Tuesday, March 22, 2005

Will Real Estate Supply Overtake Demand in 2005?

by Clif Droke

For over three years the U.S. residential real estate sector has been running in maximum overdrive with hardly a pause along the way for rest. This can be likened to an Olympic sprinter running non-stop and consecutive 400-meter races without even resting in between. Obviously, such an extreme physical exertion will eventually lead to exhaustion and a prolonged recuperative phase will be needed to allow the sprinter to catch his breath and regain his energy.

This period of recuperation, one that is likely to last several months and possibly until the next long-term cycle bottoms in 2006 (8-year cycle), is a strong likelihood for the U.S. housing market in particular after prolonging a breakneck sprinter's pace these past couple of years.

Probably the best way of tracking the trends in U.S. real estate and one especially favored by institutional analysts is the Morgan Stanley REIT index (RMS) as it is a leading indicator for the broad U.S. real estate trend. In the following daily chart of RMS showing the price history from the past two years, you will see that the important 30-week moving average -- which smooths out the dominant interim trend -- has now been broken twice in the past 1-year period. This is a sign that the upside run is at least temporarily ending and a warning sign that a "correction" of intermediate-term proportions could be near.

Whether or not the correction will take the form of a lateral trading-range or an orderly pullback is open for debate. That prognosis will have to wait until after the next dominant interim trading cycle bottoms this summer. But for now suffice it to say that the indicators warn that the proverbial sprinter's pace of the past 2-3 years is about to slow down to more of a snail's pace by comparison.

One early warning sign of a coming slowdown or cool-off period in real estate is now developing in the rental market. According to Dan Ferris of the Extreme Value newsletter, due to the recent rising trend in interest rates it is now cheaper to rent than to own a house in several major U.S. cities for the first time in years.

According to Ferris, a study recently published by real estate economist Michael Sklarz found that it's now less expensive to rent than to own in high-end real estate markets such as Honolulu, New York, Washington, San Francisco, and souther California. Sklartz's study found that even when accounting for the benefits of the mortgage tax deduction, which has been a major incentive to own a home, renters now stand to save thousands of dollars per year versus owning similar homes.

"Renting a single-family home in San Diego, for instance, saves you about $10,400 annually," writes Ferris. "You save about $6,000 a year in the Los Angeles area by renting instead of owning, and about $4,500 in New York."

Ferris reports that nationwide, apartment markets appear to be bottoming out. "In the first three months of 2004, 34 of the top 64 major metropolitan markets reported declines in rental income," according to Ferris. "For the third quarter (July, August and September) of 2004, that number shrank to just 4 cities."

Moreover, according to Ferris, no only is it getting more expensive to own than to retn, but in many cases "it now makes good financial sense for owners to sell their homes and live in rentals." Once this fact becomes abundantly clear to the many, we'll have confirmation of a housing market slowdown. Year 2005 could very well be the year in which supply finally catches up to and overtakes demand in the housing market.

Clif Droke


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