Americas UBS Investment Research Building & Building ... Housing report.pdfThis report is a collaboration between Maury Harris, UBS Chief U.S. Economist, and Margaret Whelan and David

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UBS Investment Research Q-Series®: Building & Building Products

Will Empty Homes Translate to Empty Prices?

Will Empty Homes Translate to Empty Prices? Fueled by low interest rates and artificial demand, the median sales price forexisting homes rose by 33% over the past four years. With affordability at a 15-year low and concerns over price declines becoming more prevalent now, bothpotential buyers and investors are delaying purchases, leading to a surge instanding inventory levels. In this report, we discuss the impact of higher vacantinventories on prices, starts, and new home sales.

Quantifying the Impact We developed an annual forecast for incremental housing demand driven bychanges in demographic trends. We estimated normalized frictional supply levelsand compared them to the current pace. From these estimates, we were able togenerate our sales, pricing, and starts forecasts. Based on our proprietary analysis, we believe demand will average 2 million homes through 2009. In the near term,however, supply needs to be tempered so excess inventory can be absorbed. Assuch, we have downwardly revised our forecasts to 1.55mn starts in 2007 and 1.65 in 2008.

Supply Glut to Produce Price Declines We estimate that 870k existing homes need to be absorbed to restore thesupply/demand equilibrium. We forecast a roughly 10% decline in home pricesover the next 12 months or so given that: 1) the level of unoccupied inventorycontinues to rise; 2) only 2% expected CPI inflation means nominal prices must decline in excess of historical levels to generate the real price declines required totrim inventories; and 3) the 4% decline in real median existing home sales pricesfrom the peak has not helped clear excess vacant inventories as of yet.

Navigating Homebuilding Stocks in This Choppy Environment The positive long-term industry dynamic pales in relation to the challenges weexpect through 2008, as reflected in our revisions to price and unit demand forecasts outlined above. That said, however, our 2007 EPS forecast of -46% YOY already reflects the tough environment, and includes a 28% decline inhomebuilding revenues, and on top of an estimated 26% EPS decline in 2006. As such, we believe the deteriorating fundamentals are largely incorporated intovaluations, with the builders trading at 1.2 times tangible book value, well belowthe historical average of 1.7 times.

6 November 2006 www.ubs.com/investmentresearch

Maury N. Harris Economist

[email protected] +1-212-713 2472

Margaret Whelan Analyst


David Goldberg Associate Analyst


This report has been prepared by UBS Securities LLC

mailto:[email protected]:[email protected]:[email protected]://www.ubs.com/investmentresearch

Building & Building Products 6 November 2006

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Contents page

Investment Summary 4 Homebuilding Stocks 6 Valuation 8 In This Report 9 UBS Housing Signposts 11 Maury Harris Chief U.S. Economist 21 Empty Homes = Empty Prices? 22 Margaret Whelan UBS Housing Analyst 37 Housing: The Big Picture 38 Net Immigration Trends 43 Characteristics of New Supply 46 Home Ownership Rates 48 Household Formation 51 Second Home Demand 53 Vacant Units 54 Net Removals 55 Age of Housing Stock 56 What’s in Demand? 57 Regional Profiles 61

Maury N. Harris Economist


Margaret Whelan Analyst


David Goldberg Associate Analyst



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Investment Summary The Big Picture Remains Attractive

The compelling housing market dynamic has underscored our positive thesis on the U.S. homebuilding stocks for the past four years. For example, despite an 80%, or 50 million, increase in the number of households since 1970 to 113 million, total annualized starts of 2.2 million homes at the peak of this cycle in early 2006 represented just 75% of the annualized run rate of 2.9 million starts in 1972. Furthermore, we expect established baby boomers, more affluent echo boomers, rising immigration levels, and growth in non-traditional households to continue to drive the home ownership rate higher. As well, a market share shift toward single-family housing, the steady rise in second home purchases, and accelerating net removals are contributing to incremental demand for new single-family homes.

Introducing the UBS “Housing Signposts” Forecasting Tool

This report is a collaboration between Maury Harris, UBS Chief U.S. Economist, and Margaret Whelan and David Goldberg from the U.S. Homebuilding Equity Research Group. In it, we introduce our proprietary forecasting tool, which quantifies the number of new homes needed annually. Demand is a function of population growth, immigration trends, and changes in the characteristics of households, relative to replacement requirements and changes in vacancies.

Based on our analysis, we believe that long-term annualized demand for new construction will remain close to 2.0 million homes. The current environment is more challenging, however, as measured by new home sales, for example, which are down 21% from the 2005 peak. In 2006, a glut of unoccupied homes built in the past three years, which we measure at 870,000, has flooded the market. These homes need to be absorbed before pricing and unit demand will accelerate. As such, we have revised our forecast for 2007 housing starts to 1.55 million from 1.73 million, a year-over-year decline of 15%. For 2008, we now forecast 1.65 million housing starts, down from 1.80 million, for year-over-year growth of 6%.

Buyer Hesitation Driving Inventory Glut

As demand has faltered, home prices have softened and speculative activity has ground to a halt. Those homes that had been purchased as investment vehicles have now flooded the market and are contributing to an inventory glut. Nervous buyers have delayed purchases, which is evidenced by a 1,000 basis point increase in the average cancellation rate among new homebuilders, to more than 35%. As many of the homes had already been started, we expect the inventory of new homes for sale to continue to rise through year-end, when these deliveries would have taken place. Order trends are seasonal and peak in the spring; until closer to that time, we do not expect to discern any meaningful trend in demand.


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UBS Forecasts Up to 10% Price Decline in 2007

For the reasons cited below, we believe that prices could decline by as much as 10% over the next year or so, as measured by the three major home price indices—median sales price of new homes, median sales price of existing homes, and Office of Federal Housing Enterprise Oversight (OFHEO). Although this magnitude of decline would be the largest since the Great Depression, it must be judged in the context of the record price gains of 33% in the past four years.

■ The months’ of homes represented by vacant inventories are already around the elevated levels associated with real price declines of over 10% in the past two major housing recessions.

■ Relatively low expected CPI inflation of 2%, excluding shelter, suggests that more substantial nominal price weakness, relative to past recessions, will be necessary for real prices to decline enough to help clear excess inventories.

