Wednesday, June 24, 2009

House Prices and New versus Existing Homes Sales

This week we have received the May data on existing home sales (from the National Association of Realtors) and new home sales (from Census). Existing home sales have been flat or rising a bit for 2009. Such stabilization in the market for existing homes has been a sign to many observers that we may be reaching the bottom in house prices. However, at the same time new home sales have continued to fall relative to their 2008 levels. As people have noted (see CalculatedRisk), there is now a gap between new home sales and existing home sales that did not exist before 2006. As I show here, whatever is driving a gap between new and existing homes sales is also driving a gap between the relationship of existing home sales and real house price growth. The evidence suggests that a supply side shock is driving up existing homes sales relative to new home sales and at the same time driving down prices, just as standard econ 101 predicts. Furthermore, price growth is related to new home sales, not existing home sales. The punchline: if we are seeking stability in house prices we should look at new home sales, not existing sales.

Figure 1 plots annual single family existing homes sales and single family new homes sales as a percentage of the total housing stock (the total housing stock is taken from Census). We see that new home sales average about 1% of the total housing stock, while existing home sales average roughly 4%. To get a feel for how the two series move together, figure 2 plots the percentage deviation for each series from its mean from 1975-2008. We see clearly that from 1975 to 2006 (the solid lines) that new home sales and existing homes sales move around together, with a correlation of 0.944 over the the time period up to 2006. However, as shown by the dashed lines, a gap has developed post 2006, resulting in the correlation for the sample from 1975-2008 falling to 0.876. There seems to be some type of a shock that is driving existing homes sale up relative to new homes sales.

Turning to prices, figure 3 graphs expected annual real house price growth next to existing homes sales. Expected real house price growth is the FHFA (formerly OFHEO) house price index, made real by the rate of expected inflation from the Philly Fed survey of forecasters. The existing sales series is the same as in figure 2. Once again, we can see clearly that from 1975 to 2006 both series move around together, with a correlation of 0.921. However, post 2006, a gap develops just like the gap between new home sales and existing home sales. Using the whole sample up to 2008 the correlation falls to 0.812.

Both of the gaps suggest a shock hitting the housing market. To put it more clearly, figure 4 plots both a `price shock' and and `existing sales shock'. The price shock is the shock to price growth that is not explained by existing sales in figure 3. (This is actually the error term from a linear regression of price growth on existing homes sales relative to the housing stock). The existing sales shock is the shock to existing homes relative to new home sales, the difference in figure 2. (the existing sales shock has been normalized to be on the same graph as the price shock). From 1975 to 2006 these two shocks are essentially unrelated. However, in 2007 and 2008 both shocks are sizeable, moving in opposite directions. What we have is a classic supply side shock: quantities rising and prices falling. The glut of vacant houses on the market are doing what they do: drive down prices, and drive up sales.

The implication is that the supply shock is breaking down the standard relationship between sales and price growth. Existing home sales is not the place to be looking for stability in house prices. Instead, figure 5 plots new home sales relative to house price growth. Here we can see that new home sales are related to house price growth, and this relationship has maintained itself through the crisis. The correlation from 1975-2006 is 0.881, while for the whole sample from 1975 to 2008 it is 0.899. Therefore, if we are looking for price stability, we should look to new home sales, not existing home sales. The supply side shock that is hurting prices and raising existing home sales causes new home sales to fall. To stress the point a bit more, the stability in the housing market that we want for economic recovery is stable prices and new home construction. Stable prices are associated with new home sales not existing home sales. The current stability in existing home sales is most likely just the effects of a supply side shock that is driving down both prices and new home sales. In my next entry I will use search theory to guide us in understanding this behavior in the housing market.

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