Turbulent Supply and Demand in the Economy
This post is a follow-up discussion to “Kool-Aid & Krispy Kremes,” a discussion I had with Mike Morgan at Morgan Florida on Oct. 15.
If you are hungry for donuts or thirsty for Kool-Aid, or simply have not read the above article, it is a good lead-in for what follows. Following is Morgan’s latest housing update he e-mailed me on Wednesday:
“My recent update on what we’re seeing in the housing market generated a couple dozen calls from some very large financial institutions, REITs, hedge fund mangers, public builders, and a variety of financial experts. Those callers are not just callers from the U.S., but from Germany, Australia, and the U.K. I have had so many calls that I found myself on the phone 8-10 hours a day discussing the housing industry. I learned as much as I shared, if not more. So here’s a little bit of what I heard.
“The Street is scared — scared to death that we are in for a housing crash that will rock our economy to its knees. Even Cramer attempted to reconcile his bullish position on his Tuesday night broadcast when he said he did not believe we have seen the worst of the housing market, but he does believe we have seen the worst for the builders’ stocks. Duh? What he and many others don’t realize is that the housing industry will not recover in 2007.
“Maybe he’s setting up for a flip-flop, or maybe he, like many others, simply doesn’t understand the dynamics. And how could anyone understand the dynamics unless they were on the front line? How can you evaluate a market like this from the comfort of a cushy Manhattan office? No way. No how.
“So let me tell you, simplistically, what we see and hear on the front lines. On the street we are dealing with builders and sellers every single day. And both groups are trying to leap-frog the other on the way down. That means lower margins or no margins for the builders. And that means the banks that have financed the millions of homes flippers bought, as well as the ATM cash drawn down with ARMs, will wind up owning a lot of property they cannot sell. Sure, most banks sell their paper. OK, so the guys like Fannie Mae will own hundreds of thousands of homes they can’t sell. The result is the same. Massive amounts of inventory flooding the market at foreclosure sales. And prices drop further.
“On the other end, here’s what I am hearing from the desperate builders. “Mike — we’ve got to unload inventory. Bring me offers. Please, Mike, we’ll look at anything.”
“And from the big money that have financed many of these builders? They want to know how bad it is… and how bad it is going to get. These guys are truly on the razor’s edge.
“And from the guys with smart money sitting on the sidelines? “Mike — we’re ready, and we’ve got a billion dollars to put to work. Should we start buying?”
“The answer is no, a very simple NO. Sellers are desperate. Builders are desperate. But with a 6-1 ratio of listings to sales, the markets are still being flooded with inventory. Builders are trying to monetize land by building spec homes at cost, but cost is not selling. And even though builders are unloading inventory at attractive prices, the worst is yet to come. And here’s why.
“We are still not at positive cash flow when you evaluate the rental income of housing. We’re close, but not there yet. And until it makes financial sense to buy a single-family home or multi-family project, prices will continue to drop. One public builder offered me the remaining inventory in a project of townhomes and condos. But when I ran the numbers, they didn’t make sense. This builder would have to drop prices another 30%. When I discussed the numbers with him, he said that was 15% under cost. Kiss margins and P/Es goodbye, guys.
“The soft money we saw for the last three years from flippers is gone. The funny money drove prices up more than 100% in just three years in many markets. Irrational exuberance was a replay. History repeats again. Surprise? No. So even though we are down 30-40% in many markets year over year, we now have more inventory than we have ever had in the history of the world. In high school I learned about supply and demand. This is a classic example. Too much supply and too little demand. So housing prices will fall further and the entire economy will suffer for our irrational exuberance. Far more so than we suffered during the dot-com boom.
“Now you have the top builders like Pulte, KB Homes, Lennar, Centex, D.R. Horton, Hovnanian, Toll Brothers, etc., scrambling to unload standing inventory, lots, and land. Centex was ahead of the curve when it started slashing prices in Q1 of this year. Everyone thought it was crazy. I say, crazy like a fox. Centex was right on the money. Horton concentrated on affordable housing and tried to avoid flippers as best it could, but even it got a bit carried away. Lennar concentrated on “everything included.” But do homeowners want limited choices? No. Homeowners want a design center. Flippers wanted “everything included.”
“As we enter Q4, all of the builders are scrambling to unload inventory, reduce land exposure, and bone up on hard-core centralized prayer. But it’s too little, too late. You can’t stop a tidal wave, and you can’t stop the effects of the housing crash. When in the history of the United States have you seen 20-40% drops in housing prices? Mish, you might not want to answer that question, because you’d have to look back about 77 years.