■ During the third quarter of 2006, median existing home prices were already down 2.5% in nominal terms and 4.3% in real terms compared with the prior year. Also, the continued unsold and unoccupied inventory buildup in the third quarter of 2006 suggests that the recently declining prices have not been enough to make much difference yet. In addition, many homebuilders and sellers of existing properties probably are only gradually and reluctantly lowering prices to test demand in a very unfamiliar market.

Impact on Real GDP

With a record home ownership rate of 69% and consumer spending representing some two-thirds of GDP, lower housing turnover and our expectation for further home price declines will have a negative impact on economic growth. Based on our downwardly revised housing starts forecast for 2007, we now expect GDP growth of 2% in 2007, versus 3.2% in 2006, down from a prior estimate of 2.2%.

Despite building fewer units currently relative to prior cycles, until 2006 the dollar value of new supply continued to rise, as new homes are larger in terms of square feet and have more amenities. As aggregate housing-related expenditures now represent some 15% of GDP, the dollar value of new housing is more important to the general economy than the absolute number of homes created. We will update our housing signposts forecasting tool quarterly to remain abreast of potential changes.


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Homebuilding Stocks Near-Term Pain Reflected in EPS Forecasts

The positive long-term industry dynamic pales in relation to the challenges we expect through 2008, as reflected in our revisions to price and unit demand forecasts outlined previously. That said, however, these estimates are already reflected in our 2007 EPS forecasts, which we estimate will fall 46% YOY in 2007, including a 28% decline in homebuilding revenues, and on top of an estimated 22% EPS decline in 2006.

As such, we believe the deteriorating fundamentals are largely incorporated into valuations, with the builders trading at 1.2 times tangible book value, well below the historical average of 1.7 times.

Less Bullish Given 25% Rally

Given the 25% increase in the stocks since the July 18 bottom, it would appear that value players are prepared to get involved early, while shorts are covering after generous returns. Driven by the recent rally, the stocks are now within 19% of our price targets on average. Although we do not expect them to test recent lows, we also do not expect them to outperform until the fundamentals bottom and the end is in sight. As such, we are less constructive than we have been in the past.

Risks and Uncertainty Remain

The biggest risk to our EPS forecasts is the potential for greater than expected home price declines to drive further land-related charges. This would negatively impact earnings from continuing operations, and lead to negative EPS revisions.

As we outlined in our Expect the Kitchen Sink in 4Q06 report published on October 16, the builders are already aggressively reducing their lot positions, with a focus on walking away from out-of-the-money option deposits. Given the sharp demand correction, we think this is prudent, as it frees up cash and reduces the average cost of the remaining lots under control. That said, until home prices bottom, it is unclear where land values will plateau. Declining home prices may delay an improvement in buyer sentiment, in turn extending the duration of this downturn. Further, should conditions weaken throughout 2007, financial distress among smaller private builders would become more prevalent, leading to further price cuts.

Financial Flexibility Is Key

In this environment, we continue to favor builders that are exercising restraint, focusing on profitability over volumes and maintaining strong balance sheets with moderate leverage. The resulting flexibility should enable market share gains once conditions normalize. We favor Toll Brothers, whereas we expect the most downside risk from WCI.


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Toll Brothers

■ In our opinion, Toll’s land position has significantly higher embedded margins relative to peers, as: 1) land parcels are typically controlled for a longer time period; and 2) the company entitles and develops the majority of its lots internally. As such, as prices decline, we believe Toll is less susceptible to increased land charges.

■ Anecdotally, it appears that the mid-Atlantic is stabilizing. Because of Toll’s exposure to this region—which represented 31% of total sales over the trailing 12 months and which was one of the first markets to be impacted during the current slowdown—Toll was the first of its peers to acknowledge the downturn in August 2005. Accordingly, the company’s unit order comparisons should start to ease in fiscal 4Q06 (October), though cancellation rates have risen dramatically over the prior year.

■ We rate Toll Buy 1, and our $37 price target reflects 31% potential upside to current prices. Our price target is based on 11x CY07E EPS.

WCI

■ WCI’s geographic and product concentration among luxury homes in Florida will likely drive greater margin deterioration relative to peers, as Florida was one of the last housing markets to be impacted by the slowdown and has not shown signs of improvements.

■ 25% of WCI’s land position was purchased in 2005/2006. Given the price declines we have already witnessed and are expecting in 2007, we believe increased land-related charges are likely.

■ WCI’s traditional and tower homebuilding orders fell a combined 62% YOY in its June quarter. In light of the increased margin pressures the company now faces, we expect earnings per share to fall to zero next year.

■ We rate WCI Reduce 2, and our $12 price target reflects 24% potential downside to current prices. Our price target is based on 0.5x current book value.


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Valuation Although visibility into near-term performance remains limited, we believe the long-term opportunities for public builders are attractive. With the sharp sales correction in 2006 creating an easy comparison, the stable economic backdrop and compelling industry fundamentals should result in trough EPS for this cycle in 2007.

This year, the builders have judiciously foregone less lucrative land purchases in favor of hoarding cash for future opportunities. At the same time, these cyclical stocks are now trading below comparable historical multiples of our estimates for trough EPS. Up 25% since the mid-July bottom, the stocks have already started to move towards cyclical peak multiples.

Past Cycles

Table 1: Operating Results and Macroeconomic Statistics in Past Cycles

4Q93-1Q95 4Q98-2Q00 1Q04 - Current

Peak Trough Chg Peak Trough Chg Peak Trough Chg

FFR Rate Increase (bps) 3.00% 6.00% 300bps 4.75% 6.50% 175bps 1.25% 5.25% 400bps

30 Year Mortgage (bps) 6.83% 9.20% 237bps 6.74% 8.50% 176bps 5.38% 6.80% 142bps

Home Sales (% chg) 812 621 -24% 958 793 -17% 1,367 984 -28%

Stock Prices (% chg) $7.07 $3.79 -46% $11.53 $8.31 -28% $133.89 $55.18 -59%

P/E Multiple (% chg) 15.6x 10.8x -31% 10.2x 3.8x -63% 8.6x 5.4x -37%

MBA Purchase Index 137.5 95.7 -30% 343.1 231.7 -32% 529.3 375.6 -29%

Source: U.S. Census Bureau, FactSet, Mortgage Bankers’ Association of America, and UBS estimates


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In This Report — We examine the economic and demographic variables that drive

incremental housing demand.

