by Calculated Risk on 3/23/2007 07:19:00 PM

"[T]he persistent imbalance in housing supply and demand ... is fueling intense competition and pricing pressure among homebuilders and other participants in the new home and resale markets."
Jeffrey Mezger, CEO, KB Home, March 22, 2007

The above comment raises the question: Why not adjust the price to balance supply and demand?

This diagram shows the normal Supply and Demand relationship. When supply shifts (dark blue to light blue) then the price falls from P0 to P1.

And when demand shifts, perhaps due to the changes in lending standards (from dark red to light red), the prices falls again, this time from P1 to P2.

So, with the current changes in supply and demand, we would expect falling prices, but no "imbalance in housing supply and demand".

In fact new home prices have been falling. KB Home reported their average selling price declined 5% in Q1 2007 (compared to Q1 2006). And most homebuilders have been providing incentives (upgrades, free landscaping, etc.) that can be viewed as price reductions too.

The above diagram works well for commodities, like corn, but the housing market is far more complicated. First, housing markets are local - most housing services aren't transportable - and one area of the country might have different dynamics than other areas. Second, there are reasonable substitute goods for new homes (mostly existing homes and some rentals) that compete with homebuilders for purchasers of housing services.

Note: usually existing homes compete directly with rentals. However this impacts new home sales too because of the typical chain reactions that occur in the housing market.

During periods of weakness, prices in the existing home market typically exhibit strong persistence and are sticky downward. Sellers tend to want a price close to recent sales in their neighborhood, and buyers, sensing prices are declining, will wait for even lower prices. This means real estate markets do not clear immediately, and what we usually observe is a drop in transaction volumes.

This sticky price phenomenon in the existing home market is actually good for new home sales. The homebuilders can lower their prices, and stimulate demand. This probably helped the builders in 2006. However when existing home supply reaches a certain point, prices start to fall in the existing home markets too. Also, when lenders start taking short sales, and banks are selling REOs (bank Real Estate Owned), this puts additional pressure on prices.

Click on graph for larger image.

This graph shows monthly existing home inventory since January 2004. The National Association of Realtors (NAR) noted today: "Raw inventories peaked last July at 3.86 million, and supplies topped at 7.4 months in October." However, NAR didn't note that inventories usually increase through mid-summer, and inventories will probably be well over 4 million this summer.

In fact, if inventories grow at the same percentage rate as last year, inventory levels will reach 4.8 million in August. If inventories grow by the same quantity as 2006, inventories will be over 4.6 million by August.

With tighter lending standards, demand will probably fall too. Credit Suisse recently estimated new home sales would fall by 21% in 2007. BofA estimated a decline of 15% for new home demand in 2007. We will probably see a similar decline in existing home sales.

This graph shows annual existing home sales and inventory for the last 30 years (2007 estimated). The graph shows an estimated inventory increase to 4.5 million units, and sales falling to 5.7 million units (my estimate is 5.6 to 5.8 million existing home sales in 2007).

Inventory of 4.5 million units, and sales of 5.7 million, means 9.5 months of supply this summer. For the more optimistic, use 4 million units of inventory, and sales only falling to 6 million units, giving 8 months of supply.

Usually 6 to 8 months of inventory starts causing pricing problems, and over 8 months a significant problem. With current inventory levels at 6.7 months of supply, inventories are now well into the danger zone. By mid-summer, months of supply will likely be a significant problem.

And this takes us back to the supply demand imbalance. The huge overhang of existing home supply makes the market appear to be out of balance to the new home builders.