Is the Housing Boom Headed For a Soft Landing or a Crash?

Standard & Poor's predicts that the bubble will end with a fizzle, not a bang, but says it's hard to tell when the market might weaken.
By: John Spence: The Wall Street Journal
The popping of the red-hot U.S. housing market will likely play out as a steady deceleration of prices followed by stabilization, rather than a dramatic national downturn, Standard & Poor's said Monday.

"The bubble should end with a fizzle, not a bang," said S&P Chief Economist David Wyss in a conference call Monday, adding that it's difficult to nail down exactly when the market might weaken, and what the implications might be for the overall economy.

Still, Wyss indicated that rocketing home prices in several parts of the country are unsustainable and cannot go on forever. Looming interest-rate increases are another potential problem that may affect two sectors linked to the housing market: home-builder stocks and real-estate investment trusts.

Credit rating and investment-research agency S&P unveiled multiple reports on the global housing market Monday.

Currently, the average U.S. home price is roughly 3.1 times the average household income, the highest in history and up from an average of 2.6 times since 1960, according to S&P. Driven by low mortgage rates and looser lending standards, home-ownership levels of 69.4% are also at an all-time high.

Yet most of the price appreciation is concentrated in sizzling markets in California, Florida and the Northeast. For example, on both coasts, housing costs have risen at least 30% above the normal home price-to-income ratio, S&P calculated.

Despite regional dangers, S&P estimates it would take a 30% decline in national home prices, combined with a 50% drop-off in new-home starts, to drive the economy into even a slight recession, Wyss wrote in a recent report.

"We think such a scenario is unlikely," he said.

Tiny bubbles for home-builders

U.S. home-builders have been one of the most volatile and closely watched stock sectors in recent months, with heated debate devoted to the existence of a housing bubble. Over the past year, the Dow Jones U.S. Construction Index has gained 48.4%.

Part of the reason the sector's stocks have been on investors' radar screens is that many of the largest builders do significant business in the country's hottest markets.

The 19 home-builders rated by S&P accounted for about 25% of the 1.6 million new single-family homes purchased in 2004, said S&P credit analyst James Fielding. They operate in only 25 states and approximately half of their revenue comes from California, Florida and Texas.

Therefore, home-builder earnings could take a hit if there is a cooling in the hottest, most profitable housing markets.

In the most likely scenario, Fielding sees rising long-term interest rates making homes less affordable in the important coastal markets. This could lead to a leveling-off of prices and higher cancellations in the speculative markets, with builders "slow or unable to quickly adjust production and overhead to lower demand," he wrote in a report.

"As a consequence, profitability weakens bur remains above historical averages, resulting in a deceleration of positive ratings momentum," Fielding concluded.

Mixed outlook for REITs

Historically low home-mortgage rates and a lack of rental demand have weakened fundamentals in the REIT market, according to S&P equity analyst Raymond Mathis.

However, REITs have managed to outpace the broad market so far this year. An exchange-traded fund tracking real-estate stocks, StreetTracks Wilshire REIT Fund, is up 9.9% year to date, 6.4 percentage points higher than the S&P 500 Index over the same period, according to investment research firm Morningstar Inc.

"The stocks are not tracking fundamentals, but responding to the housing bubble," Mathis said in the conference call Monday.

In particular, he sees a bubble in the valuation of multifamily residential REIT stocks, which he believes are overvalued by about 13.6%.

Yet rising interest rates and falling home prices could be a good thing for REITs as "new households and even some existing homeowners gravitate toward rental housing," S&P said.

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