— We provide 35 years of historical data for these variables and illustrate far-reaching trends that have yet to be fully recognized in the home ownership rate.

— We pinpoint which metrics grew overheated in the past three years and how best to monitor absorption rates to identify when the supply/demand imbalance has reached equilibrium.

— Using these same variables, we quantify estimated incremental annual housing demand for the next three years using our housing signposts forecasting tool.

— We present our new, downwardly revised estimates for starts in 2007 and 2008 and discuss our forecast that home prices will decline by roughly 10% over the next year or so.

— We present inventory data, by metropolitan statistical area, to provide increased granularity into which housing markets may be most impacted by excess supply.


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UBS Housing Signposts Revised Housing Starts Forecast Based on our proprietary analysis, and as detailed in the table below, we estimate total demand for new homes of 2.0 million annually through 2008. Given the current supply overhang, however, which we estimate at 870,000 of for-sale homes, we expect below-average supply in 2007 and 2008.

This is reflected in our revised forecasts for housing starts, which are now 1.55 million for 2007 versus our former estimate of 1.73 million, and 1.65 million for 2008 versus our former estimate of 1.80 million. To arrive at our starts forecast, we netted our annual estimates for total demand against excess inventory. We expect inventory reductions to decelerate over time, as builder constraint wanes with the return of pricing power.

Table 2: Forecast Housing Starts

2007E 2008E Household Formation

Forecast Total Households (mns) 115.2 116.6 Forecast Total YOY Δ Households (mns) 1.35 1.36

Teardowns Beginning of Period Housing Stock (mns) 125.9 127.4 Forecast Teardown Rate 0.44% 0.44% Total Replacement Demand (mns) 0.56 0.56

Second Home Sales Beginning of Period Housing Stock (mns) 3.9 3.9 Forecast Second Home Growth 2.34% 2.34% Total Second Home Demand 0.09 0.09

Forecast Housing Starts (SF & MF) Total Demand For New Construction (mns) 1.99 2.01 Less Inventory Reduction (mns) -0.44 -0.36

Forecast Total Starts 1.55 1.65 YOY Change in Starts (%) -15% 6%

Source: U.S. Census Bureau, Fannie Mae, FHA, Freddie Mac, Inside Mortgage Finance, MICA, National Center for Health Statistics, HUD, VA, and UBS estimates


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Demographics Driving Housing Demand Our forecast for new construction demand is primarily driven off changes in the following demand drivers:

■ Household formation. After regressing a number of likely economic and demographic variables, we determined that net births (births less deaths), average age of the population, and immigration were the most significant predictors of household formation. Since 1970, the correlation between these variables and total households has been 99%.

■ Second home sales. Our forecast for the contribution to demand from second homes is based off the total number of seasonally vacant homes, as calculated by the Census Bureau. We estimate the future growth rate based on the 10-year CAGR through the third quarter of this year. Our result of 86,000 homes per year may prove conservative given the likely increase in demand from aging baby boomers.

■ Replacement demand. With one-third of the total housing stock in this country constructed before 1960, we forecast that approximately 560,000 homes, or 0.44% of the total stock, will need to be replaced each year. This level is in line with historical averages, as measured by the U.S. Department of Housing and Urban Development.

Table 3: Household Formation, Annual Growth Rates for Predictive Metrics

Net Births Average Age Immigration

YOY % Δ YOY % Δ YOY % Δ

2006E 0.75% 0.33% 4.54%

2007E 0.75% 0.33% 4.54%

2008E 0.75% 0.33% 4.54%

2009E 0.75% 0.33% 4.54%

Source: U.S. Census Bureau, UBS Estimates


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Table 4: Household Formation, Historical and Forecasted Levels

Net Births Average Age Immigration Estimated Actual Year (Births-Deaths, 000s) (years) (000s) Households (mns) Households (mns)

1971 1,628.4 31.9 370.5 62.1 64.4

1972 1,294.5 32.0 384.7 65.1 66.7

1973 1,164.0 32.2 398.5 67.5 68.3

1974 1,225.6 32.4 393.9 69.3 69.9

1975 1,251.3 32.6 385.4 71.3 71.1

1976 1,258.3 32.8 499.1 73.7 72.9

1977 1,427.0 33.0 458.8 75.1 74.1

1978 1,405.5 33.2 589.8 77.5 76.0

1979 1,580.6 33.4 394.2 78.5 77.3

1980 1,622.4 33.5 524.3 80.2 80.8

1981 1,651.3 33.6 595.0 81.4 82.4

1982 1,705.7 33.8 533.6 82.8 83.5

1983 1,619.7 33.9 550.1 84.7 83.9

1984 1,629.8 34.1 541.8 86.0 85.4

1985 1,674.1 34.2 568.1 87.5 86.8

1986 1,651.2 34.4 600.0 89.2 88.5

1987 1,686.1 34.5 599.9 90.4 89.5

1988 1,741.5 34.6 641.3 91.4 91.1

1989 1,890.5 34.7 1,090.2 92.6 92.8

1990 2,009.7 34.7 1,535.9 93.7 93.3

1991 1,941.4 34.8 1,826.6 95.2 94.3

1992 1,889.4 34.9 973.4 95.1 95.7

1993 1,731.7 35.0 903.9 96.7 96.4

1994 1,673.8 35.1 804.0 97.9 97.1

1995 1,587.5 35.3 720.2 99.5 99.0

1996 1,576.8 35.4 915.6 101.4 99.6

1997 1,566.6 35.6 797.8 102.6 101.0

1998 1,604.3 35.7 653.2 103.7 102.5

1999 1,568.0 35.8 644.8 105.0 103.9

2000 1,655.5 35.8 841.0 104.5 104.7

2001 1,608.2 35.9 1,058.9 106.2 108.2

2002 1,578.2 36.0 1,059.4 107.8 109.3

2003 1,641.7 36.1 703.5 108.5 111.3

2004 1,722.7 36.3 957.9 110.2 112.0

2005 1,711.0 36.5 1,122.4 112.5 113.3

2006E 1,723.9 36.6 1,173.3 113.9

2007E 1,736.8 36.7 1,226.5 115.2

2008E 1,749.9 36.8 1,282.2 116.6

2009E 1,763.1 37.0 1,340.3 117.9



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Near-Term Supply Overhang: Excess Inventory Low Affordability Forces Buyers to Sidelines

Over the past three years, the growth rate in both unit sales and pricing has been above average, and affordability fell to a 15-year low by the end of 2005. Homebuyers have moved to the sidelines, and housing turnover, which includes both new and existing home sales, is now 15% below the June 2005 peak. We believe the change in buyer sentiment is primarily due to an affordability crunch, as median existing sales prices have increased 33% over the past four years. The decline in sentiment has occurred despite attractive mortgage rates that remain close to historical lows and the benefit of a strong economic backdrop.

