It's a renter's market

Potential home buyers should wait until housing bubble unwinds

Mark Kiesel

Published June 9, 2007 at midnight

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One question my friends and colleagues have asked me repeatedly over the past six months is: Are you still renting? Yes! I sold my house more than a year ago and continue to rent.

Back in late 2005, I became anxious about my investment in the American dream after spending a considerable amount of time and effort researching several factors that I thought would influence housing prices. At the time, I was nervous about housing and ended up selling my house in early 2006 after owning for eight years.

Based on the outlook for housing, I will likely be renting for one to two more years. While many factors that influence housing prices have turned negative, I suspect we have not yet hit bottom. In fact, housing prices should head lower throughout the rest of this year and next year as well. Why? Housing inventories remain high, delinquencies and foreclosures are set to rise as homes purchased in the past few years by speculators and individuals with teaser-rate and adjustable-rate mortgages come back onto the market, affordability is low, and sentiment and risk appetite have shifted negatively. Most importantly, the availability of credit is set to take a turn for the worse as lenders tighten credit standards.

This is all great news for renters and buyers who are patient. Over time, housing prices and interest rates should decline, resulting in improved affordability. This adjustment, however, will take time and occur over a period of years, not months. Housing is illiquid and prices are sticky. As a result, potential buyers should exercise patience and not jump back into the housing market too early. A year ago, I described the state of the U.S. housing market as "the next Nasdaq bubble." The Nasdaq took more than 2 1/2 years to go from peak to trough. I suspect housing prices could display a similar pattern, and we are still more than a year away from the bottom. Given these risks, I prefer renting rather than owning, and an investment strategy that favors defense over offense.

• Unwinding the housing bubble. Housing was an asset bubble influenced by bullish sentiment, robust risk appetite and speculation, lack of fundamental analysis, cheap money, inflated appraisals and easy lending standards. These factors helped drive housing prices up to new levels and the unwinding of these conditions is expected to drive housing prices down. Never before have we witnessed so many people lever up real estate with so little money down or "skin in the game." This growth in mortgage debt and risk appetite helped fuel consumer spending and corporate profits. As such, the unwinding of this bubble will have broad consequences for the overall economy.

As the housing bubble unwinds, what are the implications for the overall economy? The U.S. economy will likely experience sub-par economic growth for the next year as declining housing prices lead to weaker consumer spending, slower corporate profit growth, a decline in business investment and less job creation.

• The supply side. The inventory of new and existing homes available for sale remains in record territory. The home-building industry helped contribute to today's record inventories through its bullish sentiment and aggressive land purchases over the past several years. Unfortunately, home builders have little incentive to stop building once they have purchased land for development. In hindsight, home builders bought too many lots in the past few years, expecting the run-up in land prices would continue for several more years.

Another source of new supply will likely come from rising delinquencies, which will eventually turn into more foreclosures. A growing segment of recent home buyers has bought using teaser-rate, adjustable-rate, and no-money-down or low-money-down mortgages. As adjustable-rate mortgages reset upward, the housing market will likely see increased foreclosures involving people who can't afford the new rate. The total inventory of homes in foreclosure has risen to 437,041, a 39 percent increase in the past year.

• ARM 'sticker shock.' The problem is not only in the subprime category, as delinquencies for both prime and subprime loans are rising. In fact, the market's primary focus on subprime ignores a major issue, which is that Alt-A and prime borrowers will also face "sticker shock" when adjustable-rate mortgages reset upward. Lehman Brothers estimates $421 billion of ARMs will reset in 2007 ($308 billion subprime and $113 billion prime) and $542 billion of ARMs will reset in 2008 ($349 billion subprime and $193 billion prime). Clearly, this is not only a subprime issue, but rather an ARM reset issue as both subprime and prime borrowers potentially are forced to put homes back on the market with almost $1 trillion of ARMs resetting over the next two years. According to a study published last month by First American CoreLogic, a total of 1.1 million foreclosures with losses of about $112 billion will occur over a period of six years or more with roughly 500,000 homes going into foreclosure in the next two years.

Rising foreclosures will result in homes coming back on the market not only at a time when current inventories are near record levels, but also when pent-up demand for housing is low. Easy lending standards and innovations in the mortgage market in the past several years brought forward future housing demand. People who would have qualified for a mortgage in the future were given a mortgage today. Why? Lenders, hungry for yield, relaxed their underwriting standards and provided cheap money. Naturally, consumers took the bait, and levered up with record-low down payments. In fact, 46 percent of homes purchased in the U.S. last year had less than a 5 percent down payment. Over time, homeowners with little capital at risk and negative home equity will likely walk away from homes under water. For all these reasons, housing inventories are likely to remain high over the next few years.

• Credit availability, lending standards and appraisals. A major headwind for housing in the near future will be more restrictive credit availability. Lenders are already increasingly asking for income verification and higher down payments. Countrywide changed its no down-payment lending policy last month and now requires homeowners to have at least a 5 percent stake in their homes. The threat of increased government regulation and restrictive legislation is likely to cause lenders to reduce offerings of no-documentation loans and to ensure that adjustable-rate borrowers can qualify at the higher reset rate.

In the long run, this will be a positive for the housing market, as only buyers who can afford to purchase a house will buy one. However, in the short run, tighter lending standards will cause a reduction in demand for housing and could cause the homeownership rate to fall.

A major problem in today's housing market is not only sales to new homeowners. The "move up" market, or existing owners who want to sell their current house to buy another one, is basically frozen. Outside of speculators exiting the market, this is a major reason why cancellation rates have risen. It isn't only the speculators and investors backing away. Potential new home buyers can't sell their existing home to someone else. As a result, they cannot move up.

• Housing is today's leading indicator. I believe declining housing prices and tighter credit are set to unleash a sharp downturn in housing turnover and job creation. As housing prices fall, corporate profits are expected to be at risk as consumers pull back their spending. Today, the growth in real housing prices is falling.

I believe real housing prices will turn further negative in 2007, causing new and existing home sales to decline toward 5 million units a year, down from a peak of more than 7.5 million units a year in 2005.

Housing starts and permits tend to be a good leading indicator of job growth. Through February, housing starts were down 28 percent year-over-year. This type of decline in housing starts typically leads to a sharp slowdown in job growth, within roughly one year. As a result, I think job creation is set to slow, possibly materially. The U.S. economy created about 200,000 new construction jobs last year. It would not surprise me if we lost 400,000 construction jobs this year, as home builders complete their existing projects and then lay off workers.

For renters and potential home buyers, my advice is to still rent. The housing market has turned for the worse, but the unwinding of this bubble will take more time. Unfortunately, this is not good news for the U.S. economy, job creation or corporate profits.

Mark Kiesel is executive vice president, portfolio manager and senior member of the investment strategy group for PIMCO, one of the largest fixed-income managers in the world, with $687 billion in assets under management.

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