The Big Picture

Before we get into too many details about the housing market, there are a couple of things you should think about. First among these is to ignore or steeply discount the media reports and daily economic data. Trends develop over long periods of time and monthly data is pretty inconsequential until you have the chance to look at an extended period, except that they can feed both fears and euphoria (remember 2006) and distract you from truly objective analysis of conditions. So click off the Marketwatch report about today’s new housing starts or the Time.com story on this week’s pending home sales data, and take a calm look at where the market is in the winter of 2011.

The housing crisis – as the media portrays it – is largely a result of an excess of financing supply and the over exuberance of financial institutions to create products backed by mortgages that shouldn’t have been written. The explosion of the demand for these financial instruments led lenders to be less and less cautious about whom they were lending to, and led financial institutions to make assumptions about the never-ending appreciation of home values that weren’t sustainable.

In the final analysis, there were a lot of complicated and unsound things going on in the residential finance business in the mid-2000’s. The simple explanation for the outcome is that too many people had mortgages they couldn’t repay and too many banks had obligations based on everyone repaying. A correction was inevitable.

Keeping a New Construction Balance

For the past three years, the result of this bad judgment has been a flood of foreclosures nationally. The foreclosures have hurt many families but they are also the only way to heal the problem so normalcy can return. And there are some important things to remember about all that foreclosure news. First is that the record high number of foreclosures (2.9 million homes in 2010) is being driven by a relatively small number of bad markets. Pittsburgh is not one of them. In fact, California, Florida, Illinois, Michigan and Arizona accounted for 51% of the nation’s foreclosures last year. At the same time, foreclosures in metropolitan Pittsburgh dropped – again. In fact the number of foreclosures in Allegheny County fell to 469 last year, a level that is lower than in 2005.

Nothing suppresses value and the demand for new construction so much as an overhang in the supply of homes on the market, especially a glut of distressed or foreclosed homes.

These figures make it easier to understand why in the face of an extended decline in home values nationally, homes continue to appreciate in metro Pittsburgh. Last year the price of the average home in the Pittsburgh region increased by 2.7 percent. And for the past three years, which included the bursting of the housing bubble and the Great Recession, houses in Pittsburgh have appreciated 11.6 percent, according to the December 2010 report by RealStats.

Behind this reliable level of home value appreciation are several key factors. Key among them is the healthy job market. Pittsburgh’s unemployment rate (7.6%) has risen during the past few years, but much less than the rest of Pennsylvania’s (8%) and the national rate (9.4%). Moreover, the economic drivers of this region – healthcare, higher education/technology and now, energy – don’t track as well at the Department of Commerce; so there is anecdotal evidence that unemployment may be declining at an even faster rate.

The regional homebuilders have also helped buoy the housing market by not building as demand slowed. Western Pennsylvania lenders have tightened credit for speculative homes and builders have shown little appetite for introducing spec homes into a less robust market. Pittsburgh’s most active builders – Ryan Homes and Heartland Homes – also have a practice of starting homes with contracts rather than building specs and selling them hard.

Finally, the record low interest rates and tax credits helped boost interest in home buying during the lowest points of the recession. While such incentives did not create a groundswell of home buying, they did remove barriers of entry for a significant number of potential buyers.

Market conditions helped encourage buyers who may have been reluctant. Low borrowing rates made housing as affordable as any time in a century. Builders reduced new construction activity as early as 2007. Foreclosures in the metropolitan area have stayed within the historical norms. All these ingredients make up a recipe for steady, if unspectacular growth because supply and demand stay in equilibrium.

“Balanced is the word I use for the Pittsburgh market,” says Heartland Homes CEO Marty Gillespie. “Westinghouse in the north and Marcellus Shale in Southpointe are driving demand and our regional business leaders have done things to make Downtown and the city more attractive. We had our highest volume ever in 2010 and we see conditions getting a little bit better in 2011.”

Gillespie’s optimism is echoed by another builder. “I’m getting a little more optimistic each year,” says Chris Cinker, general manager for S & A Homes in Mars. “Last year there was still a lot of caution early but the spring went well and that carried over into the summer and then the fall. You can call it a hunch but I feel like 2011 will be a good year.”

Homebuilders continued to keep a lid on building plans in 2010, however. At year end the Pittsburgh Homebuilding Report listed 2,767 total dwelling units started, a 1.4 percent decline compared to the 2,807 started in 2009. Traditional detached units showed a 23 percent increase, but the drop-off of nearly 400 units of attached or multi-family units dragged the total into negative territory. The forecast for 2011 is for improvement in the attached home and multi-family categories, and continued recovery in detached homes but that volume for new construction that is restrained by historical standards.

“Home value is the biggest positive in the market here,” says Hanna Realty Services CEO, Howard ‘Hoddy’ Hanna III. “That should have a positive impact on new construction if financing loosens up. We see appreciation near five percent this year, which should further close the gap between new construction prices and those of existing homes that are newer construction.”