Buyer Hesitation Driving Inventory Glut

As demand has faltered, home prices have softened and speculative activity has ground to a halt. Those homes that had been purchased as investment vehicles have now flooded the market and are contributing to an inventory glut. Nervous buyers have delayed purchases, which is evidenced by a 1,000 basis point increase in the average cancellation rate among new homebuilders, to more than 35%.


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Quantifying Excess Inventory In our opinion, current inventories exceed normalized levels by approximately 870,000 homes, based on the average of:

■ Normalized inventory based on months’ supply. In addition, we estimated excess inventories from current months’ supply, based on total home sales over the trailing 12 months. Typically, selling an existing home takes five months—as sales usually occur 90 days after listing, with closings 60 days thereafter. New home sales are delivered six months after an initial order, reflecting average build times. These normalized levels suggest that excess inventory levels exceed 986,000 units, as detailed in Table 5.

■ Normalized inventory based on vacant for-sale homes and unsold, in-process construction. Current levels of vacant for-sale inventories exceed normalized levels—which we estimate as an average of the 2001-03 amounts—by some 660,000 homes. In addition, the number of unsold homes currently being constructed has grown by approximately 100,000 homes over the past three years. In turn, this suggests that excess inventories today exceed demand by 757,000 homes, as detailed in Table 6.

Table 5: Excess Inventory Estimate—Months of Supply Table 6: Excess Inventory Estimate—Vacant For-Sale Units

EHS Normalized Months Supply 5.0 NHS Normalized Months Supply 6.0

Existing Homes For Sale (000s) 3,746 New Homes For Sale (000s) 557 Total For Sale (000s) 4,303 TTM EHS (000s) 6,642 TTM NHS (000s) 1,118 Total Sales (000s) 7,760 Current Months Supply 6.7 Normalized Months Supply 5.1

Estimated Excess Inventory (000s) 986

Current Vacant For-Sale Level (000s) 1,935 Normalized Vacant Level, Avg '01-'03 (000s) 1,276 Excess Vacant For Sale (000s) 659 Current Unsold, In Process (000s) 310 Normalized Unsold, In Process, Avg '01-'03 (000s) 212

Excess Unsold, In-Progress Inventory (000s) 98

Estimated Excess Inventory (000s) 757

Source: U.S. Census Bureau, National Association of Realtors, and UBS estimates Note: Normalized levels based on 2001-03 averages.

Source: U.S. Census Bureau, National Association of Realtors, and UBS estimates


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Weekly Inventory Trends Given our view that builders will not be able to report profitable order growth until inventory levels retract to a more normalized pace, we have created a proprietary database that analyzes weekly trends in the inventory of homes for sale and asking prices in the top 47 Metropolitan Statistical Areas (MSAs). As a percentage of annual permits issued nationally, the markets we monitor represent 50% of the total. However, the builders are geographically concentrated in the fastest growth markets, with close to 75% of the public builders’ sales taking place in the top 50 MSAs.

We have been collecting this data since June 6, 2006. As such, peak levels are based on trends in the past 22 weeks.

Table 7: Inventory Summary, Week of November 3, 2006

# of Markets at Peak

Absolute Inventory Inventory % of Total WOW Change % of Peak Peak Below Peak

Single-Family Total 887,238 60% -1.7% 97% 3 56

Single-Family 0-12 Months 134,082 9% -0.4% 100% 13 46

Condos 294,002 20% -1.1% 99% 12 47

Other 297,180 20% 1.5% 100% 14 45

Total 1,479,783 -0.9% 99% 2 57

Absolute Price

SFH 25% $239,537 -0.3% 97% 6 53

SFH 50% $321,289 -0.1% 97% 8 51

SFH 75% $477,924 -0.1% 97% 9 50

Absolute Price

Condo 25% $171,864 -0.4% 100% 13 46

Condo 50% $235,874 0.4% 100% 15 44

Condo 75% $340,145 0.9% 100% 13 46

Note: *SF total includes SF 0-12 months; WOW = Week Over Week; % of peak since 6/6/06. Source: National Association of Realtors


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Drivers of New Home Sales Household Formation To forecast new home sales, we bifurcated new households into purchasers and renters. To find the likely division, we estimated homeownership rates as a function of nominal per capita income, divorce rates, average age, and subprime issuance as a percentage of total originations. Interestingly, the level of subprime loans issued was the most highly correlated variable, supporting our thesis that much of the increase in homeownership rates has been fueled by increased minority participation, as minority groups typically have less home equity built up.

Chart 1: Homeownership Rate vs. UBS Estimated Homeownership Rate

62%

64%

66%

68%

70%

1972 1976 1980 1984 1988 1992 1996 2000 2004

Hom

eown

ersh

ip Ra

te

Actual Homeow nership Rate Estimated Homeow nership Rate

R2 = 85%

Source: U.S. Census Bureau, Fannie Mae, FHA, Freddie Mac, Inside Mortgage Finance, MICA, National Center for Health Statistics HUD, VA, and UBS estimates

Table 8: Homeownership Rate, Annual Growth Rates for Predictive Metrics

Per Capita Divorce Average Subprime

Income Rates Age Issuance

2006E 4.00% -1.99% 0.33% -3.00%

2007E 3.00% -1.99% 0.33% -10.00%

2008E 3.00% -1.99% 0.33% -10.00%

2009E 3.50% -1.99% 0.33% -10.00%

Note: Estimates for divorce rate and average age are based on a historical 10 year CAGR. Per capita income and subprime issuances are based on UBS estimates. Source: U.S. Census Bureau, Fannie Mae, FHA, Freddie Mac, Inside Mortgage Finance, MICA, National Center for Health Statistics, HUD, VA, and UBS estimates


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Table 9: Homeownership Rate, Historical and Forecasted Data

Estimated Actual Per Capita/Income Divorce Rates Average Age Subprime Issuance Homeownership Homeownership

