U.S. Housing Outlook 2010: A Year of Recuperation

• The housing correction will end in 2010, but by nearly all measures, activity will remain very weak.
• High affordability, abating job losses, and a slight easing in credit will support demand for housing.
• Low construction costs and low inventory levels will encourage homebuilding.
• Foreclosures remain the main weight on housing.

Housing markets are starting off the new year on shaky ground, and the worst housing correction since the Great Depression still has more to play out. Home sales, residential construction, house prices and foreclosures had all improved or stabilized at the end of 2009, but rising foreclosures will send house prices back down in the first half of the year. Nevertheless, the healing job market and policy measures that have supported sales and prices and slowed foreclosures will be enough to help the housing market fully shake off its correction in the second half of this year. By the end of 2010, the stage will be set for a stronger rebound in 2011 and 2012.

Factors driving demand for housing are improving and will increase home sales for 2010, after a post-tax credit adjustment, to 6.2 million, the best performance since 2007.

Foremost among the demand-side positives is affordability. The National Association of Realtors' affordability index remains near a record high, thanks to the sharp decline in house prices and very low mortgage interest rates. Moreover, homes are much more affordable than before this cycle. Homes are now 13% more affordable than they were at the previous peak in 1971. Further, the cost of owning relative to renting is improving: While still slightly elevated, the price-to-rent ratio is nearing its long-term average.

Affordability will remain high this year. House prices will not rise. Mortgage interest rates, which have been held down in large part by policy actions, will reverse course but remain low by historical standards. Renting will remain a cost-effective alternative to buying a house, particularly given the large supply of owner-occupied homes converted to rentals. Nonetheless, falling house prices will keep the price-to-rent ratio about stable.

Homes may be affordable, but credit remains scarce to all but the best credit risks. On this front, 2010 should bring some relief. A stabilizing housing market will encourage lenders to loosen standards slightly. At the end of 2009, several lenders, including Genworth Financial and Wells Fargo, had reduced down payment requirements.

Further, the Treasury Department's pledge in December to give Fannie Mae and Freddie Mac unlimited assistance for the next three years offers hope that the GSEs can continue to help lenders provide credit by purchasing mortgages. This support will be crucial once the Federal Reserve ends its purchases of mortgage-backed securities in March.

Another key driver of housing demand is abating job losses. Although the economy's job-creating engine will not kick into gear until the second half of the year and although job growth will be weak, some of the newly employed will buy homes. By the second half of 2010, brighter job prospects and a sense that the housing market is nearing a bottom will improve confidence all around and generate more sales.

Finally, the extension and expansion of the first-time homebuyer tax credit—which expires June 30—will result in 300,000 to 400,000 additional sales in the first half of this year.

Negative homeowner equity will remain a major constraint on housing demand. The trade-up market will suffer as underwater homeowners—those who owe more on their mortgages than their houses are now worth—are unable to sell their homes without a loss. About 21% of all homeowners are under water.

Home construction on the mend

For the first time since 2005, residential construction will boost rather than drag down national output this year. After having stabilized at the end of 2009, housing starts will rise steadily through 2010.

Starts will increase 32% from 2009—a seemingly strong rate given housing's still-weak drivers, but it reflects the low base from which housing starts will grow rather than real strength in construction. Moody's Economy.com expects starts to reach a pace of 750,000 this year, still the second-slowest pace in the data's 50-year history. Not until 2012 will construction return to a more normal pace.

Construction will be concentrated in regions where the recession was less severe and where the housing boom had created fewer imbalances and consequently fewer foreclosures, including Texas and the South outside of Florida and Georgia.

There are some positives for homebuilders. First, the pain of the past few years has brought inventories of new homes to a nearly 30-year low, providing some slack for new construction. Also, construction cost inflation is modest. Certainly, labor costs are very low.

Homebuilders still face two major constraints: Financing of land purchases and construction remains very tight, and foreclosed homes are sucking away demand for new homes. Private builders in particular rely heavily on bank financing, and they still represent a large share of the industry.

Foreclosures will sink prices again

Foreclosures remain the millstone around housing's neck. Given the low conversion rate from trial to permanent loan modifications thus far, Moody's Economy.com expects that HAMP will keep only 400,000 to 1 million loans out of foreclosure this year, compared with the more than 4 million in the pipeline. Thus, sales of distressed homes will climb to 2.4 million this year from 2.1 million last year. These homes will come on the market in the first half of this year, depressing house prices once again. Prices will stabilize in the second half of this year as foreclosures ease. Prices will not grow significantly until 2011. By the time the Case-Shiller home price index stabilizes in the third quarter, it will have declined by 37% from its peak.

The risks to the housing market remain weighted to the downside. The potential for even more foreclosures than expected is the main threat that would prolong and deepen the housing correction. Stronger than expected confidence on the part of homeowners and investors and further policy actions to shore up housing are the main upside risks to the outlook.