Investment Research

Update on the Improving Foundations of US House Prices (September 2013)

Ronald Temple, CFA, Managing Director, Portfolio Manager/Analyst

Home prices have continued their upward climb, as evidenced by the latest report from S&P/Case-Shiller. However, the most recent data show a sequential deceleration in aggregate price increases. While there are several variables that influence the price trajectory of housing, the recent spike in borrowing rates—in anticipation of tapering by the US Federal Reserve—appears to be a primary driver. In this paper, we discuss the key variables, in addition to housing price indices, that contribute to create a more complete assessment of the fundamentals for a further price recovery.

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Home prices continued to surge through the second quarter of 2013 according to the most recent reports. At the same time, mortgage rates have increased by about 130 basis points since the lows reached in May 2013 when the market began to believe the US Federal Reserve (the Fed) would begin tapering monetary stimulus in the near future. An increase of this magnitude translates into an increase in the cost of buying a home of approximately 17%. Given the combined effect of higher financing costs, the 21% increase in national home prices since the end of 2011/early 2012, and seasonal patterns, we expect month-on-month price increases to decelerate substantially in the fourth quarter.1 Importantly, a decrease in sequential price increases will greatly reduce the number of mortgage borrowers moving back into positive equity. To the extent home prices stop increasing altogether on a sequential basis—a reasonable prospect—we could also see consumer confidence weakened as homeowners would become less optimistic regarding the balance sheet recovery they have enjoyed of late.

Through the last quarter much of the investor debate revolved around the impact and timing for tapering of large scale asset purchases by the Fed. While the central bank ultimately decided to maintain the same level of monetary stimulus and asset purchases in its September meet-ing, the markets raised the cost of financing substantially for home buyers in advance of the meeting. However, the impact of tapering on housing demand has been a bit difficult for many to understand as the varying timing lags in the range of housing data are not well known. In this update, we will provide perspective on the most recent data and how to interpret incoming information as higher mortgage rates gradually impact housing demand and prices.

The most recent house price reports from S&P/Case-Shiller in September (based on data from May through July 2013) were in line with our previous expectations. Prices in all cities in the S&P/Case-Shiller 20-City Composite Home Price Index (the 20-City Index) have increased from their levels 1, 3, 6, and 12 months ago. The 20-City Index was up 21.2% from the low in March 2012 and up 12.4% from a year ago. The report also showed a third sequential deceleration of price increases in aggregate. This reflects the diverging patterns we have seen across the cities in the index. Exhibit 1 shows the extent of the decline in house prices during the bust (the change from the high reached up until December 2008) and then shows what percentage of the decline has been recouped. The highlights we would point to include:

• Dallas and Denver are outliers on two counts: 1) Prices did not decline as much in the downturn (i.e., the period from mid-2006 to early 2009) and 2) they have now reached new highs. To be fair, in the housing bubble, neither Dallas nor Denver participated fully on the upside so their relative resilience should not be a surprise. As an example, prices in Dallas rose at an annualized pace of only 3% from the beginning of 2000 to the bubble peak in mid-2007. This contrasts with an average annualized increase of 14% for Las Vegas until its peak in the fall of 2006 and the 20-City Index which increased approximately 12% annualized through August 2006. The magnitude might not sound great, but the cumulative increase for Dallas from 2000 to 2007 was 26% versus Las Vegas where prices increased 134%.

• Losing cities continue to suffer: We have highlighted in the past that some cities in “sand states” that saw the sharpest declines in

home prices had also rebounded most strongly. In this note, we look at the data in a different way. True, the prices have increased a large amount from the recent lows, but when approached in terms of how much of the previous decline has been recouped we get a slightly less encouraging view. In Exhibit 1, one can see that six of the twenty cities have regained at least half of the ground they lost in the downturn. Notably, San Francisco was among the cities with the largest decline but it is also among the strongest recoveries. On the other extreme, four cities have regained less than 25% of the decline. Three of these four cities were among the hardest hit with declines ranging from 48% to 62% from peak to cycle trough.

The key data points that we are watching beyond the 20-City Index include (in order of importance):

1. Mortgage borrowing rates, as illustrated in Exhibit 2: A 100 basis point increase in mortgage rates from 3.5% equates to a monthly payment increase of approximately 13%. The rise from the recent

Exhibit 1Housing Price Declines and Recovery from Low

-100

-50

0

50

100

150

Max–Min DeclineProportion Recovered

Las

Vega

s

Mia

mi

New

Yor

kTa

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Phoe

nix

Chi

cago

Co

mp

osi

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land

San

Die

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itW

ashi

ngto

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CM

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apol

is

Seat

tlePo

rtla

ndA

tlant

aC

harlo

tte

Bos

ton

San

Fran

cisc

oD

enve

r

Dal

las

(%)

As of 24 September 2013

Source: Standard & Poor’s

Exhibit 230-Year Mortgage Rates

(%)

3

4

5

6

7

8

9

Sep 13Jul 11Jul 08Jul 05Jul 02Jul 99Jul 96

As of 17 September 2013

Source: Bloomberg

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low of 3.45% in early May to almost 4.75% by mid-September implies a 17% increase in the cost of financing the same home.