Year ($s) (Rate/1000 People) (years) (% of total issuance) Rate % Rate %

1971 4,342 3.7 31.9 0.0% 64.2% 64.2%

1972 4,717 4.0 32.0 0.0% 64.5% 64.3%

1973 5,231 4.3 32.2 0.0% 64.8% 64.4%

1974 5,707 4.6 32.4 0.0% 65.0% 64.5%

1975 6,172 4.8 32.6 0.0% 64.9% 64.6%

1976 6,754 5.0 32.8 0.0% 64.9% 64.6%

1977 7,405 5.0 33.0 0.0% 64.4% 64.7%

1978 8,245 5.1 33.2 0.0% 64.4% 64.8%

1979 9,146 5.3 33.4 0.0% 64.7% 65.0%

1980 10,114 5.2 33.5 0.0% 64.5% 65.2%

1981 11,246 5.3 33.6 0.0% 65.1% 65.6%

1982 11,935 5.1 33.8 0.0% 64.4% 65.3%

1983 12,618 5.0 33.9 0.0% 64.0% 64.8%

1984 13,891 5.0 34.1 0.0% 64.4% 64.6%

1985 14,758 5.0 34.2 0.0% 64.3% 64.5%

1986 15,442 4.9 34.4 0.0% 63.9% 63.9%

1987 16,240 4.8 34.5 0.0% 63.7% 63.8%

1988 17,331 4.8 34.6 0.0% 64.0% 64.0%

1989 18,520 4.7 34.7 0.0% 64.3% 63.8%

1990 19,477 4.7 34.7 0.0% 64.7% 63.9%

1991 19,892 4.7 34.8 0.0% 64.7% 63.9%

1992 20,854 4.8 34.9 0.0% 65.2% 64.1%

1993 21,346 4.6 35.0 0.0% 64.5% 64.1%

1994 22,172 4.6 35.1 1.4% 65.0% 64.0%

1995 23,076 4.4 35.3 2.9% 64.9% 64.0%

1996 24,175 4.3 35.4 4.5% 65.2% 64.7%

1997 25,334 4.3 35.6 7.3% 66.2% 65.4%

1998 26,883 4.2 35.7 5.7% 66.2% 65.7%

1999 27,939 4.2 35.8 4.6% 66.2% 66.3%

2000 29,845 4.1 35.8 5.3% 67.9% 66.8%

2001 30,574 4.0 35.9 4.6% 67.5% 67.4%

2002 30,810 4.0 36.0 4.5% 67.0% 67.8%

2003 31,463 3.8 36.1 5.4% 66.5% 67.9%

2004 33,090 3.7 36.3 13.8% 68.8% 68.3%

2005 34,495 3.6 36.5 17.4% 69.7% 69.0%

2006E 35,875 3.5 36.6 16.9% 69.9%

2007E 36,951 3.5 36.7 15.2% 69.6%

2008E 38,060 3.4 36.8 13.7% 69.3%

2009E 39,392 3.3 37.0 12.3% 69.3%



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Second Home and Investor Demand On top of household formation, we add second home demand, but exclude teardowns, in line with the Census Bureau’s methodology for calculating new home sales. Further, we include additional demand from investors, who act as liquidity providers by purchasing homes and renting these units to end-users. We differentiate these buyers from speculators, as we believe these investors have a longer-term focus and as such are less concerned about short-term price volatility. That said, we believe more long-term investors are on the sidelines today, waiting for increased visibility on home prices. This is reflected as a reduction in investor demand to 5% in 2006 and 2007, down from the 10% normalized rate.

Net of Anticipated Inventory Absorption Rates We reduced our new home sales forecast for each of the next three years, as inventory needs to be absorbed. Our annual estimates for inventory reduction are based on 25% of the total inventory reduction, reflecting the fact that new home inventories represent just a fraction of the total level.

Table 10: Forecast New Home Sales

2007E 2008E Household Formation

Forecast Total Households (mns) 115.2 116.6 Forecast Total YOY Δ Households (mns) 1.35 1.36

Predicted Homeownership Rate 69.6% 69.3% YOY Change (Bps) -32 -25

Second Home Sales Beginning of Period Housing Stock (mns) 3.9 4.0 Forecast Second Home Growth 2.34% 2.34% Total Second Home Demand 0.09 0.09

Forecast New Home Sales Forecast Demand by Homeowners (mns) 1.03 1.03

Invest to Rent Demand Invest to Rent Demand (mns) 0.05 0.10 Invest to Rent Demand % 5% 10%

Forecast Total Demand For New Homes 1.08 1.14 Less Inventory Reduction (mns) -0.11 -0.09

Forecast New Home Sales 0.97 1.05 YOY Change in NHS (%) -10% 8%

Notes: Inventory reduction based on 50% of excess taken down in ‘07, and 40% in ‘08. Total households and YOY change in households for ‘06 based on UBS estimated values. 2007 new home sales YOY change based on seasonally adjusted annual rate through September 2006. Source: U.S. Census Bureau, Fannie Mae, FHA, Freddie Mac, Inside Mortgage Finance, MICA, National Center for Health Statistics HUD, VA, and UBS estimates

Our estimates are based on total demand, including: single-family, multifamily, and manufactured homes. Although they appear to be well below current levels, we would note the following:


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■ Single-family sales now represent 76% of total starts, up from the historical average (since 1970) of 62%. Single-family growth has largely come at the expense of manufactured housing, which now represents just 6% of starts, down from its 15% historical average.

■ Our estimate does not include cancellations, which for the public builders have historically averaged some 20%, compared with 35% in the third quarter of 2006. Although the Census Bureau tries to avoid double-counting cancelled homes, we believe its efforts are largely ineffective. As such, new home sales are potentially overstated relative to our estimate.

■ We have found that the reduction in demand to reflect only single-family purchases and then the overstatement of new home sales largely cancel each other out.


UBS 21

Maury Harris Chief U.S. Economist


UBS 22

Empty Homes = Empty Prices? Oversupply Is the Overhang Over the past four years, the median sales price of existing homes has surged 33%. However, those higher prices have inevitably triggered oversupply in relation to underlying needs, as indicated by soaring inventories of unoccupied housing units for sale.

