If the economy slides into recession, will it be because of the housing downturn? Conversely, if the housing market crashes completely, will it be because of the economy? Or both? This third installment of Big Builder's series on economic scenarios for the coming months examines the relationship between housing and the overall economy. Not surprisingly, they are linked, but the conundrum is that there is no precedent for the current state of affairs. Never before has housing fallen as far and as fast as it has while the economy was growing. Still, given the magnitude of the decline in new-home sales, pricing, and starts, there is no question that things will worsen considerably if the national economy tanks. The impact on builders would vary. Among the big publics, which account for some 35 percent of the home building market, the well-managed builders could probably weather the storm, continuing to shrink balance sheets, and methodically work off inventory and landholdings. The less-well managed could face trouble; the more land they impair, the more they erode equity, the book value of the company, and thus the stock price, making them acquisition targets, at best. Up against loan covenant triggers, they could not prop up their stock prices with buyback programs. No one would lend them money. Bankruptcies could result. Among private builders, those with too much debt would go under, as they always do in recessions. Some already have. Most builders will continue or accelerate their orderly withdrawal from unappealing markets and just get smaller. And pray that the recession is short and mild.
It's hard to believe, but Columbus, Ohio, was once a robust home building market. As the state capital, it was considered somewhat recession-proof. Infused with government jobs as well as financial and university-driven employment, the local economy was thought to be well-diversified and not solely dependant on its manufacturing base.
For years, the price for entry-level homes climbed steadily until, at the beginning of this decade, homes selling for under $175,000 became rare, if they could be found at all. It was then that the law of supply and demand played nicely into the hands of entrenched home builders such as Dominion Homes, Centex Corp., and M/I Homes, which each offered a neotraditional product line that included rear-loaded garages on small lots, the latter the result of a relaxation of zoning laws.
Quickly, developments sprung up. Pricing dropped to as low as $135,000, nearly $50,000 less than the market had seen for several years. Apartment renters were lured into homeownership. By 2003, permits hit a historic high of 12,117, and starts surged from 6,000 to more than 10,000.
Builders in Columbus, Ohio, were about to become victims of their own success.
In 2004, the local economy took a hit. Manufacturing was depressed, shake-ups at corporate headquarters such as Wendy's and Nationwide led to job losses. Compounding the problem was a state-tax system criticized as inefficient, and there was no economic development plan to attract new jobs. A sagging economy and no demographic growth continued to depress the Ohio market over the next couple of years, compounded in the last year by the current national slowdown.
Hindsight being 20/20, its clear today that builders drained the demand pool by buying forward in the market. Then, however, it seemed as though the surge would continue forever. So local builders inventoried land, developed and inventoried lots, and they built and inventoried spec homes. Along the way, entry-level pricing, of course, crept back up.
Today, central Ohio's economic growth is one-third that of the national average.
For home builders in Columbus, the spigot has been shut, and market experts see no sign of a turnaround in the foreseeable future. Market share leaders such as locally based M/I Homes and Dominion Homes both report that sales have dropped by more than a third in the last year–on top of two tenuous prior years.
Citing tough market conditions, Centex says that after more than 20 years, it is leaving the Columbus marketplace. "The company is not investing any future capital in Columbus," says company spokesperson Eric Bruner. "We have evaluated the changing conditions in the home building industry and concluded that we have greater opportunities to execute our future growth strategy by redeploying resources to other operations."
"It's difficult to determine when things might come back," says Jim Hilz, executive director of the Building Industry Association of Central Ohio. "There isn't anything to point to that will bring a big upswing in job, population, or economic growth."
The New Economy
Unlike conditions in Columbus, a stable economy has served as the anomalous factor–and saving grace–in the national housing market correction and sub-prime meltdown.
In today's environment, most builders are blocking and tackling, taking on a defensive operating strategy. The thinking is that by right-sizing their operations–being vigilant about managing expenses, improving the balance sheet, and reducing landholdings–managers can put their companies in position to weather the current cycle.
But what if it's not enough to pare back where possible and focus on the elusive pockets of demand? What happens if uncontrollable forces–increasing interest rates, stalling job growth, or rising unemployment–kick into motion as a result of the housing slump and eventually prey on the national economy?
Once builders reveled in markets that maintained strength in defiance of the cycle, but today they are no longer holding them up as a beacon of sustained hope for recovery. "There's no point in sitting around and just talking about Charlotte, N.C., and Raleigh, N.C., all day because, you know, most markets aren't like that," says Robert Schottenstein, chairman and CEO of M/I Homes. "They've held up well, but the question is, 'Will things start to get tougher there?' I believe they will. Then, the question is: When demand returns, at what price? Where will margins be?"