2. Mortgage Bankers Association Mortgage Loan Applications for Purchase Index (the Loan Applications Index), as shown in Exhibit 3: This index measures the volume of applications to buy a home (new or existing). By excluding refinancing volume, we can get a clearer picture of future closings on home purchases. We have been consistently disappointed with the lack of improvement in this index. Even when mortgage rates were at record lows in early May, the index climbed only to a level well below the activity seen one year earlier when rates were at 5%. Perhaps the lesson is that mortgage rates are less important to borrowing activity than are other factors such as the ability to accumulate a down payment and employment growth. Regardless of the driver, we will continue watching this index as a divergence from our expectations could mean that economic growth substantially trumps borrowing rates. If that is the case, we can be more optimistic that the eventual tapering of monetary stimulus might not impair activity as much as we currently suspect.

3. New single-family home sales: Closely monitoring this series is a priority, as it is the most current tangible measure of actual activity. New home sales are recorded at the time of contract signing rather than actual purchase closing. As a result, the report tends to reflect activity with a lag of only one month. The most recent report was materially disappointing relative to consensus expectations. In our view, this report reflects the spike in mortgage borrowing rates since May (see Exhibit 4).

4. National Association of Home Builders (NAHB) Housing Market Index (the NAHB Index): The NAHB Index is next in our queue of key data series to monitor, as it captures a combination of actual activity and sentiment. As such, we see it as offering positives and negatives. The positive to this index is that it should reflect demand for new construction better than other indices as it incorporates traffic of potential home buyers, as shown by the underlying index components in Exhibit 5. On the negative side, while we would expect home builders to be very aware of mortgage rates, they likely would have a difficult time discerning which potential customers might be squeezed out of the market by higher financing costs. Hence we consider this index slightly less predictive of future activ-ity in aggregate (beyond new home construction) than the new home sales data.

5. Existing single-family home sales: Existing home sales are the least predictive in our sample of key metrics, as these data generally reflect a lag of two to three months from the date of a purchase agreement. This delay results from recording the transactions only at the actual closing of the purchase, which typically takes a few months given the time required to obtain a mortgage and arrange document signings. Nevertheless, we believe it is instructive to monitor this series even with its drawback of delayed data (see Exhibit 6).

When we weigh the combined evidence of the previously described indicators, we conclude that sequential price momentum will decel-erate meaningfully through year end. However, the data also leave reason to suggest that we may be too pessimistic. The two key data points that would support a more constructive view on housing,

Exhibit 4New Single-Family Home Sales

(Units, thousands)

200

550

900

1250

1600

Jul 13Jan 11Jan 08Jan 05Jan 02Jan 99Jan 96Jan 93

As of July 2013

Source: US Census Bureau, Haver Analytics

Exhibit 5Components of the NAHB Housing Market Index

0

25

50

75

100

Aug 13Jan 11Jan 08Jan 05Jan 02Jan 99Jan 96Jan 93

Index

Sales of New Single-Family Homes Next 6 Months

Traffic of Prospective Buyers of New HomesSales of New Single-Family Homes

As of 15 August 2013

Source: NAHB, Haver Analytics

Exhibit 3Mortgage Bankers Association Mortgage Loan Applications for Purchase Index

100

200

300

400

500

Aug 13Jul 11Jul 08Jul 05Jul 02Jul 99July 96Jul 93

(Index, March 1990=100)

As of 6 September 2013

Source: Mortgage Bankers Association, Haver Analytics

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even against a backdrop of higher borrowing rates, are the Loan Applications Index (Exhibit 3) and the NAHB Index (Exhibit 5). The Loan Applications Index seems to imply that activity has not increased substantially as a result of lower rates, but on a positive note perhaps might not decrease as much when rates normalize. The NAHB Index implies that even with a substantial interest rate increase, actual traffic of prospective buyers to new home sites has con-tinued to improve, albeit flattening slightly in the last observation. We hope these are the right leading indicators, but on a closer look other variables will help determine the magnitude of price deceleration, which we describe next.

• Mortgage rates and a reduction in the Fed’s asset purchase programs (i.e., tapering): In light of the Fed’s decision to delay tapering, we might have a retracement in mortgage rates to slightly lower levels. We recognize that the current rates are not sustainable on a multi-year basis, but we do believe there is a self-governing feedback loop

that limits how much rates can increase without leading to a reac-tion from the Fed.

• Growth in personal income and employment: House price increases since the cycle lows have been driven by a range of factors includ-ing, but not limited to, investor activity, employment growth, income growth, and record affordability. In the long run, however, we believe the governing factors for house prices are personal income growth and financing rates. While this might seem obvious, sustained patterns of price increases well above or below income growth in particular tend to lead to large subsequent moves either down or up in home prices.