By the end of the third quarter of 2006, the number of unoccupied completed housing units for sale (reported by the Census Bureau) had jumped by 665,000 (52.4%) units versus four years earlier to a staggering 1,935,000 units for sale. Furthermore, over this period, there was a 109,000 (54.2%) increase in the number of unsold single-family housing units under construction to 310,000. Therefore, since 2002, there has been around a 750,000 rise in the number of unoccupied housing units for sale to approximately 2.25 million units. Why this happened and what it means for home prices and housing starts over the next two years are the subjects of this report.

How could there be so much overbuilding? After all, students of the homebuilding industry have been emphasizing a more concentrated and disciplined industry that increasingly responded to homebuyers’ orders instead of building homes on speculation about likely demand and prices. The answer lies on both the demand and supply sides of the housing market.

The Story Begins With Demand Why did the overbuilding happen? The story begins with demand. Unusually low interest rates earlier in the decade likely accelerated home ownership for first-time buyers who normally wouldn’t have qualified for credit without a few more years of income growth. In the process, however, some home ownership demand was being “borrowed” from what would have normally evolved in subsequent years. In addition, the low interest rate environment probably accelerated purchases of retirement homes by baby boomers who were able to own more than one residence. Such extra home ownership demand, though, was unsustainable and, in effect, “borrowed” from demand that normally would have evolved a few years later.

Soaring unoccupied housing units for sale indicate that far too many housing units were built in earlier boom

An economist’s perspective on how it happened

Genesis: Unusually low interest rates


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Chart 2: Investor demand for residential real estate(*) had risen to unusually high and unsustainable levels.

Chart 3: Now the largest U.S. homebuilders are reporting surging cancellations of earlier orders.

0

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12

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

Inv estor share of purchase loans, %

15

20

25

30

35

40

00 01 02 03 04 05 06

av erage home sales cancellation rate, %

Q3 prelim

*(investor share of non-agency mortgage financing) Note: Data for 2006 are only through early May, and the share could have declined since then. Source: Loan Performance; UBS

Source: UBS

Investor Activity Contributing to Oversupply Even more important, those temporarily unusually low interest rates coupled with related faster rising home prices fostered higher but inevitably unsustainable investor demand for residential real estate properties.

For instance, our calculations with data compiled by the Loan Performance organization indicate that the investor share of non-agency home purchase loans had risen to as much as 10.8% in 2005 (Chart 2). That was just over double the peak 5.7% annual share for the previous decade, in 1997. Moreover, it was close to the 11.2% share in 1987 at the start of a severe housing downturn, which lasted through 1991. To be sure, such data are only a rough approximation of actual investor participation. (The available data are for non-agency mortgages, which represented only 30% or so of the overall stock of mortgage-backed securities at the end of 2005. In addition, some observers believe such data understate the role of investors, who may sometimes list themselves as residents instead of non-residents on their loan applications.) Nevertheless, while it is difficult to precisely gauge investor participation, virtually all observers of the housing industry acknowledge that investors played a key role.

Supply Is Not in Demand With strong demand ultimately slowing since mid-2005, homebuilders have responded by reducing production. Single-family housing starts in the first nine months of 2006 were down by 135,800 units (–10.3%) versus the comparable year-ago period. Despite such production cuts, however, inventories of unsold new single-family homes still rose by another 70,000 in the year ending September 2006. A key reason that supply has not fallen as fast as demand is the surging number of individuals canceling new home orders after contracts have

Investor demand prompted homebuilders to supply more housing units than needed by residents in recent years

Builders’ production has not fallen as fast as demand, partly because of soaring contract cancellations


UBS 24

been signed and after builders have begun the process of completing those orders (Chart 3).

Quantifying Oversupply Reflecting overproduction in relation to longer-term fundamental needs, the number of empty housing units for sale has mushroomed. As discussed earlier, since 2002, the number of unoccupied units has jumped by around 750,000 to 3.3 million in the third quarter of 2006. During this time, the number of completed but unoccupied single-family residences rose by 531,000 units, or 50.0%, to 1,587,000 units.

How much housing output must decline to eliminate excess inventories of vacant residential units depends, of course, upon sales. And with quarterly total (new and existing) home sales peaking over a year ago in mid-2005, there has been a surge in the number of months of sales represented by inventories—the common benchmark for judging housing inventory adequacy (Chart 5). Note that the Census Bureau’s calculation of the number of months of “new homes sales” represented by inventories is increasingly becoming an understatement. That is because the Census Bureau reports sales based on contracts, which are being cancelled much more often than normal this year.

To better gauge the residential real estate market impact of skyrocketing unsold inventories, we focus on the quarterly unoccupied homes for sale data from the Census Bureau (Chart 4). Empty residences should weigh more on market prices than the familiar National Association of Realtors inventory concept covering all existing homes for sale, whether they are vacant or occupied. This is because the seller of an occupied primary residence typically is a subsequent homebuyer of another property or a renter of some other dwelling. However, sellers of unoccupied units already are either owning or renting elsewhere, and their sales are not matched by subsequent purchases to help stabilize prices.

In support of this hypothesis, real (inflation-adjusted) median existing home sales price changes, for instance, are more closely correlated with an inventory measure reflecting unoccupied units for sale than with an inventory measure reflecting all units for sale (Charts 7 and 8). In the third quarter of 2006, the months’ supply of inventory gauge based on unoccupied units for sale that are either completed or under construction rose to 4.1 months of total sales. That was the highest level for this measure since the last major housing recession in the late 1980s and early 1990s (Chart 6).

Now the residential real estate market is being flooded with empty housing units for sale

Inventories stacking up versus sales

Empty units for sale harm prices more than occupied units on the market


UBS 25

Chart 4: More “for sale” signs are popping up on vacant properties.

Chart 5: There have been noticeable rises in various months’ of unsold inventory statistics.

0

700

1400

2100

80 82 84 86 88 90 92 94 96 98 00 02 04 06Total

Vacant housing units for sale

Unsold new units under construction (NSA)

000s

23456789

10

80 82 84 86 88 90 92 94 96 98 00 02 04 06

Months supply of new homes for sale

Unoccupied inv entory /total (new + ex isting) 1-family home sales

Source: U.S. Census Bureau Source: U.S. Census Bureau and National Association of Realtors

Characteristics of Housing Recessions Of course, too much inventory spells a combination of output and price cuts to trim excess supply. During the past four decades, there have been seven housing recessions (Table 11). They provide a frame of reference for starting to assess the ultimate home production and price developments in the current housing downturn. In addition, even if that history may be a rather imperfect guide to what actually happens to housing starts and sales prices during the rest of 2006 and in 2007-08, historical experience is still critical for understanding contemporary expectations.