“The fallout is nationwide. Truckers delivering building supplies and carting away debris are losing their jobs. Many builders have cut their sales staff by more than 50%. In our local markets, more than 20% of the real estate agents are leaving the industry. How about mortgage brokers, insurance agents, title companies, attorneys, furniture manufacturers, and the companies that make paint, concrete, plywood, toilets, and the kitchen sink? This crosses all industries and the entire U.S. economy.
“For November I already have booked most of the month with bankers, REITs, hedge fund managers, and industry experts that want research and tours of the housing markets. One caller, an institutional client with more than $5 billion invested in real estate, wanted to know whether it should sell and convert to cash. I looked at the Staples Easy Button on my desk and replied without hesitation, YES. Then I hit the Easy Button and heard the familiar voice say, “That was easy.”
“It was an easy call because of the basic fundamentals we learned when we were kids… supply and demand.”
Ah yes, supply and demand. The interesting thing to me is the big disconnect with what you hear from media pundits who have for weeks now been calling for a bottom on the flimsiest of evidence and actual field results. We have also seen upgrades out the wazoo lately in the face of clearly deteriorating figures.
Today, more nonsense was trumpeted by Bob Willis at Bloomberg in an article entitled “U.S. September Housing Starts Unexpectedly Increase”:
“Housing starts in the U.S. unexpectedly rose last month from a three-year low, as falling mortgage rates began to draw buyers back into the market, a sign the housing slump may be nearing bottom.
“Housing starts increased 5.9% to an annual rate of 1.772 million from a 1.674 million pace in August, the Commerce Department said today in Washington. Stepped-up construction in the Midwest and the South made up for declines in the Northeast and the West. Building permits dropped for an eighth straight month to the lowest level in almost five years.”
Talk of pent-up demand or a stabilizing market are both ridiculous. Who does not have a house that wants one? Contrast that with those still wanting to cash out in a bubble market and move somewhere cheaper. Add in desperate flippers, and then let’s look at the above numbers Willis presented from the correct frame of mind, building permits.
The key point is that permits reflect future optimism of builders and that is falling even as builders scramble like mad to complete started projects. Those factors do not represent strength or any kind as he suggests. What it does represent is a massive amount of additional pent-up supply.
Besides, who does not have a house that wants one? Nor can comfort be taken in any supposed drops in inventory. Some sellers have pulled their listings while “Waiting for Godot” (oops, I mean better conditions). Since good conditions may be years away, sharply rising REOs are also going to add to pent-up supply. What about the effects of $2 trillion in mortgages with rates that will reset in 2007? That represents more pent-up supply.
What’s going to happen if and when Morgan’s institutional contact (and those in the same seat) sitting on untold billions in real estate holdings all hit the “Easy Button”?
Realty Times is reporting “Real Estate Agent Complaints Rise”:
“California’s Department of Real Estate said it received more than 10,000 complaints in the fiscal year ended June 30, up 29% from the previous year and up one-third from three years ago…
“The increased level of complaints and backlog coincides with a 44% increase in the number of real estate agents in last five years, pushing the total to about 400,000. In some areas, including Los Angeles and Silicon Valley, the number of real estate agents outnumber the number of properties for sale…
“Nationwide, the number of licensed real estate agents has swollen to 2.5 million, according to the Association of Real Estate Law Officials and NAR says membership has risen 25% over the last five years to more than 1 million.”
The obvious question is how many of those 2.5 million agents really depend on that license to make a living? Even assuming the answer is as low as 20%, that is still half a million real estate agents that are making a lot less than a year ago. The top end is likely to be doing very well, and once again, let’s try to be generous with the numbers and claim 50% of them are still doing well. That leaves perhaps as many as 250,000 agents who are seriously hurting if they ramped up their spending and lifestyle to a higher sales level and have little savings as a cushion. The next question to address is “How many real estate agents have investment properties of their own?”
All things considered, real estate agents themselves will eventually add to housing supply.
Perhaps the ultimate in pent-up supply may come from tens of thousands of real estate agents who have not made a sale for months. Those agents are about to find out this is NOT a “totally new paradigm.” They represent still more potential foreclosures and thus potential supply when they are unable to pay their bills.
It would be fitting irony if massive property sales by real estate agents (or former real estate agents) mark the bottom of this market some number of years to come.
The Easy Button
Let me join Morgan by clicking the “Easy Button.”
Pent-up supply is coming from every nook and cranny. There is no way this is the bottom, and there is no way we have a soft landing, either.
Mike Shedlock ~ “Mish”
October 19, 2006