Realogy (H)... has the most leverage to the housing downturn

**Real-Estate-Realist** Tue Sep 19, 2006 8:25 pm

Realogy (H)... has the most leverage to the housing downturn
The housing downturn is going to be a lot longer than 3 to 6 months, and a lot more painful. Anyone saying otherwise is speaking out of his a@@. You'll notice how most of them don't back up their statements with any facts or data. Fortunately, the U.S. housing market is a very mature market with lots of history behind it. The best research on the subject that I’ve found is out of the Dallas Federal Reserve. If you visit: www.dallasfed.org/research/swe/2005/swe0505b.html you’ll get a clearer picture of the problem.

While the entire research piece is just great, the two most important charts in the research piece are Charts 5 and 6. If you extrapolate both charts out using the most recent data, it should be clear to everyone why this housing market isn’t going to correct itself anytime soon. The most recent data that we have on for Chart 5 is from July2006, which has the housing affordability index at a 20-year low of 102.8 (with a similar trajectory to the 1978 market correction). Basically, the combination of rising home values, interest rates, and property taxes have made it more expensive than at any other time in the last 20 years for the median household to afford the median priced house.

With housing no longer affordable, the demand for housing has dried up. This can be seen in many ways, including (1) an all time high level of housing inventory for sale, (2) housing turnover decreasing, and (3) real price appreciation falling off a cliff. If you look closely at Chart 6, you’ll notice that home turnover and real price appreciation tend to move together. It turns out that the two sets of data are 87% correlated (which means that 87% of the movement of one of the data sets can be explained by movement in the other data set). If you look even closer, you’ll see that the home turnover data (teal color) is almost always just above the real home price inflation data.

If you extrapolate this data to the most recent data points, what you’ll see is that real home price inflation (year over year home price inflation minus core inflation) has fallen from 12.3% in 3Q05 to -1.8% (0.9% home price appreciation – 2.7% core inflation) in July of 2006. This takes the dark blue line from about 10 at the right hand side of the chart, down to -2 in a little over a year. To keep the tight correlation between the data, home turnover will fall along with home price inflation. We’ve started to see this in the July data as turnover has fallen from 6.4% turnover to 5.6% turnover. While the July data is the most recent data we have, we’ve heard anecdotal data points about how housing sales and traffic have fallen off a cliff. As the next 6 months of data comes out, we’ll see that housing turnover has indeed fallen off a cliff as well.

Why is this? The biggest reason that home turnover falls off a cliff is that sellers don’t want to fess up to the fact that housing prices have stopped rising (and have actually started to fall in real terms) and don’t lower their asking prices to the new market reality. Buyers on the other hand realize that the market has turned into their favor and don’t need to offer anything close to asking price because there are tons of houses for sale (that aren’t selling) to choose from. These two mindsets create a gap between (1) what the seller thinks his house is worth (usually based on homes that have sold in his neighborhood over the last year…before the bubble burst) and (2) what the buyer wants to pay (the buyer realizes that he is buying into a falling market and sees no reason to pay up to pre-burst prices). In the end, both the buyer and seller wait for the market to come to them. In the meantime (while everyone is waiting), foot traffic dies and no transactions take place. This is basically what we’re currently seeing in most major markets…especially in Florida and California… virtually no traffic and transactions a fraction of what they were a year ago.

The people who get hurt the most are the real estate companies and their agents. Real estate companies like Century 21, Coldwell Banker, ERA, etc., make their money by taking a certain percentage from each real estate transaction. For the last 5 years, this has been a great business. Home values were rising at double-digit rates, and home turnover reached all time highs. Unfortunately, this same phenomenon kills them on the way down…and like most asset bubbles that burst, the trip down is much faster (and painful) than the way up (like the stock market bubble in the late 1990s). With real home price appreciation of -2%, home turnover will fall from 6.5% turnover to about 3.5% turnover. This drop represents an almost 50% decline in the number of transactions for the Century 21s of the world and their real estate agents. So basically, Century 21’s parent company, Realogy (H), is going to see its sales fall by about half (from the end of 2005) in the next 6 months or so…and each agent is going to see their gross pay fall by the same amount.

For companies like Realogy, a 50% sales decline will cause them to go from earning $1.99 per share to actually losing money. The worst part about all of this is that with housing inventories at an all time high and the housing affordability index at a 20-year low, it is going to take a very long time (at least 18 months, if not 3-4 years) for houses to become affordable again. Using history as our guide, the only other time that the housing market has fallen so far, so fast is the 1978 – 1983 timeframe. As you can see, it took until 1986 (8 years after the 1978 peak) before housing turnover went above it’s mean of 4% … and 30 years before it reached another peak of 6% (2005).

So for all you real estate agents out there, you might want to re-think your profession… and for all the owners of real estate franchises and Realogy stock, you might want to find something else to invest in.

Realogy's sales are directly tied to housing transactions and home price appreciaiton. With transactions falling by 50% from the 2005 highs, and with prices flat to down, the company's sales will fall by half and the earnings will go negative. The company won't admit to this, but if you look at the 30 year history of the U.S. housing market (chart 6), this falloff in transations isn't just a bearish opinion, but just the reality of how the housing market works (and Realogy has no control over it).

With Realogy stock being artificially supported by the tender offer that expires on September 27th, now's the time to short it and make money on the bad housing market.

**zdlan** Wed Nov 01, 2006 11:04 am

Value of a house
This is a good post.

We can not predict if the house price will go up or down next year, but we can estimate the intrisinc value of a house.

From what I know, we can say

House price = 15 years rent fee (or 16 years rent fee)

From the point of affordability, we can say
one can spend 28%-33% income for mortgage,
or the house price should be around three times
annual income.

More ideas how to estimate value of a house?