Chart 6: The months’ supply of unoccupied housing units for sale is soaring. This is the dominant variable influencing real home prices.

1.5

2.5

3.5

4.5

5.5

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04

Q3

months’ supply of unoccupied housing units based on total home sales*

* Unsold new single-family homes under construction plus vacant housing units for sale. Source: U.S. Census Bureau, National Association of Realtors, and UBS

What excess inventories have meant for output and prices in the past


UBS 26

The last seven housing recessions have varied in length from just one year in 1995 and 2000 to five years between the annual average housing starts peak in 1986 and the eventual trough in 1991 (Table 11). The three deepest peak-to-trough housing starts declines of around 50% were registered in the housing downturns during 1973-75, 1979-1982, and 1987-1991. During those deeper downturns, the cumulative decline in annual average real (inflation-adjusted) median existing home sales prices were 0.8% in the 1973-75 housing downturn, 9.8% in the subsequent 1979-1982 episode, and 2.7% in the last severe housing downturn in the 1987-1991 period.

Not surprisingly, the deepest real price declines were in the prolonged 1979-1982 downturn, when the calendar average of months’ sales represented by unoccupied inventories rose to a very high 4.7 months in 1982 (Table 11).

Chart 7: Real home prices changes are more closely linked to inventories of vacant properties for sale . . . (**)

Chart 8: . . . than to inventories of both vacant and occupied units for sale. (**)

y = -2.885x + 13.368R2 = 0.5361

-6-4-202468

10

2 3 4 5 6

Months' supply (based on ex isting home sales)**

Real

exist

ing h

ome

price

s, %

ch

y/y*

*

y = -0.7319x + 7.3575

R2 = 0.3251

-4

-2

0

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4

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3 5 7 9 Ex isting homes months' supply

Real

exist

ing h

ome

price

s, %

ch

y/y*

*

Note: Existing home price appreciation deflated using CPI ex shelter. ** Unsold new houses under construction plus vacant houses for sale versus single-family existing home sales. In the regression equation, “Y” is real existing home price inflation and “X” is months’ supply of inventories. Sources: U.S. Census Bureau, National Association of Realtors, and UBS

Note: Existing home price appreciation deflated using CPI ex shelter. **Existing homes months’ supply data availability limited the time period for which the above-cited correlations could be calculated to a shorter span than was used to calculate real home price correlations with the vacant inventories measure in the adjacent chart. Over the same time periods, the calculated R-squared of 0.47 still was well over the .32 correlation with the existing months’ supply of all existing home inventories. In the regression equation, “Y” is real existing home price inflation and “X” is months’ supply of inventories. Sources U.S. Census Bureau, National Association of Realtors, and UBS

Housing recessions can range from short and shallow to long and deep


UBS 27

Table 11: Characteristics of Housing Recessions

Cumulative % change in real home prices*** (weakest 4-quarter real home price change in

given housing recession period)

Period Duration (years)

Total Housing Starts*

Single-Family Housing Starts*

New Single Family Home

Sales*

Highest Annual Months' Supply

for Sale**

existing home prices

new home prices

OFHEO home price measure

1964-1966 3 -26.6% -22.9% -20.5% n/a n/a n/a n/a 1969-1970 2 -4.6% -9.6% -8.6% n/a n/a -13.0 (-15.9) n/a 1973-1975 3 -50.9% -32.0% -29.0% 3.3 (1974) -0.8 (-2.8) -1.4 (-3.9) n/a 1979-1982 4 -47.1% -53.2% -48.7% 4.7 (1982) -9.8 (-4.7) -19.2 (-11.2) -12.8 (-4.9) 1987-1991 5 -44.3% -29.4% -31.8% 4.2 (1990) -2.7 (-7.4) -12.2 (-11.2) -8.9 (-6.3) 1995 1 -5.9% -9.2% 0.3% 3.4 (1995) 0.1 (-2.1) -0.3 (-1.6) 0.1 (-2.1) 2000 1 -4.5% -5.7% 0.2% 2.8 (2000) 0.7 (0.0) 0.8 (-0.5) 3.4 (2.4)

*Calculated from preceding peak annual average to subsequent trough annual average. ** Calculated as unsold new houses under construction plus vacant housing units for sale versus total single-family home sales. ***Calculated as percentage change in annual average home prices from peak to trough, deflated with CPI ex shelter index. Source: U.S. Census Bureau, National Association of Realtors, OFHEA, and UBS

Real Home Prices Have Fallen in Some Past Housing Recessions Current dollar existing home sales prices, on a calendar average and four-quarter percentage change basis, have not fallen in the past half century (Chart 9). Significant price declines, though, have happened on a regional basis, especially in response to relatively poor regional economic conditions that triggered net population migration to other regions. In those circumstances, however, prices firm in regions experiencing the in-migration. Moreover, on a real (inflation-adjusted) basis, home prices have declined during some past recession periods (Chart 10).

Chart 9: To date, we’ve witnessed real but not nominal house price declines.

Chart 10: Real (inflation-adjusted) home prices have declined at times in the past.

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Home prices Real home prices*

4-quarter % change

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69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05

Ex isting homes New homes

OFHEO home price index

real home prices (deflated w ith CPI

* deflated using CPI ex shelter Source: Freddie Mac and Bureau of Labor Statistics

Source: U.S. Census Bureau, Bureau of Labor Statistics, National Association of Realtors, and Office of Federal Housing Enterprise Oversight

In past housing recessions, average home sales prices have declined on an inflation-adjusted basis, but not in current dollar


UBS 28

The variety of past housing recessions makes history a limited guide to the current setting. To be sure, what they do have in common is higher interest rates as a key precipitating factor. Nonetheless, the magnitude and duration of the output and real price reductions necessary for clearing excess housing inventories have much to do with the accompanying economic climate.

Housing vs. Employment Most important, employment is critical for maintaining housing demand during an inventory correction, when production must, at least temporarily, be under whatever sales are dictated by underlying fundamentals, such as job formation. Thus, cyclical swings in single-family housing starts are well coordinated with movements in employment for workers aged 25-34 years (Chart 11). They are a key to the pivotal entry of the first-time homebuyers in leading incremental single-family housing demand.

