Recovery Cycle: Three Scenarios For New-home Economics

Five-Year Growth Rate Chart

Pent-Up Supply Chart

Sales Figures Chart

Ever since the first economist stumbled upon the theory of supply and demand (it was actually the 19th century French economist Antoine Augustin Cournot who did so), business has been conducted largely through the attempt to achieve balance between the two. When the two are in balance, the market is said to be in equilibrium. This is not the ideal situation from the business owner's point of view, but it is at the least orderly. It is to the business owner's advantage to limit supply enough to drive demand to slightly outstrip supply. That allows for the raising of prices and profit margins. The wild card in the supply/demand equation is thus scarcity. Scarcity can be good for business, as in when there are more buyers chasing goods then there are goods. But it also can be bad for business, as in when goods are too scarce businesses cannot make enough to satisfy demand.

That is what appeared to have happened in the housing boom of the mid-oughts. The problem, however, was that the demand, which created the necessary scarcity, was an illusion. It was created, as most things are, by politicians and bureaucrats who decided at the dawn of the new millennium to allow consumer indebtedness to buoy the U.S. economy. What better way than through homeownership; there is no better way to get consumers to spend a whole lot of money. The homeownership continuum expanded its base and drew forward hundreds of thousands buyers who otherwise might have taken years more to be ready to own their own homes. This new "demand," supported by loan terms previously unheard of in the world of home finance, rippled up the housing chain, eventually igniting a fever of speculative residential real estate activity that actually pulled retail money out of stocks and bonds in favor of homes to buy and sell.

The home building business responded by mortgaging its future, in a sense. True, margins ballooned as land value increased from the moment of purchase to the moment of delivery, often by double-digits. No amount of volume capacity seemed to be sufficient to meet the needs of buyers who were coming out of the woodwork to get their share of the appreciation game.

Everyone suspected the rate of growth was unsustainable. What everyone didn't know was just how much the market had swelled from home buyers who either didn't really have the means to pay for their homes or didn't have the intention of doing anything more than flip the house for a profit. The demand, therefore, created a false scarcity. Tomorrow's buyers bought yesterday, meaning they would not be buying again anytime soon, even if they managed to stay afloat financially. Speculators were not demand at all, just gamblers playing a market.

Hence, housing's paralysis. Where there's no scarcity, there's little to motivate anyone to move, period.

This is the second of a three-part analysis that explores scenarios for the road to an eventual housing market recovery. The first part, "Pent-up Demand: Myth or Reality," in the June 8th issue, assumed the possibility that as time passed, demand would grow, which, in turn, would lead to a tailwind sooner than later. Our second piece, "Head Winds Be Damned," assumes relative economic stability as an environment for a plodding, workmanlike, path to recovery. Next month, we consider even more challenging circumstances, as suggestions that a broad economic recession may at least be a possible factor to contend with ahead.

Chicago's a tough town to start up a home building enterprise under the best of circumstances. Up cycle or down, Carl Sandburg's "City of Big Shoulders" has exacted more than its fair share of big builder casualties through the years.

So why has home building veteran Ron Benach chosen now to re-enter the Windy City? The litany of hostile conditions is long and lengthening. As it battles a fundamental demographic ebb that afflicts many old-line Rust Belt metropolitan areas, Chicagoland also has 33 months of inventory overhang at the current annualized sales rate; a 32 percent drop in sales from the high times seen in April 2005; a growing list of distressed players in the arena; and, perhaps, most unsettling of all, a moribund home-buyer mentality. Yet, Benach, founder of Lexington Homes, will open six urban infill communities by year-end (See "Chi-Town Come Back," on page 30).

In four decades, Benach has started up, grown, taken public, and then sold, three separate home building operations, starting with 3H Development, a company he founded in the late 1960s. In other words, adverse market conditions and he coil together like strands of the same DNA molecule.

Pragmatically, he estimates that roughly 30 percent of the 2004 buyer market was mere fantasy. Oversupply exists, he says, because investors and buyers who shouldn't have qualified for loans inflated demand.

But Benach operates in the here-and-now. He assumes there is no magic formula, nor a secret sauce that will make the current market taste any better. To survive, and hopefully thrive, pure elbow grease is what it will take.

"This is going to be a tough year for a lot of people," says Benach. "Next year could, too. All the inventory has to get worked down and the system has to digest it. You can't hurry it, and we know that. We just have to suffer through it."

Suffer indeed. At the end of the year's first quarter, the National Association of Realtors reported that 3.7 million existing homes were available for sale, and standing inventory for new homes added another 545,000 units–more than an eight month supply–to the glut of for-sale inventory. As if dealing with the after-effects of the last two years' over building weren't enough, the byproduct of recent credit deterioration may add another 20 percent of homes to the inventory levels starting as early as this summer.