We would like to borrow a phrase from Edward E. Leamer PhD., the esteemed Professor of Economics at UCLA: “Housing is the Business Cycle“. Professor Leamer’s landmark paper on the importance of housing in the business cycle in many ways has shaped the prism through which we view the economic landscape. It also helps explain the market’s huge rally since mid-March. Quite clearly, the data on housing over the past few months has been more positive and this in part has emboldened the bulls. We have grown increasingly confident that a floor in new and existing home sales VOLUME (not price) has been reached. Although it is not the primary focus of PAA Research, we wanted to provide you with a few observations on the housing market and then propose an investment idea based off our views.

Affordability Still Matters, Just Look at California

Our confidence that a floor has been formed in home sales volume is almost entirely predicated on affordability. Over the past few months, it seems as if many economists and housing market experts have held the view that affordability doesn’t matter. Economic concerns are paramount, the consumer is shell-shocked and credit is tight. However, at the end of the day we are all “economic animals” and if the price of something appears compelling enough, then we will do everything in our power to purchase that good. On a personal level, we haven’t taken stock, but we know of more than a few items in our possession that were purchased, not for obvious utility, but simply because we could get them at a good price. We recognize the importance of consumer confidence and the job market in dictating the direction of the housing market, however, empirical evidence suggests that affordability will eventually trump all.

The combination of a rapid decline in home prices and unprecedented lows in standard mortgage rates (not to mention an $8,000 tax-credit for first-time home buyers) has created an environment where housing in many markets is not only affordable, but outright attractive. According to the National Association of Realtors, the Housing Affordability Index averaged more than 170 in the first quarter, its highest level EVER. No market exemplifies the impact that affordability can have on volume better than California.

Arizona, California, Nevada and Florida were the unequivocal epicenters of the housing bubble. Each of these markets is in varying stages of recovery, but it has become increasingly clear over the past 6-months that a significant element of price discovery has occurred in California. Brushing off our supply and demand curves from Econ 101, we view price discovery as the process of determining a price at which huge levels of excess inventory in the housing market will be eliminated. In the case of California, a 50%+ reduction in the median home prices was required. A huge increase in distressed sales combined with low mortgage rates and first-time home buyer tax credits has created a perfect storm of affordability in California. According to the California Association of Realtors, affordability for existing home owners and first time buyers is now higher than it has been at any other point this decade.

The response to improved affordability in California was not immediate, but over the course of the past 3-6 months concerns about the economic environment and credit availability have been trumped by the appeal of price. In the first quarter of 2009, single family home sales in California have approached levels not seen since 2005. Single family home sales volumes were up more than 63% YOY in March!

California is not a perfect proxy for the rest of the country, as we certainly have not had the same level of price discovery nationwide. Other housing markets were also not as severely inflated. We do expect home prices to continue to decline into the first half of 2010. However, a combination of fiscal and monetary stimulus are likely to compel buyers off the sidelines. With this as a fundamental backdrop, we told ourselves to act accordingly and find compelling investment opportunities.

In Search of a Forgotten MicroCap

Here’s the problem: where can one find truly compelling value in any housing related stock? It appears as if every single name we looked at much like the rest of the market, appears hugely overbought. This is not to say, we don’t see longer term value in some of the better capitalized homebuilders or the best of breed home improvement retailers (a strong case can be made that foreclosure properties will require a greater amount of home improvement spend per home), but we were hoping to find something that hasn’t moved.

This is not the first time in our investment careers that we encountered such a quandary. In late 2002 and early 2003 we found ourselves looking for names that had been forgotten, or perhaps “left for dead”. In late 2002, we ran a screen to identify companies that had outstanding balance sheets (cash in excess of 50% of market cap), a total market cap of less than $250 million, positive revenue growth for a minimum of three consecutive years, a price/revenue multiple of less than 1.0x and a few other criteria. It turned out that this particular screen unearthed some of the highest returning investment ideas of our careers.

We recently ran a similar screen, which not surprisingly returned a few names. One of the names that stood out to us was ZipRealty, Inc., the 9th largest residential real estate brokerage firm in the U.S. ZipRealty is a microcap with a great website, outstanding balance sheet and a less than seasoned agent base.

We think ZIPR could represent a good way to play a housing recovery; the stock is cheap and it has underperformed almost all of the housing related stocks. Our thesis is based on the following:

1. ZIPR is well positioned in California, now the fastest growing residential real estate market in the country.
2. ZipRealty is gaining market share. The company has increased the number of closed transactions YOY for each of the past three-years. Ziprealty.com generates approximately 2.0 million unique visitors a month and traffic has increased in excess of 50% YOY during 1Q09.
3. We expect operating losses from the company’s operations in new markets to decline over the next 12-24 months as housing volumes stabilize and recently hired agents increase productivity.
4. ZIPR has an outstanding balance sheet. As of 12/31/08, ZIPR has $49.4 million in cash and no debt. Stated another way, the market has afforded a total enterprise value to ZipRealty of $7 million, despite the company’s huge presence on the Internet and its track record of profitability in established markets.

Please click on the following link to read our full write-up on ZIPR.

Housing has become affordable, volumes are stabilizing and ZipRealty is well positioned to benefit. The company reports 1Q09 results today, after the market close.

As always, please act accordingly…

Disclaimer: The author of this post owns shares in ZIPR, positions can change at any time without notice.