The gap Hanna refers to is one of the reasons new home construction has been muted in a fairly solid market. The buyers of new construction have traditionally been willing to pay a premium for new construction. As prices for existing homes have continued to rise, that premium has shrunk. The move-up buyer has been very cautious since 2008, a fact that has slowed demand for new housing and kept new product from becoming inventory. Hanna thinks the improved perception about the overall economy could be a tipping point.

“I feel there is a lot of pent up demand for people who were planning a move up to their second or third home but who took themselves out of the market because of concern about their job security or the stock market,” he says.

Moving Up by Staying Put

Economic upheavals like we recently experienced tend to chill the market differently across the spectrum of housing available. Tighter credit conditions make it much harder for first-time buyers to qualify for mortgages, so even with an $8,000 tax credit the demand for new starter housing really dropped off. Recessions tend to put a chill on the move up buyer as well, since the move up depends on selling the existing home and maintaining the higher income level that usually motivates the upgrade. These kinds of buyers drive the need for new construction, which explains the reduced number of new homes in recent years.

Conditions have been better for the homeowner who is interested in moving up by expanding or improving the house he or she occupies. Since the 1970’s, the volume of new construction and improvements has essentially moved in lock step, equally dependent upon good economic conditions to drive volume. The economy has dented homeowner confidence significantly since 2008 and for many owners it has made more sense to invest in the home in which they have been building equity.

This dynamic has been especially true in Pittsburgh, where homeowners can feel justifiably confident about improving a home that is continuing to appreciate. Another boost for home improvement is the fiscal conservatism of the lenders and borrowers historically in Western Pennsylvania. That conservatism restrains growth during ‘go-go’ periods but it also results in higher equity levels in homes regionally, making it easier to qualify for second mortgages or refinancing to pay for that new kitchen or family room addition.

The proof of the pudding is in the numbers. The National Association of Remodeling Industry reported increased volume in remodeling projects and dollars spent in 2009 and 2010.

In part, the increased spending on existing homes was due to the loosening of credit for homeowners. Another factor were the tax incentives for renovations that increased energy efficiency or that added alternative energy sources – like solar panels or windmills – to homes. A third factor was the shift in perception about the economy, which gave buyers confidence to purchase existing homes – many of which were dramatically reduced in price – that could be remodeled or expanded to add significant value.

The latter factor seemed to be most evident in Greater Pittsburgh. Remodeling was up especially in the communities where home values and appreciation remained higher and older homes were available for purchase and renovation. Activity was brisk in places like Mt. Lebanon, Sewickley, Aspinwall and Pittsburgh neighborhoods like Shadyside and Squirrel Hill.

Remodeling an existing home is something that should be thought through and thoroughly planned with experts, regardless of what the economy is like. One of the most common mistakes that homeowners make is to assume that all dollars invested in a home are equal in their return. This is the critical issue with renovating, especially in evaluating the investment with the owner’s expectations for his or her time remaining in the house. If the homeowner expects to remain in the home for another 20 years, almost any renovation will make sense. But if the homeowner plans to move within five or ten years, some projects will have a better justification.

What we’re talking about here is improvements rather than repairs. Upgrading the house’s electrical system or replacing a roof can have little or no impact on the home’s value, but the need to avoid a fire or water damage outweighs any value consideration. Renovations that improve the convenience, functionality or appearance of the home should be considered first, along with any addition or renovation that adds to the living space. Remodeling areas that get the most usage, like kitchens or family rooms, or that appeal to the woman of the house, like bathrooms and kitchens, will bring the highest return on investment in the quickest time.

In all cases, remodeling should not be undertaken without consulting with a qualified remodeling contractor or designer first. These professionals can bring their experience to bear on your project, evaluating the specific characteristics of your home and recommending what projects will make the most sense for your lifestyle and your expectations about resale.

Looking for the Clouds to Clear

It has been a stormy few years for the housing market, even in a market like Pittsburgh that had fewer thunderclaps. Consumer activity at the recent holidays is the first strong suggestion that buyers may be feeling comfortable about the future. If that is so, better days lie ahead for residential construction and real estate. With a global economy that seems to be healing as well, there are reasons for optimism that Pittsburgh’s improved housing conditions are permanent; however, there are a couple of clouds that bear watching in 2011.

One problem area that is carrying over is the tightness of credit. It is true that banks have enormous cash balances right now and pressure to lend, but there are still unanswered questions about many of the regional banks’ real estate portfolios and their need for higher reserves for bad loans. This uncertainty, which isn’t true for all lenders, will keep lending standards conservative in 2011. Don’t expect loans to be approved for more than 80% of the value of the home or for more than the historical ratios of debt-to-income. Expect FICO credit scores of less than 700 to disqualify a borrower more often than not and expect that documentation of income and obligations will be extensive.

The other potential hurdle is the threat of higher costs and inflation. Several commodities that are used extensively in construction – diesel fuel, copper and steel – have experienced price increases of more than 20 percent in 2010. Government intervention in the monetary markets during the financial crisis greatly increased the amount of money in circulation, a condition that has preceded high inflationary periods in the past. If the global economy begins to grow at a more rapid pace in 2011, one of the possible outcomes is across the board inflation. This would make building or improving a house much more expensive. In Pennsylvania, 2011 also marks the beginning of mandated fire sprinklers in new homes, a system that is adding $5,000 to $15,000 to the cost of new construction.