During early July, when this article went to press, a host of reports from economists, financial wizards, and market experts were laced with gloom. Inventory overhang remains the biggest concern in housing, with nearly nine-month's supply of existing single-family homes on the market–the most in 15 years. Job creation was slowing, and the construction sector specifically, which was formerly a crucial driver for stronger job creation, added no new jobs in May, usually an active month. In addition, 30-year mortgage rates, which at the end of May averaged 6.37 percent, rose further to an average 6.74 percent in June, according to Freddie Mac. By early July, there was increased economist chatter over inflation.
"It's beginning to look to me like '08 may be a very tough year, too," concedes Schottenstein. "Maybe a tougher year than '07. I know you can't paint every market with the same brush, but, I really don't think that things are going to begin to improve much in most markets now until '09."
Closer To Home
Historically, housing corrections have been regionally focused, with booms and busts showing up in certain regions for economic reasons. The surging global oil prices of the 1970s drove an economic boom in the oil patch. But when the industry crashed in the early 1980s, local economies tumbled with it, severely affecting the housing market. From 1983?1988, nominal home prices in Houston dropped 22 percent, according to the Office of Federal Housing Enterprise Oversight. Smaller markets with an oil-related economy were hit even harder: Lafayette, La.'s home prices plummeted by 40 percent.
In the decade that followed, the S&L scandal, a tumble in commercial real estate, the collapse of the junk-bond market, and military downsizing resulted in the recession of 1990?1991. The recession led to a sharp decline in the housing market along both coasts. In areas of Southern California, home prices tumbled 19 percent from 1993–1998 while, during the same period, Hartford, Conn., saw prices fall roughly 17 percent.
Although the industry has matured, and companies have diversified their geographic mix, home building remains a local business and so, when there is a downturn, it affects a local economy. But eventually, the accumulation of locally impacted economies becomes big enough to affect the national economy.
On June 5, Federal Reserve chairman Ben Bernanke addressed the 2007 International Monetary Conference in Cape Town, South Africa, and spoke directly on the affect of the U.S. housing market in the global economy. Despite the fact that the U.S. economy is expected to continue to expand below its average trend rate of 2 percent, Bernanke said he remained optimistic, if cautious, regarding housing. "The adjustment in the housing sector is still ongoing, and the slowdown in residential construction now appears likely to remain a drag on economic growth for somewhat longer than previously expected," said Bernanke. "Thus far, however, we have not seen major spillovers from housing onto other sectors of the economy."
Some see things differently. Citing stalled retail and auto sales in late June, UCLA Anderson Forecast senior economist David Shulman made this statement with the release of his quarterly forecast. "We suspect that the weakness in the housing market is finally spilling over into consumption spending. This is not a recession, but it is certainly close."
John Mauldin of Millennium Wave Advisors agrees. "In this [housing] cycle, I think we're going to see something that's different than normal. Normally, the economy goes into recession and housing suffers. This time, I think the housing market is going to be what puts us into a mild recession," he says. "If not a mild recession, it's going to be close enough that it'll hurt like one."
Although most agree that the weakness in the housing sector has become a drag on the national economy, it's unclear when it could reach the point where it can sink the national economy.
In the stock market, what constitutes a crash is clear–market experts concur that a 10 percent decline in a major index is a correction and 20 percent decline is a crash, depending on how quickly it happens. For the macroeconomy, recession means two consecutive quarters of declining gross domestic product (GDP).
But when it comes to a housing recession, there is no precise formula for determining a crash. Tim Sullivan, president of Sullivan Group Advisors, speculates the tipping point for housing is truly when the "downturn virus" becomes so prominent in a majority of markets that it's responsible for creating job losses, increasing buyers' fear, dropping demand, inceasing supply, and then eroding prices. By that definition, we're there.
But applying that housing drag to the macroeconomic picture is tricky. One of the challenges in calling a recession is that they are never actually benchmarked as they are happening. They only get called in hindsight, when enough quarters are visible in the rearview mirror to pinpoint when the GDP rebounded and a top and bottom are clear. (Visit the National Bureau of Economic Research's Web site to see how the Business Cycle Dating Committee pinpoints recessions: www.nber.org/cycles/recessions.html )
Still, there are overarching indicators to consider while maintaining a watchful eye on the canary in the mineshaft: namely, GDP growth, job formation/growth/unemployment, and the wealth effect.
At the individual level, you can't say "this is the one factor that, when it goes south, means the economy is in a recession," says Andrew Jakabovics, associate director of the economic mobility program at the Center for American Progress. "It's when you get enough of these data points happening together, we are in a recession."
Learn more about markets featured in this article: Los Angeles, CA.