As we’ve mentioned in the past, we are firm believers in Edward Leamer’s thesis that “Housing is the Business Cycle“. It continues to shape the prism through which we view the economic cycle. The relative stability in new and existing home sales VOLUME (not price) has, in part emboldened the bulls who most certainly will look to the housing market for the first signs in a broader economic recovery. We thought it might be interesting to take a top-down look at the housing market through an analysis of national level statistics and a more detailed review of new and existing home sales in the former bubble states: Arizona, California, Florida and Nevada. We continue to believe that volumes for both new and existing home sales have bottomed, but we are still a year or two away from a bottom in pricing. Before we get into greater detail, we wanted to provide you with our key conclusions on the state of the housing market:

1. The inventory of new single family homes is in very solid shape, but that doesn’t make us bullish on homebuilders
2. There are actually three separate housing markets now: a) The market for foreclosure/distressed sales, b) the traditional resale (existing home) market, and c) the market for new homes. The national data can be misleading as to the overall state of the housing market because it is not capturing the cross-currents in each of these markets.
3. Existing home sale volumes in former bubble markets likely have bottomed but will not increase at the same pace going forward as the type of foreclosure properties move to higher price points.
4. Any sequential improvement in median existing home prices in former bubble states should be taken with a grain in salt. As argued brilliantly by Whitney Tilson, of T2 Partners, the sequential improvement is largely a function of more higher priced homes entering foreclosure, which we will prove out with an analysis of the data in Arizona.
5. Concerns about defaults down the line from investors that have purchased foreclosure properties and then rented them out in the past year appear to be unfounded. Based on current mortgage rates and the median price for a distressed sale, the average high school graduate in this country can service a mortgage on these properties. Talk about unintended consequences.
6. An environment with steady to slightly improving volumes and rising median prices in former bubble markets still appears to be favorable for ZipRealty
7. Finally, the prospects for housing suggest some level of economic stability but a pretty tough slog for the next 2-3 years.

On a National Level – New Single Family Home Inventory Is In Good Shape, Existing Home Inventory Not So Much

Let’s start at the highest level before we dig down into some very revealing state level data. The chart below is probably familiar to many of you. It displays existing single family home sales as provided by the National Association of Realtors over the past 40-years. As you can see, existing single family home sales have been stuck in a range of 4.0-4.3 million on an annualized basis for about a year now. This puts the number of existing single family home sales at the top end of the range witnessed in the late 1980’s through the mid 1990’s. We anticipate sales will remain at least at these levels for the next 12-18 months, barring a major change in the interest rate environment (click on chart for full image view).

The inventory situation for existing single family homes is not yet encouraging – inventory on an absolute basis and months supply is still well above historical norms. The one encouraging sign has been that existing single family inventory has declined on an absolute basis. At over 9-months supply and 3.2 million single family homes, we think inventory needs to decline by approximately 750,000 homes to return to a more normal environment (click on chart for full image view).

Existing single family home inventory has been declining on an absolute basis for 10 straight months now, which is encouraging. To the extent that Obama and leading lending institutions can stem the tide of foreclosures, existing single family home inventory could be reduced far more rapidly than 15% on a YOY basis. Based on the number of option-ARM resets over the coming 18-24 months, this could be a very tall order (click on chart for full image view).

The situation in the market for new single family homes is much more encouraging from an inventory perspective, although demand remains weak. The management teams of the home builders have always argued that there will always be a certain segment of the population that just wants a new home. This has been put to the test over the past 12-18 months and it looks like in an environment of great distress, there are approximately 300-350,000 families or individuals annually who want a new home, no matter what the economy is doing. This is the worst environment for new home sales in the past forty years.

The good news is that many leading home builders have reported positive sequential improvement in order trends from late winter/early spring to late spring/early summer. However, the availability and price points of existing homes available in the resale market continues to strip away demand from the new home market. From an inventory perspective, the new home channel looks clean. Even though the supply stands at more than 11-months, at the current pace of sales, the absolute level of inventory is consistent with bottoms in other economic downturns (click on chart for full image view).

We expect inventories to stabilize at current levels or perhaps even go lower, which would be encouraging. Many privately-held homebuilders have gone into bankruptcy and the remaining players are highly reluctant to take on “spec” inventory. Looking at it another way, this is the biggest inventory correction of new homes in the past 50-years (click on chart for full image view).

We do not foresee a meaningful uptick in new home sales until the inventory issues in the existing home market are addressed, which still will likely take 18-24 months. The national level data leaves us encouraged about the overall level of inventory of new homes, but not much else.

