Housing Headed to the Woodshed By Doug Kass Street Insight Contributor 9/29/2006 10:14 AM EDT Click here for more stories by Doug Kass Editor's note: This column by Doug Kass is a special bonus for TheStreet.com and RealMoney readers. It first appeared on Street Insight on Sept. 28 at 8:29 a.m. EDT. To sign up for Street Insight, where you can read Kass' commentary in real time, please click here. "We do expect an adjustment in home prices to last several months, as we work through a buildup in the inventory of homes on the market. ...This is the price correction we've been expecting -- with sales stabilizing, we should go back to positive price growth early next year." -- David Lereah, economist, National Association of Realtors The New York Times, September 2006 Wrong! Lereah, whom I debated on CNBC's "Town Hall Special: The Real Estate Boom," in April 2005, is a very nice man and a capable economist. I recently had a most pleasant conversation with him at CNBC studios two months ago prior to a CNBC Survival special on housing hosted by Bill Griffeth. Lereah is also the author of the book Are You Missing the Real Estate Boom? Why Home Values and Other Real Estate Investment Will Climb Through The End of the Decade -- And How to Profit From Them. Not the most timely publication, Lereah's book was published within four months of the statistical peak in housing activity and prices in 2005. In fact, the paperback version came out in February 2006, when the down cycle was beginning to escalate. I am in no way trying to embarrass Lereah. I am just stating the facts and my opinions, like I try to do when I admit my (many) views and mistakes on Street Insight. Don't think for a minute that the National Association of Realtors' Lereah was expecting a price correction last year, as stated in this month's New York Times interview above. Back in April 2005 (on the CNBC special), Lereah and the managements of Hovnavian (HOV - news - Cramer's Take), Prudential Realty and LendingTree were fully convinced (you might say glib) that the housing market was destined for a long boom. They saw a new paradigm of uninterrupted, noncyclical growth. One month later, Lereah was quoted as saying, "We simply don't have enough homes on the market to meet demand." That was then, and it doesn't pay to dwell on the past. So let's look into the future. Unfortunately, many within the homebuilding business continue to talk their book despite clear trends that do not support their bullish view. Forgive my preoccupation with the housing markets, but it has had a disproportionate role in economic growth since 2000 (and maybe before). This merits a continued discussion as to the possible slope of the decline, and the nature of the inevitable recovery. The housing cycle, among other variables, is a key influence on aggregate economic activity. I expect a hard landing, and I have roughly quantified my expectations as to when the housing market will bottom (2009). It is folly to think that an unprecedented rise in home prices (in real and nominal terms) will be over in relatively short order. Yet this has been suggested by Lereah and others. Housing cycles are long, and they play out over many years. We have learned that the peaks are surprisingly high and the up cycles unexpectedly long. Unfortunately, so too are the depth and duration of the down cycles. Days/months inventory have only begun to rise as the glut of homes will be exacerbated by continued overbuilding, disposition of land, and the selloff of homes by flippers. And, as discussed previously, the consumer enters the current downturn in a weak position. Consumers are highly leveraged after the overconsumption binge of the last decade and after massive cashouts of home equity. Consider the dramatic sale of D.R. Horton (DHI - news - Cramer's Take) homes in the Daytona Beach market in Florida. Please note the message at the bottom of this advertisement: "Realtors Warmly Welcomed!" That's never a good sign. These discounts include up to $90,000 a unit or as much as 30% (plus a free washer/dryer and refrigerator). This is not unusual: Most homebuilders have offered large price discounts and/or large incentives (vacations, car leases, reduced mortgage rates, etc.) for several months. For a moment, let's suppose that you were a flipper in the Daytona Beach D.R. Horton community who owned and speculated on a few homes without the intention of moving in. You just took a 30% haircut on your inventory, not to mention carrying costs of a mortgage, real estate taxes and expenses to keep up the property (landscaping, utilities, etc.). And when the unit is finally sold, you have to pay a real estate agent a 6% commission. That speculator likely put up less than 20% up front (probably far less), and is now out, by my calculation about 50%. But making the situation worse is this: Who wants to buy a used home when you can get a new one like one in the advertisement above? The ramifications of an extended housing downturn are broad -- far broader than many realize. For example, the apartment REITS, a sector I am short, argue that there has been no new construction, so supply/demand favors an escalation in rents. But just wait until speculators, unable to sell their condominiums and homes, resort to renting the units. Or consider the implications for building materials companies like Eagle Materials (EXP - news - Cramer's Take), which warned on Tuesday. What about the sale of pickup trucks, which are often used on the construction trade? What does an extended downturn portend for carpet, gypsum, lumber and appliance manufacturers? Or for subprime and some prime lenders? And what do you suppose happens to the plethora of real estate agents and mortgage brokers? (Do they become daytraders again?) You get the point: The housing decline is just beginning to be felt. The fixed-income market recognizes this. But for now, equity market participants don't. Common sense has taken a sabbatical. Don't believe the housing soft-landing advocates, and do recognize the broad economic impact that a protracted downturn will have on our economy. The worst is yet to come.