Real Estate Mini-Bubble Deflating May Be Economy’s Next Problem

The housing and automobile industries are the main driving forces of the economy - in both directions. That makes sense since consumer spending accounts for 70% of the economy, and homes and cars are the biggest ticket items consumers spend money on. More importantly, unlike most purchases, it’s not just spending the money they made last week, but through loans and mortgages it’s spending in advance money they will earn for the next five to thirty years.

That housing and autos therefore continue to be the economy’s main driving forces was dramatically demonstrated when both home and auto sales were so instrumental in driving the economy and markets higher after the 2000-2002 meltdown. And then when the resulting real estate bubble burst in 2006, housing and autos led the way down into the sub-prime mortgage catastrophe and then the meltdown into the 2008-2009 Great Recession.

Their powerful influence continued when in 2008 and early 2009 $trillions were spent, mostly on the bailout of banks and the rest of the financial sector, but the economy didn’t begin recuperating to any noticeable degree until the housing industry and automakers began their substantial recovery.

And they have indeed experienced a substantial recovery.

While the auto industry in Europe continues in recession (auto sales down 8.2% last year to the lowest level in 18 years), by 2012 U.S. automakers had jumped from reverse gear all the way into 4th gear, posting their highest annual sales since 2007, with the pace of sales continuing so far this year (although automakers missed the forecasts for their sales growth in July).

Meanwhile, for close to two years the real estate sector has been blasting through the most optimistic forecasts for its recovery.

At the end of May new housing starts were up a huge 28.1% year-to-date. Existing home sales had increased 15.2% over the previous 12 months. Home prices have shot up 12.2% nationally over the last 12 months, the biggest year-over-year jump since March, 2006 (near the peak of the housing bubble). Prices were up more than 20% in some of the trouble spots of the last housing bubble like Florida, California, and Las Vegas. It’s been hot. The National Association of Realtors reported two weeks ago that 47% of all homes sold in June were on the market for less than a month. As in the big bubble of 5005-2006, multiple bids and selling prices higher than asking prices have been fairly common.

However, there have been some troubling signs in the recovery, easily ignored because the basic numbers of sales and prices have been so impressive.

For instance, it’s no secret that the recovery has been mostly driven by institutional investors building inventories of rental properties. For them it’s all about profit. So far they’ve been able to take advantage of low interest rates and depressed home prices. But as prices rise and that opportunity fades away there are already indications they are dialing back on adding more homes to their inventory. Speculators looking for quick profits by buying at the distressed prices and flipping for a quick profit have also been significant factors in the sales numbers. RealtyTrac reports that single family home flips, where a home is purchased and sold again within six months, were up 19% in the first half of this year, and up 74% from the first half of 2011. But RealtyTrac expects that interest to also fade as bargain prices disappear, and is already seeing ‘buying to flip’ tapering off in many markets.

A sustainable housing recovery has always needed real home buyers who intend to live in the homes, and particularly a healthy percentage of first-time home buyers. We haven’t been seeing that, and we’re not liable to any time soon with the higher home prices and higher mortgage rates raising monthly mortgage payments significantly.

Meanwhile, even much of the reported increases in new home construction have been for multi-family housing for renters. As of June 30, single-unit housing starts were 67.6% below their January, 2006 pre-recession level.

And now we’re seeing the first indications of the mini-bubble potentially beginning to deflate.

New housing starts plunged 9.9% in June, to their lowest level in 10 months. Permits for future starts fell 7.5%. Existing home sales declined 1.2% versus the consensus forecast for a 1.5% increase. Pending Home Sales fell 0.4% in June. Construction Spending unexpectedly fell 0.6% in June, well below the consensus forecast for an increase of 0.5% (and the largest monthly decline in five months). And these reports are mostly from housing activity in the period prior to the spike in mortgage rates of the last six weeks.

The real estate sector led the way down into the financial meltdown and 2007-2009 bear market. It turned back up in early 2009 precisely at the bear market low even though housing sales and prices were still tumbling.

With the housing recovery potentially stumbling again investors would do well to keep an eye on the SPDR Home-Builder ETF, symbol XHB, and home builder stocks like Toll Brothers (TOL), DR Horton (DHI), Pulte Corp (PHM), and Lennar Corp (LEN).

The Home Builder etf XHB was down more than 12% in May and June, but has been recovering some but lagging well behind the overall stock market’s spike to new highs.