Trends in the Former Bubble States Look Eerily Similar – They Have Been Driving the Improvement in the National Level Data

We have reviewed home sales data for Arizona, California, Florida and Nevada and we are surprised how similar the markets look. California appears to be further along in churning through inventory financed by subprime and alt-a issuance. The volume of existing home sales appears to have bottomed in the fourth quarter of 2007 in California. The affordability equation improved over the following 12-18 months and existing home sales took off. However, not until the past three months did the median sales price show any signs of stability (click on chart for full image view).

It is important to note that stabilization of the median sales price is not synonymous with a bottom in home prices. The mix of homes can impact median price dramatically and mask what otherwise might be overall price weakness (more on this later). The inventory of existing homes for resale stands at 4.2 months, levels not seen in more than four years. This can be attributed to several factors: 1) an overall improvement in the pace of sales (obviously) 2) a reduction in foreclosure activity due to government efforts and 3) more proactive policies from banks to reduce the number of foreclosures. We think the median sales price has improved sequentially over the past three months due in large part to a lack of new foreclosure inventory coming to market.

The chart below compares the YOY change in median sales price for existing single family homes to the months supply of inventory. It is interesting to observe that in 2007 the median price of an existing single family home in California continued to increase even though the supply of inventory approached a year. Over the past three months, the M/M change in median sales price has improved. Price trends in real estate aren’t nearly as dynamic as other markets, so this might suggest the median sales prices could continue to increase sequentially for a few more months even if California gets hit by a new wave of foreclosures in the second half of 2009 (click on chart for full image view)

The situation in Las Vegas appears eerily similar. The volume of existing single family home sales bottomed in the fourth quarter of 2007 and have since surged in large part in response to lower prices. However, unlike California there are no nascent signs of price stability.

The situation in Florida looks similar, although the magnitude of recovery in existing single family home sales volume has not been as strong. Whereas, the volume of existing single family home sales has increased YOY for 14-consecutive months in both Las Vegas and California, Florida has only seen improvement for 9-months and sales at their most increased 40% YOY. As you might expect, prices have not declined as much so it is possible that many home buyers and investors are waiting for more attractive entry points (click on chart for full image view).

Arizona Under the Microscope – Median Price of Foreclosure Sales Higher Than That for Traditional Sales

The housing data for Arizona looks very familiar – existing single family home sales bottomed approximtely 14-months ago and since that time sales volume has more than doubled. The median price has declined approximately 50% from the peak and median prices have declined approximately 35% on a YOY basis (click on chart for full image view).

Looking at the chart above one could be encouraged by the strong YOY increase in existing home sales volume (73.9%) and sequential month-to month improvement in median price (4.2%). However the top-level data masks some divergent cross-currents between traditional home sales and foreclosure sales. According to ASU Realty Studies, foreclosure/REO/short sales represented approximately 6.2% of total existing single family home sales in May 2007. By February of this year foreclosure sales represented more than 50% of total existing single family home sales in Arizona. However in the past three-months, the pace of foreclosure home sales has slowed and in May only represented 30% of total existing single family home sales.

We can only attribute the slowdown in foreclosure sales to efforts made by banks to modify mortgages and the Administration’s $75 billion loan modification plan. We anticipate theses efforts could stem the tide of foreclosure for a period of time but given the magnitude of employment weakness and continued weakness in home prices, we do expect foreclosure activity to reaccelerate, particularly for higher priced homes.

As one would expect, the increase in foreclosure home sales over the past two years brought the median sales price down precipitously. Once foreclosure homes as a percentage of existing single family home sales exceeded 40%, median home sales price started to drop by double digits. This is true for both the median sales price for foreclosure sales AND traditional sales. For example, a year ago foreclosure sales in AZ represented 40% of total existing single family home sales. According to ASU Realty Studies, in May 2008 the median sales price for a foreclosure sale declined 17.4% YOY while that for a traditional sale declined 15.7%. In terms of cause and effect, a big increase in foreclosures will drive down prices almost immediately. Looking at the chart below, it is interesting to note that the median sales price did not change dramatically until foreclosure sales represented more than 40% of total sales for a number of months.

An interesting dynamic has developed in Arizona and we think trends are likely similar in California and Las Vegas. The median price of foreclosure sales is now higher than that for traditional sales. It sounds completely counter-intuitive, but for the past four months the median price on foreclosure sales in Arizona have been $23,000 higher on average than traditional home sales – wow!

