Rising Inventory Could Stall Home Price Rally

The economics blog Calculated Risk put up a very interesting graph last week that showed the relationship between housing inventory and home prices at a national level.  It was so interesting, in fact, that I decided to “borrow” the concept and recreate the graph for San Diego County.

It is below, but it requires some explanation.  The orange line indicates the number of months’ worth of San Diego housing inventory.  This is simply the number of homes for sale in a given month divided by the number of sales that same month, and it allows us to measure the supply of homes in terms of how much demand there is for that supply.  I only had supply data going back to 2006 so the graph is not as far-reaching as the one on Calculated Risk.

The red line indicates price changes according to the San Diego Case-Shiller index. (The index is only current through April, hence the missing data point at the end).   Prices are measured in terms of the monthly change, but they are annualized (multiplied by 12) to put in perspective for us folks who are used to looking at annual rates of change.  Now, this part is important: the price change is inverted, meaning that prices are falling when the red line is high and rising when the red line is low.  The reason for this inversion is to show how high inventory tends to correlate to price declines and low inventory to price increases.

OK, with that exposition behind us, you are allowed to actually look at the graph:

 

 

As with the national figures charted on Calculated Risk, there is definitely a correlation between prices and months of inventory.  (A negative correlation, to be exact — remember that prices are inverted!)  That is to say, prices have tended to increase when inventory was low and to decrease when inventory was high, with the price effects even more pronounced when inventory got really out of whack.  This is actually just what you’d expect intuitively, but it’s nice to back these expectations up with actual data.

The relationship did notably break down during the late-2008 to early-2009 timeframe.  Even though inventory was far down from its prior heights (the orange line declined), home prices continued to plummet (the red line stayed high).  There is an obvious candidate for this discrepancy: the fact that the economy was more or less imploding during that same period.  The economic turmoil was so bad that even a reduction in inventory couldn’t staunch the price decline.  But prices did eventually make a bit of a catch-up move to the upside in mid-2009 after the crisis had receded.  And outside of that crisis period, the inverse correlation between home prices and inventory has been fairly reliable.

It also appears that there is something to the rule of thumb that six months’ worth of inventory makes for a balanced market.  All price increases on the chart took place when inventory was lower than six months, and the great majority of price declines happened when inventory was higher than than six months.

This topic is particularly relevant right now because unlike last year, when the supply of homes remained at a very depressed level, inventory has been rising this year.  You can’t really see it in the graph above because sales volume has also increased to keep pace with inventory.  But the number of homes for sale has indeed been rising, and it is likely that volume was only as strong as it was because of tax credit programs that have either expired or will soon do so.

Then we have that shadow inventory of homes whose owners are not paying their mortgages.  While the precise nature and timing of the outcome for these homes is unknowable, there is a good chance that most them will eventually have to be disposed of on the open market.

The trend toward higher inventory, the likely post-tax credit lull in demand, and the potential for even more inventory to come out of the shadows all combine to suggest that months of housing inventory could start rising dead ahead.  If so, and if the relationship illustrated in the above graph holds up, the price rally that San Diego has enjoyed since early 2009 could stall out or even go into reverse.

– RICH TOSCANO

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K Hernandez

K Hernandez
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