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Why It's Safe To Buy Homes Again

The mortgage meltdown hasn't killed Americans' belief in homeownership. And there are signs that now may be a prime opportunity for homebuyers and investors.

By Anthony Mirhaydari
MSN Money

It's no secret: We've just been through an economic nightmare. And it was all because of a corruption of the American Dream.

What caused the mortgage mess?

Instead of being the blessing that promised wealth, independence and self-determination, homeownership became a shackle that still ensnares nearly 11 million Americans. These are the souls who now live with the burden of negative home equity.

You know the story. Ultralow interest rates, caused by Federal Reserve errors and Chinese currency manipulation, encouraged a housing boom, the greatest of all bubbles and the resulting fallout. Unemployment. The bank bailouts. The automaker bailouts. The stimulus package. Even the European debt crisis.

But that's old news. And many, including value investor and hedge fund operator Bill Ackman of Pershing Square Capital, who made billions shorting housing-related bond insurer MBIA (MBI, news, msgs) in the last days of the boom, are now calling for its resurrection.

In a leaked research report titled "How To Make A Fortune," Ackman doesn't just say the path to wealth through homeownership has been restored. He says this road has seldom been easier.

Core beliefs unchanged

If you're like most people, you're probably skeptical -- particularly since home mortgage rates kicked higher recently, albeit off record lows.

A recent Fannie Mae survey found that 66% of Americans believe buying a home is a safe investment. Compare this to a high of 83% back in 2003. And the Conference Board's recent report on the number of consumers planning to buy a home in six months fell to 1.7% in November from 2.2% previously.

Recent economic data haven't been supportive either, as the temporary boost from the homebuyer tax credit fades. Sales are down. Prices are falling again. New construction activity is down. It's harder to get a loan. And now, mortgage rates are creeping higher as the bond market prices in higher inflation and stronger economic growth.

But deep down, this is a message that still resonates with people. Another survey by Fannie Mae found that despite what the housing market's just been through, most people still aspire to homeownership.

And as the economy continues to improve and jobs are created (see "2011 -- the most new jobs since 1995?"), the coming rebound in the housing market will become increasingly clear. Barring some unforeseen calamity, another self-perpetuating cycle of higher home prices encouraging increased homeownership and even higher prices is coming as early as next year. Here's why.

Why it's time to buy

Basically, the bull's case as outlined by Ackman can be boiled down to a few simple bullet points:
  • Home prices are at their lowest valuation in at least a generation.
  • A large number of forced sellers gives buyers negotiating power.
  • Attractive, low-rate financing.
  • Still favorable long-term supply dynamics as the U.S. has one of the best demographic outlooks in the developed world.
  • Housing is an out-of-consensus idea that is under-owned by institutional investors.

The most important factor is affordability.

With home prices down by nearly one-third from their high, housing affordability as calculated by the National Association of Realtors has moved to the highest levels since the recordkeeping started in 1971. Also, with rents on the rise again as vacancy rates fall, the required annual home price appreciation needed to "break even" on a comparative analysis of buying versus renting costs has also fallen to levels not seen since the 1970s.

Right now, according to the work of academics Eli Beracha of East Carolina University and Ken Johnson of Florida International University, home prices would need to rise by 4% annually to make homeownership a better deal than renting. Compare this to the high of 10.5% reached in the early 1980s.

30-year conventional mortgage rates © MSN Money
This is being driven in large part by the massive decline in long-term interest rates over the past 30 years. After former Federal Reserve chairman Paul Volcker smashed inflation in the early 1980s, a "Great Moderation" ensued in which economic volatility and inflation were kept in check by what was believed to be infallible central banking theory. That helped keep interest rates down for years.

After the Great Recession blew away the Great Moderation, ultraloose monetary policy support by the Federal Reserve, including its latest $600 billion money-printing operation dubbed "QE2," pushed rates to historic lows. During QE1, the Fed purchased more than $1 trillion worth of mortgage securities to keep rates low. All that money has done the trick, giving homebuyers some of the most attractive financing terms in the economy. Where else can you borrow hundreds of thousands of dollars at 4.5% for 30 years?

Don't fear the 'shadow'

We should mention the supply side of the equation. There's a lot of concern that the "shadow" inventory of homes under foreclosure, or soon to be foreclosed on, will weigh on prices for years to come.

Already, there's an 11-month supply of homes on the market. New-home inventory totals around eight months of supply. Compare this to a low of less than four months of supply in 2004, and it's clear that the market is swamped.

But Maury Harris at UBS isn't worried. He believes that despite as many as 2 million annual foreclosures putting homes on the market in the next few years, prices should stabilize by the end of 2011. It's as simple as supply and demand.