“I would certainly hope that 2011 is finally better for new housing,” says Jim Eichenlaub, executive director of the Builders Association of Metropolitan Pittsburgh. “A lot of what will happen depends on what the financial markets are like and whether or not inflation begins to drive up the cost of construction. At this point I just don’t know.”

That uncertainty extends to the lenders as well, who are very interested parties to the housing market. “We’re really not sure,” chuckles Mike Henry, vice president of residential lending at Dollar Bank, one of Pittsburgh’s leading mortgage lenders. “We know that this market didn’t experience the troubles that many others did and that overall there has been some appreciation in home prices, but there have also been some valuation problems.”

“Dollar is optimistic about 2011. We think it will be a decent year, but we still expect the volume to be on the lower end of average,” Henry says.

The problems in the mortgage market started in 2007, so you’d be reasonable to think that conditions were improving but that isn’t the case right now. “Overall the residential mortgage market continues to get tighter,” observes Dan Dintino, vice president in charge of First Niagara’s mortgage business. “That’s not because First Niagara is getting tighter. It’s set by Fannie and Freddie.”

Dintino refers to the government sponsored enterprises (now fully government operated) Fannie Mae and Freddie Mac. Fannie and Freddie are by far the largest buyers of mortgages that the banks originate, so their standards for loan underwriting become the industry standards. These entities were the vehicles the Clinton and Bush administrations used to boost home ownership by loosening standards. That decision, unfortunately contributed greatly to the crisis that followed. Because of the enormous portfolio size of these organizations (at their peak they owned $4.5 trillion of the total $5.5 trillion mortgage market), the government continued to support Fannie and Freddie through the financial crisis. Even though neither is financially healthy, Fannie and Freddie provide almost all of the secondary market for banks to sell their mortgages. Because they have tightened their standards dramatically, lenders have to follow suit.

Banks that are willing to keep residential mortgages in their portfolios do have more flexibility in lending than Freddie or Fannie may allow, but that carries a price.

“We try not to portfolio residential loans because that usually leads to a higher rate for the borrower,” explains Chris Martin, president of Northwest Savings Bank’s Pittsburgh region. “If we keep the loan we take on the risk and that can mean a quarter or half point more in rate but the fact that we can portfolio a loan allows us to service more customers.”

Lenders that hold some of their own loans are able to make discretionary decisions about borrowers or properties that they know well enough to understand what risks are involved in the decision. Those kinds of decisions are generally made on consumer loans or refinancing rather than new construction.

“Construction financing has also dried up because lenders no longer can do construction loans with a single closing and a single rate,” says Dintino. Lenders have typically done new construction deals by offering a rate during construction that rolled over into the mortgage at one closing when the home was completed. Again, the secondary market is uncomfortable now with construction loans with durations of more than three or four months, which doesn’t allow for completion of most houses in Western Pennsylvania.

“Another of the problems for new construction has been how hard is to get mortgage insurance for the past two years,” explains Dollar’s Henry. Premium mortgage insurance allows buyers with less than 20 percent down payment to still borrow at the most favorable conditions. The upheaval in the housing economy was especially true for new construction in the worst markets, which caused mortgage insurers to run from the risk guarantee business. “We met with a mortgage insurer [in mid-January] and I was pleased to hear that they were coming back into new construction,” he says.

New construction heavily serves first-time buyers, who often don’t have the 20 percent saved, and move-up buyers, who often have the equity accrued to exceed the down payment threshold. The problem for move-up buyers is that homeowners had less confidence that they could start building a new home and have their existing one sell in a timely fashion. Mortgage insurance presented lenders and borrowers an opportunity to bridge the gap until the existing home sold. Without it, many potential new homebuyers held back from selling.

If the climate for new construction does turn stormy because of higher costs or tight credit, it will also mean that the market for existing homes will be better. Pittsburgh has a mature and varied stock of existing housing, improving employment and more people moving in than moving out. These conditions are good for new construction, but in a market where new construction is limited by other factors the current economic conditions in Greater Pittsburgh will be that much more favorable for existing homes.

Northwest’s Chris Martin hasn’t seen any reason to be pessimistic about the overall demand. “In our region we did more productive consumer lending in 2010 than in any of the previous five years and we had a higher volume of mortgages than in any of the previous five years,” he says. “Loan volume hasn’t been a problem.”

The year 2011 seems likely to be marked by continuing economic question marks for the national and global economy, but for Western Pennsylvania the coming year should have many more positives. While the news for all parts of the housing market may not be so great, Pittsburgh’s economy will support residential real estate appreciation. And demand for more homes will be real in metropolitan Pittsburgh. The question marks are for how that higher demand will be met, rather than whether or not there will be demand.

It’s a good time to tune out the noise of the 24 hour news cycle and focus on Western Pennsylvania’s housing market. You’ll like that news better. NH

NH