Home sales are improving, but they have a long way to go before they return to normal. By James K. Glassman, Contributing Columnist December 1, 2011 The recession that started five years ago was caused by a gigantic bubble in real estate prices. According to the S&P/Case-Shiller Home Price index, the value of U.S. homes prior to that had been remarkably stable for a century. Starting at a benchmark of 100 in 1890, inflation-adjusted prices fluctuated modestly, bouncing between about 65 as a low and 125 as a high. In 2000, the index was at 110. In other words, over a period of 110 years, the value of the average U.S. home had risen just 10% more than the rate of inflation. SEE ALSO: Kiplinger's Economic Outlook for Housing Sales Then something utterly unprecedented happened. The value of homes started rocketing into the stratosphere. The index burst past 125 in just two years and then past 200 by 2007. In seven years, home prices roughly doubled. The rocket reached its apogee and headed down on the same trajectory it went up; the index is now at about 140. Bubble Trouble We can argue about why the bubble occurred and whether it could have been prevented, but there is no arguing about the consequences—a deep recession and an anemic recovery. (My own view is that the culprits were lax Federal Reserve monetary policy and political pressure brought to bear on Fannie Mae and Freddie Mac to underwrite untenable loans.) Advertisement Sure, there have been bubbles before. Think of tech stocks: The Nasdaq Composite index soared 170% between July 1998 and January 2000 and then lost three-fourths of its value in the next two and a half years. Residential real estate, however, is unique. First, it’s by far the most important thing most families own. For example, in 2006, U.S. households had real estate assets worth $23 trillion and stocks and mutual fund assets worth $14 trillion. Second, homes are bought with a lot of debt. Home mortgages totaled $10 trillion in 2006, and they total about the same today. That compares with less than $3 trillion for all other consumer credit. The leverage used to buy real estate made sense to lenders because historically the risk profile of a home was extremely modest. Over time, although the value of a home went up, prices weren’t especially volatile. And because a home was an asset you lived in, you weren’t likely to dump it, as you might a faltering tech stock. But the collapse of housing prices, in two short years, changed history. Today, 22% of homeowners with a mortgage owe more than their house is worth. The problem is that "we are not as wealthy as we thought we were," as Tyler Cowen, the George Mason University economist who writes the Marginal Revolution blog, aptly put it. This imaginary wealth, built on the evanescent value of our homes, led us to borrow and consume at a feverish pace, before the party came to an abrupt halt. Advertisement All of this suggests that the most important question for the U.S. economy is, When will housing recover? Nothing counts more. Unfortunately, it’s not a question that can be easily answered. The economy both drives housing and is driven by it. If unemployment falls, businesses begin to invest more and consumers start purchasing again, then we can expect home sales and prices to rise. But, conversely, those economic activities are also dependent on rising home sales and prices. A bit more than a year ago, I wrote a column in which I expressed my conviction that investors were too gloomy about real estate—and about the stocks of the dozen or so national companies that build homes. Two stocks I picked have done very well. PulteGroup (symbol PHM), then trading at $7, now fetches $17 (all current prices are as of the October 4 close). Ryland Group (RYL), then $17, now trades at $32. But the path to these large gains has not been smooth, and the big increases have occurred only recently. At one point, Pulte fell below $4 and Ryland below $10. But sales for both Pulte and Ryland are at last increasing, and the companies have actually started to turn a profit again. For the quarter that ended August 31, revenues for another large homebuilder, KB Home (KBH), climbed 16% from the same period a year earlier, and the average selling price of one of its homes, at $234,100, rose 8%. KB still lost money for the first nine months of its fiscal year, but the deficit was cut by nearly two-thirds. Advertisement The news from homebuilders is good, but it’s not great. The issue for investors is whether that news justifies the recent stock moves. Pulte, the largest homebuilder, doubled in price between the beginning of June and the end of September. How can we determine whether $17 is too low, too high, or just right? It’s not easy. Like Ryland, KB and many other homebuilders, Pulte has not earned an annual profit since 2006—though it may eke out one this year. Revenues for the 12-month period that ended June 30 totaled $4.4 billion, lower than they were a decade ago and less than one-third the level of 2006. Let’s assume that in three years, Pulte can get back to its 2002 revenues of $7.5 billion (an annualized growth rate of about 20%) and profits of $1.80 a share. Even when Pulte was in the black, its stock rarely sported a double-digit price-earnings ratio. So it is hard to see how, at its current share price, Pulte is worth the risk—unless, of course, home sales go through the roof in the next few years. Which brings us to the bigger picture: What’s happening today in residential real estate? Improving Numbers The recession slowed new-housing starts severely, and, as the years have passed, the supply of new houses has constricted. In August, the industry reached what the National Association of Home Builders called “a historic low” of just 141,000 units on the market—that’s a supply of roughly four and a half months at the current sales pace, down from close to a year’s supply at the end of 2008 and seven months’ supply in 2010. Meanwhile, median home prices rose in six of the seven months between February and August, at an average annual rate of 6%. Advertisement Home sales are moving in the right direction, but they have a long, long way to go to get back anywhere close to normal. The nation’s homebuilders expect to sell 373,000 new houses in 2012. That’s well below the million-plus annual sales that prevailed as the bubble was inflating in the middle of the last decade and, more important, about half the level that prevailed during the late 1990s. Certainly, homebuilders have benefited from tightened supply and pent-up demand, but I am not optimistic that we are on the brink of a housing boom that will get us back to normal quickly. So I offer several investing suggestions: First, instead of buying homebuilders, buy home-improvement stocks. A company such as Home Depot (HD), which sells to contractors as well as ordinary consumers, will benefit from a housing boom, but it will also do well as homeowners perform maintenance on residences they can’t sell. Home Depot’s P/E of 18 (based on estimated earnings for the year ending January 2014) is at its highest level in a dozen years. But what’s especially impressive is that the company almost doubled its profit margin between 2009 and this year with nearly flat sales. Over the next few years, as the economy regains its footing, sales will rise and profits should increase briskly. I also like Home Depot’s smaller competitor, Lowe’s Companies (LOW), which trades at 15 times estimated earnings and yields 2.1%. Also attractive is Lumber Liquidators (LL), but, at a P/E of 29, it’s too expensive. Keep an eye on it. In my piece last year, I told readers to buy iShares Dow Jones U.S. Home Construction Index (ITB) because the exchange-traded fund had twice the concentration in homebuilder stocks as its rival, SPDR S&P Homebuilders (XHB). Since then, ITB has returned 60%, while XHB has gained 45%. Today I prefer XHB because it’s loaded with companies that support the housing sector, such as Lennox International (LII), in air conditioning and heating; A.O. Smith (AOS), water heaters; and Mohawk Industries (MHK), carpets; as well as Home Depot and the like. The SPDR ETF also holds homebuilders, led by NVR (NVR). The amazing Reston, Va.–based builder has almost no debt on its balance sheet and managed to make profits each year of the downturn. NVR is expensive (both in terms of its absolute price of $873 per share and its price-earnings ratio), but I would still add it to my portfolio. Otherwise, beware of homebuilders for now. James K. Glassman is founding executive director of the George W. Bush Institute in Dallas, whose new book on economic policy is titled The 4% Solution. He owns none of the stocks mentioned. Kiplinger's Investing for Income will help you maximize your cash yield under any economic conditions. Subscribe now!