TOP CONTRIBUTORS

Adam Farren

Residential real estate includes the construction, sale, and resale, of all residential properties across the country. Conditions in this market are indicative of the state of the economy as a whole. Homes are durable goods, meaning that new home construction and sales are often highly correlated with economic cycles; people tend to buy new homes only when they are confident that they'll have enough income to pay for it, so economic downturns can depress the housing market considerably. In addition to the buildings themselves, homes require appliances, furniture, utility services, and any number of other secondary goods and services - meaning the state of the housing sector is a key indicator for the state of the economy as a whole.

Companies involved in the housing market

Construction and home improvement

• D.R. Horton (DHI), Toll Brothers (TOL), Pulte Homes (PHM), Lennar (LEN), and other residential construction companies are highly leveraged to conditions in the housing market.
• Home Depot (HD) and Lowe's Companies (LOW), both home improvement retailers, are dependent on the housing industry for business. Housing slumps have a significant impact on these companies' bottom lines.
• Plum Creek Timber Company (PCL), Weyerhaeuser Company (WY), and Louisiana-Pacific (LPX), as well as other producers of lumber and other wood-based building materials, benefit from housing booms and are harmed by housing slumps.

Appliances, furniture, and accessories

• General Electric Company (GE), Whirlpool (WHR), Black & Decker (BDK), and Sears Holdings (SHLD) all manufacture home appliances and tools. Sales for these types of items are highly correlated with conditions in the housing market.
• La-Z-Boy (LZB), Bed Bath & Beyond (BBBY), Williams-Sonoma (WSM), and Pier 1 Imports (PIR) either produce or sell home furnishings or accessories.
• Select Comfort (SCSS), Tempur-pedic International (TPX) and Sealy (ZZ) are mattress manufacturers that suffer when home sales decline. Fewer upgrades to larger homes (with more bedrooms) and fewer second home purchases means slower growth.

Mortgage REITs and financial institutions

Deteriorating conditions in the housing market can substantially impact mortgage companies such as lenders. If demand for residential real estate falls, prices are likely to fall as well. As such, any homes that a lender repossesses to cover mortgage defaults is worth less, possibly even less than the company lent in the first place. Also, extremely poor conditions in the housing market might lead to a decrease in interest rates, which would make each new loan less profitable.

• Federal National Mortgage Association (FNM), Freddie Mac (FRE), Wells Fargo (WFC), Washington Mutual (WM), and other large figures in the residential mortgage market could be negatively impacted by a housing slump as the value of their mortgage portfolios decreases.
• Mortgage REITs like Annaly Capital Management (NLY), Redwood Trust (RWT), and Thornburg Mortgage (TMA) are hurt by deterioration in the housing market as more of the mortgages they own go into default.
• Goldman Sachs Group (GS), Bear Stearns Companies (BSC), Merrill Lynch (MER), Morgan Stanley (MS), Lehman Brothers Fin SA (LEH), and other investment banks could be harmed by a housing slump in some way. Many of these firms invest in the housing market either through purchasing secondary mortgages or investing in mortgage-backed securities. Regardless, a severe housing slump resulting in the lowering of interest rates would impact financial services firms of all types.

Digital Outdoor Advertising companies with exposure to the residential real estate market

• Lamar Advertising Company (LAMR) and Clear Channel Outdoor Holdings (CCO) operate billboards across the US. ~9% of these companies' revenue comes from real estate advertisers. When the real estate market softens, advertising budgets are among the first to be cut and these billboard companies suffer.

What causes housing booms and slumps?

^[1]

The housing market is very closely related with prevailing economic conditions. There isn't a perfectly clear cause-and-effect relationship between the two; conditions in one can impact the other, and vice versa. In general, the housing market reflects the state of the economy as a whole. There are times when the economy seems to be humming right along, but the demand for residential real estate falls nonetheless. In cases such as these, the slump is often a sign of economic weakness that just hasn't manifested itself in other areas of the economy. While the relationship between the housing market and the entire economy is somewhat complicated, there are some observable factors that can impact the demand for residential real estate. Some this housing cycle is caused by overbuilding. Developers saw excessively low rates for quite a while and used that to theorize that everyone can now get into a home. Together with lenders the thought was that if potential buyers can afford a $100K home at 6% then they can afford the same home for $200K at 3%. When this market dried up and it came time for rates to go back to normal levels, enter the bursting bubble. Homebuilders got caught with inventory, mortgage lenders have customers who can't afford the new rates, and homeowners who are in over their head are looking for a place to stay. The effect is far reaching and long term.

Impact of residential real estate on the U.S. economy

Business cycles have a number of significant repercussions for the economy. The most notable of these is the fact that household disposable income rises during booms and falls during recessions. The average American's purchasing power, therefore, rises and falls in tune with these economic cycles. When disposable incomes decrease, spending decreases overall, but some goods and services are more sensitive to these changes than others. Food and gasoline are two goods that are relatively less affected by these cycles; people still need to eat and get around, even during hard times. Durable goods, or larger purchases that are generally meant to last a while, are very hard hit by recessions, however. For example, if a person's income is halved, their food consumption will probably not change that much; they will be more likely, however, to put off buying a new washing machine, car, or house. Since these goods are "durable", the ones they already have will probably last until their finances improve.

Because the demand for durable goods decreases during recessions, and a house is about as durable as a good gets, the residential real estate market is extremely sensitive to economic cycles. A recession can lead to lower demand for new home construction, appliances, furniture, and even cars.

Interest rates over time

Interest Rates

Interest rates are another factor that can dramatically impact the housing market and new home construction. When interest rates either rise or fall, the economy as a whole is affected. The housing market, however, is particularly sensitive to these changes for a number of reasons.

Cost of Borrowing

As interest rates increase, it becomes more expensive to obtain a mortgage on a home. Given mortgages' generally long terms (usually 15 or 30 years), even small changes in interest rates can significantly impact monthly payments and the total cost of buying a new home. Higher interest rates are likely to cause a decrease in demand for housing due to these rising costs. Conversely, lower interest rates can make borrowing money cheaper and stimulate demand in the housing market.

Subprime mortgages

Increasing interest rates can also harm preexisting mortgages and result in higher foreclosure rates, increasing the supply of homes on the market just as it becomes more expensive to buy them. The reason for this is the adjustable-rate mortgage, or ARM. ARMs are different from fixed-rate mortgages in that the interest rate is variable, changing with current interest rates throughout the term of the mortgage. These ARMs became very popular in the early- to mid-2000s, when low introductory, or "teaser", rates caused many people to take out ARMs and buy houses. After the introductory period, however, the rates on these ARMs were reset to reflect current interest rates, resulting in much higher monthly payments. As a large percentage of these ARMs were made to subprime borrowers, many of whom could not afford the higher monthly payments, increasing numbers of homes began being repossessed. As many ARMs are still in their introductory periods, future waves of rate resets could further increase foreclosure rates, leading to a credit crunch in the financial sector. Interest rate increases could further exacerbate the problem, causing even more consumers to default on their mortgages. This increased number of foreclosures could lead to rising inventories of homes for sale, which would, in turn, depress real estate prices and decrease demand for construction.

Outstanding mortgages and foreclosure starts in 1Q08, by loan type^[2]

References