drops in consumer confidence following Katrina. The University of Michigan recorded its lowest reading in 13 years in October.

Ken Goldstein, an economist at The Conference Board, doesn't expect much of an improvement until consumers weather their winter heating bills. “It's going to feel like a recession, at least for a couple months. People are going to behave as if one's going on,” he warns. That translates, he says, into fewer people willing to make big-ticket purchases, such as cars and houses.

Builders' confidence has fluctuated a bit in the NAHB's monthly reading, but the group is largely bullish despite the consumer confidence readings. At a recent investor conference coordinated by UBS analyst Margaret Whelan, D.R. Horton president and CEO Don Tomnitz declared that 2006 will be an even better year for his company than 2005.

Even bears can see that reasoning. “It's hard not to be optimistic after the run home building has been on for the last 10 years,” says Mark Zandi, chief economist of Moody's Economy.com, who has been among the economists forecasting a decline in housing activity for several years.

Other builders concede that it will be difficult to top last year. “This is the beginning of the end of the housing bonanza,” David Hill, chairman of Kimball Hill Homes, told an audience at the BIG BUILDER '05 conference in November. “It will be good next year, but not as good as [2005].”

Bottom line: The Midwest and, depending on which economist you listen to, some coastal markets.

The old adage of location, location, location holds as true for builders as for home buyers. The Midwest, battered by the outflow of manufacturing jobs, was hit hard in 2005 by automakers' losses. Ford reported a third quarter loss of $284 million, while GM topped that with a decline of $1.6 billion, in part due to faltering demand for sport-utility vehicles.

FIRST-HALF FORCE: The hurricanes slowed the country's economic engine in the second half of 2005—though the growth rate continued to surprise pundits—but once the cleanup is done, rebuilding will stimulate faster-than-normal economic growth in 2006's first two quarters.

Then came the announcement of the bankruptcy of Troy, Mich.–based Delphi, the nation's largest auto parts supplier. Though reorganization plans haven't yet been publicized, thousands of Midwest-based workers may lose their jobs as plants are shuttered or moved.

“The Delphi bankruptcy will have a huge effect on the future of the southeastern Michigan economy,” says economist Patrick Anderson of Anderson Economic Group, based in Lansing, Mich. The filing will likely halt many move-up or second-home purchases, he says.

Some builders are anticipating the shock waves—Centex's Tim Eller says his company's worst markets in the coming year will be where cars are made—while others have been feeling the effects of the weak Midwest economy for years. Columbus, Ohio–based Dominion Homes' closings fell 8 percent in 2004, and new orders in 2005's third quarter were down 28 percent from the prior year.

Pinpointing other weak markets is tougher. Some of the cities cited most often in analysts' and economists' reports are also among those that have performed the strongest in recent years. Says Zandi, “Essentially all of California and Florida are overvalued. Washington, D.C., is the most juiced-up market, followed by Boston.”

Reports out of the nation's capital and Massachusetts indicate that Zandi may be right, as for-sale inventories have risen and prices have flattened. Public builders have been hurt by slowing sales in Washington, where NVR's orders fell 19 percent in the third quarter of 2005; Toll Brothers trimmed its projections for 2006 in part due to softness in the Mid-Atlantic region.

But others say the market fundamentals support continued—if slower—growth. In 2004, the District of Columbia, Maryland, and Virginia—the D.C. housing market—all registered higher per capita personal income levels than the national average, and according to the Bureau of Labor Statistics, Virginia and Florida are tied for the second-lowest unemployment rates nationwide, at 3.5 percent.

Bottom line: No.

Even those who decry bubble theories acknowledge that the days of double-digit price appreciation may be past. As he predicted a banner year in 2006, D.R. Horton's Tomnitz noted that pricing power will likely wane in the year ahead.

Most economists decline to rule out price decreases in individual markets, though they say factors such as severe job losses would need to be present. “There are regional markets at risk,” says David Berson, chief economist of Fannie Mae. “I would say the markets with the highest percentage of investors are at the greatest risk unless it's offset by job gains and income growth.”

BACKTRACK: At the NAHB's economic conference in October, Economy.com's Mark Zandi told the audience—many of whom had listened for several years to his predictions that the housing market would begin its decline—that his forecasts had underestimated housing activity for three reasons: stubborn interest rates, the surge in investor activity, and creative mortgage financing.

Extreme factors aren't needed, though, to bring home prices and household income back in line. Many economists predict a few years of flat or slightly increasing prices will do that. Currently, prices average about 3.2 times household income, a record high for that ratio, says David Wyss, chief economist for Standard & Poor's. “It seems to me that home prices have to come back down to their historical average [2.6 times income],” he says. “The adjustment process probably won't involve price declines unless there's a spike in the interest rates.”

The Federal Reserve has been on a measured campaign to rein in inflation and bring the Federal Funds target rate back to neutral—commonly estimated at about 4.5 percent—for more than a year. (At press time, the rate stood at 4 percent.) Ben Bernanke, the recently nominated successor to Fed chairman Alan Greenspan, says he'll pursue a similar course, which has helped raise adjustable mortgage rates.

Fixed mortgage rates have finally begun to fall in line with economists' expectations, after global investments helped hold down rates of the 10-year U.S. Treasury bond, to which long rates are tied.

David Seiders, the NAHB's chief economist, told a conference in mid-October that he had a “dogged insistence” that starts would begin to fade in 2005's fourth quarter, but he said that slowing would depend on where interest rates headed. At press time, Freddie Mac reported a 30-year fixed rate of 6.26 percent and a 1-year ARM rate of 5.16 percent.

Even with the multitude of mortgage products available today, economists say, the higher interest rates will reduce affordability and, therefore, builders' pricing power. “As a result, I think that will put the brakes on a five-year series of records in overall home demand,” says National City's DeKaser. “[The year] 2006 is going to be a down year for the housing market.”

Bottom line: Signs point to yes.

At Seiders' October conference, economists cited their beliefs that long-term interest rates would rise as their reasoning for underestimating housing activity during the past several years. Now that those rates have started to move northward, they're more confident that their projections will be closer to reality. “We all agree there is something unsustainable going on out there,” Seiders says.

Some also have begun to agree that the market peaked in the weeks after Katrina. Some metrics, such as the Mortgage Bankers Association's index of purchase applications, seem to indicate that demand is slowing, but others, including new-home sales data, show no weakness.

Perhaps it's a question whose answer will become clearer as the calendar's months turn.

Builders encourage the United States to end tariffs against Canadian lumber and Mexican cement.

In his testimony before the U.S. House Committee on Financial Services after Hurricane Katrina struck, NAHB president Dave Wilson urged the government to lift the duties and tariffs imposed on Canadian lumber and Mexican cement to ease the supply crunch expected to accompany rebuilding efforts.

Builders in parts of 32 states continue to lack adequate supplies of cement. It looks as though there may be help coming on that front: Preliminary discussions to reduce tariffs on Mexican cement from 54 percent to 40 percent were under way this past fall, Global Insight's Michele Halickman told an NAHB economic conference in October, and a final decision was expected by December. Nevertheless, she said, pricing and shortages will ease in 2006 and 2007, as the United States will be able to supply more of its own inventory as domestic producers step up output.

There's less success with America's northern neighbor. The United States imposed tariffs and antidumping duties of more than 20 percent on Canadian softwood lumber in 2002. Though panels assembled under the North American Free Trade Agreement have consistently ruled against the U.S. tariffs, the government has declined to lift them, and in late October the U.S. Commerce Department asked for an extension to clarify the latest ruling. The good news: Prices will likely decline in 2006 anyway.