On the demand side, Harris is looking for a big bounce in job-driven household formation. Census data show that as the recession bared its claws, young adults were increasingly forced to live with relatives -- pushing the household-formation rate to 50-year lows. Although the jobs recovery has been tepid so far, the number of new households being formed has returned to pre-recession levels. Living with mom and dad loses its appeal pretty fast, no matter how much cash you save.

Also contributing to demand is the need to replace old, unwanted homes. Urban blight and areas with heavy foreclosure activity have encouraged local leaders to bulldoze. Detroit has destroyed nearly 13,000 homes over the last decade, and the city's incoming mayor has vowed to tear down an additional 10,000. Around Cleveland, 1,000 abandoned homes will be leveled next year.

On the supply side, extremely low housing starts will limit the number of new homes hitting the market. The dearth of construction and tightened credit standards force people into rentals -- boosting rents and changing the buy-versus-rent calculus back in favor of homebuyers and landlords/investors looking to cash in on the rental boom.

Another point is that so-called "distressed" properties -- the ones that carry big price discounts -- don't tend to have as big of an impact on surrounding homes as is commonly believed. Harris chalks this up to the fact that 44% of distressed sales represent homes in below-average condition. This quality difference is likely behind the big price difference between homes sold before foreclosure (such as short sales) versus post-foreclosure sales (after the previous owner strips the home of light fixtures, etc.).

Although they'd never admit it, this is why the banks haven't been in a big hurry to foreclose on people -- letting mortgage defaulters stay free of charge rather than kicking them out and paying for the upkeep of a vacant property.

You can see this in the gap that has developed between loan delinquency and foreclosure rates. Historically, the two have moved in tandem. But according to data from the Mortgage Bankers Association, a 3% gap has formed between the two rates -- up from 0.5% in 2007.

The skeptics

To be sure, not everyone is convinced. Oliver Chang and his team of housing analysts at Morgan Stanley believe that housing is still unaffordable once traditional measures of affordability are properly adjusted and a stiffer lending environment is accounted for.

Indeed, the Federal Reserve reported that during the third quarter 13% of bank loan officers reported loan standards had tightened while fewer than 4% said standards had loosened. The average credit score for FHA-backed loans moved over 700 for the first time in October. And loan-to-value ratios are falling as the era of 0%-down loans fades away and new buyers are required to pony up 20% down payments again.

Moreover, it's harder for people to meet these new, higher hurdles given the volatility in the labor market. Variable income, periods of unemployment and newfound self-employment make two years' worth of income documentation increasingly difficult to produce.

As a result, Chang believes that the NAR's Affordability Index doesn't paint a completely accurate picture of the affordability dynamic playing out in open houses and real-estate offices around the country.

Other measures, such as price-to-income and price-to-rent ratios, are similarly misleading according to Chang's analysis. By filtering out the hardest-hit housing markets in places like Las Vegas and Phoenix, and ignoring the price impact of distressed property sales, both measures of affordability are still elevated. Based on income, prices would need to fall by 12% to get back to 2000 levels. Based on rent, prices would need to fall by 27%. All of this assumes incomes and rents remain constant.

There are other, structural issues to contend with as well.

The issues of mortgage put-backs and shoddy foreclosure paperwork have increased the risks and costs of loan origination for the banks. It's still not clear what the politicians in Washington intend to do with Fannie Mae and Freddie Mac, which now dominate the mortgage lending market as Wall Street has pulled back. And there is still considerable uncertainty about how Wall Street's mortgage activities will be regulated under the new financial reform legislation.

Still, Chang is cautiously optimistic over the long term, noting that while limited mortgage credit availability presents "a headwind to housing recovery," positive demographic trends, rising household formations and falling prices "should eventually reconcile demand with supply."

In other words, the fact that America maintains the highest fertility rate in the developed world -- at 2.1 births per woman -- will eventually result in higher home prices.

So if you ever need to be reminded of the rationale for believing in the housing recovery, just remember that other part of the American Dream: a big, happy family to fill that big house.

The way to play

The obvious way to profit from the coming housing rebound is to buy a home. Particularly if interest rates rise from here, distressed buyers and low rates mean a rare buying opportunity. (Pardon me if that sounds like a real-estate sales pitch.)

For investors looking to play a housing rebound, the SPDR S&P Homebuilders (XHB, news, msgs) is a good candidate. It provides good overall exposure to the sector, with holdings that include construction outfits like PulteGroup (PHM, news, msgs) and KB Home (KBH, news, msgs), home heating and cooling manufacturer Lennox International (LII, news, msgs) and paint expert Sherwin-Williams (SHW, news, msgs). Another option is the iShares Dow Jones US Home Construction ETF (ITB, news, msgs) which focuses on just homebuilders.