ConclusionIn summary, we remain constructive on the still young US house price recovery. We continue to expect substantial divergences across regions and cities based on local economic conditions and foreclosure processes, as discussed in our prior updates.2 We also acknowledge that a range of factors could derail improving consumer confidence. Such risks include the potential for US military engagement in Syria, the risk of a debacle around the debt ceiling, or an overly aggressive approach to tapering by the Fed that could cause an incremental spike in borrow-ing rates. In spite of these risk factors, we believe the price recovery is strong enough to endure the headwinds of higher rates, although prices are likely to rise at a slower pace than our recent experience.

Exhibit 6Existing Single-Family Home Sales

3000

4000

5000

6000

7000

Jul 13Jan 11Jan 08Jan 05Jan 02Jan 99Jan 96Jan 93

(Units, thousands)

As of July 2013

Source: National Association of Realtors, Haver Analytics

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Notes 1 Note year-on-year prices will continue to show strong increases in all likelihood as prices have increased over 8% in the last seven months alone. Source: Standard & Poor’s, as of 24

September 2013.

2 Papers available at: http://www.lazardnet.com/investment-research/

Important InformationPublished on 4 October 2013.

Past performance is not a reliable indicator of future results.

This paper is for informational purposes only. It is not intended to, and does not constitute, an offer to enter into any contract or investment agreement in respect of any product offered by Lazard Asset Management and shall not be considered as an offer or solicitation with respect to any product, security, or service in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited.

Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the date of this presentation and are subject to change.

Australia: Issued by Lazard Asset Management Pacific Co., Level 39 Gateway, 1 Macquarie Place, Sydney NSW 2000. Germany: Issued by Lazard Asset Management (Deutschland) GmbH, Neue Mainzer Strasse 75, D-60311 Frankfurt am Main. Japan: Issued by Lazard Japan Asset Management K.K., ATT Annex, 7th Floor, 2-11-7 Akasaka, Minato-ku, Tokyo 107-0052. Korea: Issued by Lazard Korea Asset Management Co. Ltd., 10F Seoul Finance Center, Taepyeongno-1ga, Jung-gu, Seoul, 100-768. United Kingdom: For Professional Investors Only. Issued by Lazard Asset Management Ltd., 50 Stratton Street, London W1J 8LL. Registered in England Number 525667. Authorised and regulated by the Financial Services Authority (FSA). United States: Issued by Lazard Asset Management LLC, 30 Rockefeller Plaza, New York, NY 10112.

LR22962

AppendixS&P/Case Shiller 20-City Home Price Index (January 2000 = 100)

CityLow Since

December 2008 Date of LowHigh Since Inception

(January 1987) Date of High CurrentChange from Low

(%)Change from High

(%)

San Francisco 117.7 Mar 09 218.4 May 06 176.9 50.3 -19.0

Detroit 64.5 Apr 11 127.1 Dec 05 90.8 40.8 -28.5

Phoenix 100.2 Sep 11 227.4 Jun 06 139.4 39.1 -38.7

Atlanta 82.5 Mar 12 136.5 Jul 07 111.5 35.1 -18.3

Las Vegas 89.9 Mar 12 234.8 Aug 06 120.6 34.2 -48.6

San Diego 144.4 Apr 09 250.3 Nov 05 188.3 30.4 -24.8

Los Angeles 159.2 May 09 273.9 Sep 06 206.3 29.6 -24.7

Minneapolis 105.8 Mar 11 171.1 Sep 06 134.9 27.6 -21.2

Seattle 129.0 Feb 12 192.3 Jul 07 159.5 23.7 -17.1

Miami 137.0 Apr 11 280.9 Dec 06 169.1 23.4 -39.8

Washington, DC 165.9 Mar 09 251.1 May 06 203.0 22.3 -19.2

Chicago 102.8 Mar 12 168.6 Sep 06 125.7 22.3 -25.5

Tampa 123.9 Feb 12 238.1 Jul 06 151.2 22.0 -36.5

Portland 129.0 Mar 12 186.5 Jul 07 157.3 21.9 -15.7

Denver 120.2 Feb 09 145.6 Jul 13 145.6 21.1 0.0

Dallas 112.3 Feb 09 131.5 Jul 13 131.5 17.1 0.0

Charlotte 108.4 Jan 12 135.9 Aug 07 124.2 14.6 -8.6

Boston 145.8 Mar 09 182.5 Sep 05 167.0 14.5 -8.5

Cleveland 94.2 Feb 12 123.5 Jul 06 106.3 12.8 -13.9

New York 157.4 Mar-12 215.8 Jun-06 171.0 8.6 -20.8

Composite-20 134.1 Mar 12 206.5 Jul 06 162.5 21.2 -21.3

As of 24 September 2013

Data include transactions from May to July 2013.

Source: Standard & Poor’s