There are a few factors contributing to this seemingly counter-intuitive dynamic. First, the type of home entering foreclosure has changed. A high percentage of the smaller, lower priced homes which were originally sold for $200-$300,000 have been flushed through the system already and foreclosures are now capturing homes that were once sold for high-six figure prices, if not $1 million-plus. Second, a number of traditional home sales are actually foreclosure home sales that are being sold for the second time. According to ASU Realty Studies, the markdown on a formerly foreclosed home that is sold again is approximately 24%. Finally, the median sales price for a traditional home sale has a downward bias when prices are declining. Unless an individual or family is forced to sell for economic or relocation reasons, they are highly unlikely to consider selling a home in this environment. This leads to a greater percentage of home sales at lower price points as affluent families sit on the sidelines to wait for a better price environment.

In California, foreclosure home sales over the past few months have been as much as 50% of total existing home sales and a similar dynamic exists in Las Vegas. Foreclosures have pressured home sales prices and there is increased convergence between the price of foreclosure and traditional sales. Looking at the median home sales price data for California again, it seems highly likely that a shift in the type of foreclosure property towards homes that were originally sold for a higher price, has caused the month-to-month improvement in median home prices. We expect this dynamic to manifest itself in Florida and Las Vegas as well.

Foreclosure Sales Drag Down the New Home Market, but It Still Is a Separate Channel

As we discussed earlier, the volume and price of new home sales has been negatively impacted by the glut of inventory in the resale channel. However, new home sales continue to command a premium price and there is a baseline level of demand. According to the Greater Las Vegas Association of Realtors, approximately 378 new homes were sold in the month of May, down 58% from May 2008. The median price declined 23% YOY from May 2008 to 212,000, but was still 68% higher than the median price for an existing single family home sold in Las Vegas last month. As we stated earlier, we do not expect an improvement in new home sales and the prospects for homebuilders until the overhang from foreclosure inventory wanes materially. In the coming months, it will be interesting to see how homebuilders respond to higher quality inventory (higher original selling price) coming through the foreclosure channel.

Embracing Whitney Tilson’s Views

If you haven’t had a chance to review the lengthy but persuasive presentation by Whitney Tilson of T2 Partners, you can find a link to it here. It is hard to dispute Mr. Tilson’s arguments about the likelihood that the downturn in the housing market, particularly as it relates to home prices could extend for 3+ years at a minimum due to a surge in the number of option-ARM’s that will reset. Mr. Tilson estimates there are more than $200 billion in option-ARM’s that will reset over the next 3-4 years. In many cases the mortgage payment reset amounts to a 50-100% increase in the monthly payment. Given the state of the job market this will result in a high percentage of defaults. Depending on your view of default rates, this could mean as much as 250-750,000 additional homes nationally could become distressed sales. Additionally, as described by John Hempton on his fantastic blog Bronte Capital, delinquency rates on traditional mortgages continue to tick higher. According to Freddie Mac, the number of single family mortgage loans that were 90-days or more delinquent increased to 2.62% in May from 2.44% in April, which is the largest sequential increase thus far this year.

Home prices are likely to decline a bit further from current levels and then stabilize at low levels for an extended period of time in our view. As we’ve demonstrated, investors need to “peel back the onion” a little bit when evaluating changes in median sales prices. We do expect the median sales price to increase as the foreclosure plague starts to capture homes backed by prime mortgages and homes that were originally sold for a higher price.

ZIPR is One of the Few Housing Related Stocks That Will Benefit from Stable to Rising Volumes and a Change in the Sales Mix

As we highlighted in our original post on the housing market and ZIPR, we think the company is well positioned in former bubble market’s where activity has been the strongest. ZipRealty has over $2.00+ in cash per share and no debt, which we think positions the company well to take advantage of market opportunities as other brokerage firms flounder. A shift in the median price of foreclosure sales towards higher priced homes would directly benefit ZIPR. The company generated approximately 37% of its transaction volume in California in the first quarter. Looking at the number of unique visitors to the leading residential real estate brokerage websites, ZipRealty still has a one of the most popular sites. According to Compete.com, the number of unique visitors to ziprealty.com increased 10.8% YOY for the month of May (click on chart for full image view).

In terms of overall engagement, as measured by the number of monthly visits, ZipRealty still has a strong lead over its competitors (click on chart for full image view).

As always, please act accordingly….

Disclaimer: The author of this report owns shares of ZIPR. Positions can change at any time without notice.