GENERALLY FAVORABLE ECONOMIC AND FINANCIAL market conditions, together with price cuts and widespread use of non-price incentives by sellers, led to convincing stabilization of both gross and net (gross less cancellations) single-family home sales toward the end of 2006. Furthermore, standard measures of unsold housing inventory have shown some improvement in recent months.

Despite those favorable market signals, builders must realize that the single-family inventory overhang is a good bit larger than the standard measures portray and that the composition of the true inventory overhang has serious negative consequences for the housing supply-demand balance going forward.

THE CANCELLATION ISSUE When sales contracts on existing (previously owned) homes are cancelled, the homes generally are re-listed and thus reappear in measures of existing homes for sale (as they should). But when sales contracts on new homes are cancelled, the government's data system does not allow those homes back into the measures of new homes for sale. Nor do those homes get into the National Association of Realtors' measure of existing homes for sale. They simply fall though the measurement cracks!

The NAHB's survey of builders shows that cancellations of new-home sales increased dramatically from mid-2005 through the summer of 2006, particularly at large builders. And although cancellation volume began to taper down late last year, seasonally adjusted cancellation rates still were riding quite high as the year drew to a close.

The government says that 454,000 unsold new homes under construction or completed were in the hands of builders at the end of 2006, a five month's supply at the December sales pace. That's a historically high inventory overhang, but inclusion of the homes left with builders through cancellations would make the historical comparison much more serious—since the 2005–2006 run-up in cancellations was world-class.

THE VACANCY ISSUE Completed new homes for sale by builders (including those left with builders though cancellations) obviously are vacant units. In the market for existing previously owned homes, for-sale units typically are occupied at the time of listing. Thus, a sale of an existing home typically releases a household to purchase or rent another housing unit—a turnover process that represents vitality in the housing market and that generates the dominant source of demand for new homes. On the other hand, vacant existing homes for sale definitely worsen the supply-demand balance in the overall single-family market.

The number of vacant for-sale units in the existing housing stock has climbed considerably during the past two years, particularly in 2006. This is largely a legacy of the unprecedented surge in home buying by investors/speculators during the housing boom of 2004–2005. In fact, the Commerce Department reports that 1.554 million single-family homes were vacant and for-sale at the end of 2006, implying that 1.382 million were in the existing-housing stock—440,000 more than two years earlier.

THE OTHER SHOE? The current overhang of vacant homes for sale (new plus existing) may not be the end of the story. The single-family rental vacancy rate recently climbed to a record level, presumably reflecting difficulties being encountered by investors that are biding their time before reselling single-family homes back onto the markets.

It's hard to estimate the number of single-family rental units that will become for-sale units, or the time frames involved, but builders should listen for this shoe to drop. There's also the issue of competition from the multifamily condo market, where the number of vacant for-sale units (new and existing) has climbed even more dramatically than in the single-family market. Stay tuned!