If new housing output changes are a primary cause of cyclical changes in job formation, then the magnitude of a housing inventory correction is being determined by the degree of previous overbuilding. However, if housing output is not a most critical job determinant, then the severity of a housing downturn ultimately reflects economic conditions outside of housing.

Chart 11: Swings in single-family housing starts reflect employment of 25- to 34-year-olds, who are critical for the growth of first-time homebuyers.

Table 12: Housing-related employment has started declining after being a significant boost to payrolls in 2005. So far, though, non-housing-related job growth has held up well.

500

1000

1500

2000

1959

1963

1967

1971

1975

1979

1983

1987

1991

1995

1999

2003

-2.0

-1.0

0.0

1.0

2.0

3.0

1-family housing starts Employed (25-34 years old)

000s Change in employ ment ratio, pct pts Housing-related* payrolls

Average monthly change, 000s 2005 1Q06 2Q06 3Q06 Aug 06 Sep 06

Total housing related 34 27 -1 -4 16 -6

Construction 19 8 -7 -5 12 -10

Manufacturing 0 1 -3 -3 2 -4

Wholesale 1 1 0 0 -1 0

Retail 5 10 2 -1 -4 2

Financial 7 3 5 0 0 2

Professional 3 4 2 4 7 3 Non-housing related 131 149 116 124 172 57

Source: U.S. Census Bureau and Bureau of Labor Statistics * Includes estimated residential portion of construction payrolls, plus estimated residential construction-related portions of furniture and wood products in manufacturing, furniture, furnishings, lumber, hardware, and construction equipment in wholesale trade; building materials, furniture, and furnishings in retail trade; real estate leasing, credit, and mortgage brokers in financial; and architecture and engineering in professional categories of payrolls. Source: Bureau of Labor Statistics and UBS

But is housing history a reliable guide to necessary output and price adjustments in the current setting?

Job formation is pivotal for demand

Chicken-egg controversy: Do housing starts cause or reflect jobs?


UBS 29

In the current setting, the employment losses stemming from the direct effects of the residential real estate recession have not been large enough yet to trigger much slower job formation (Table 12). Looking ahead, we do believe that the sudden and dramatic halt in home sales price inflation will generate lagged, negative wealth and home equity borrowing effects. They should also ultimately result in somewhat more of an overall payroll job slowdown than has occurred through the end of the third quarter of 2006. Nonetheless, we do not believe that developments outside of the housing sector will deteriorate enough to trigger a long period of overall job stagnation or decline, which, in turn, could cause persistent sharp declines in single-family housing demand throughout all of 2007.

— The likely upcoming negative wealth/home equity extraction effects stemming from the current residential real estate slump probably will be spread over a number of quarters. Also, they could lag the negative direct economic impacts from lower home sales and production.

— Non-residential construction should help cushion the blow to the economy from weaker near-term residential construction activity. In fact, architects’ strong recent billings in the commercial and industrial category (Chart 12), suggest that our forecast for real non-residential business structure spending growth of 9.8% is on the low side.

We expect both interest rate and exchange rate adjustments to cushion the blow to the economy from the housing recession. The benchmark 10-year Treasury note yield is expected to decline to a 4.3% calendar average in 2007 versus an estimated 4.8% this year. Also, the foreign exchange value of the dollar is still anticipated to depreciate, with the euro rising to $1.35.

Chart 12: Higher billings by architects suggest a further acceleration in nonresidential building.

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94 95 96 97 98 99 00 01 02 03 04 05 06

45

47

49

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53

55

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59

Real nonresidential structures inv estment (left scale)

AIA billings index (Commercial & industrial) (right)

4-quarter av erage4-quarter % change

Source: Bureau of Economic Analysis and American Institute of Architects

In our opinion, developments outside housing will be critical for determining the jobs that help determine housing demand


UBS 30

Reflecting such considerations, we expect non-farm payroll growth of 0.9% in 2007 (4Q/4Q). That reflects a slowdown from the 1.3% 12-month change through September 2006 but is still much firmer than job growth during past housing recessions.

UBS Housing Starts Revised Forecasts Although already weaker home sales may not fall much further, there still has been a dramatic buildup in unsold and vacant housing units and the accompanying home price weakness. Reflecting these considerations, we reviewed and substantially trimmed our housing starts forecasts. Specifically, we have re-estimated projected housing starts to be roughly consistent with reducing much of the excess supply over the next two years (Please see a detailed discussion of our underlying assumptions on actual and normal demand on page 7).

We now expect annualized housing starts from the current 4Q06 through 4Q07 to be at 1.60 million, 1.50 million, 1.53 million, 1.58 million, and 1.60 million, respectively. The earlier forecast profile for these periods were 1.65 million, 1.65 million, 1.70 million, 1.75 million, and 1.80 million, respectively. For calendar 2007, the updated forecast is for 1.55 million units versus our earlier 1.73 million projection. The latter had reflected our below-consensus interest rate forecasts, but our analysis of evolving overbuilding now suggests much weaker starts, even with the expected mortgage rate relief next year. (We note that the latest available October 10, 2006, Blue Chip consensus forecast for 2007 housing starts was 1.64 million.)

Reflecting lower housing starts in 2007, we reduced our overall 2.2% forecast for real GDP growth in calendar 2007 to an even lower 2.0%. Looking further out into 2008, we cut our earlier housing starts projection by 150,000 units to 1.65 million.

Managing Supply From a business strategy standpoint, the large publicly owned homebuilders probably can better satisfy shareholders with further output cuts versus sharp reductions in prices. That is because steep price cuts would have adverse consequences for builders’ profits and also could harm longer-term public confidence in residential real estate as a good investment. Moreover, sharp price cuts probably would not do much in the current setting to stimulate overall market demand. (Considering the earlier acceleration of underlying demand and the still-high cost of new homes, there probably is little price elasticity of overall market demand for new homes.)

The challenge, though, for the largest homebuilders in regional markets will be whether to temporarily cede sales market shares to smaller builders. Insofar as the latter are pressured by lenders to quickly raise cash, they could be more willing to cut prices in order to garner somewhat more market share.

We believe that a further, relatively sharp correction in housing starts is likely in the near term

Large homebuilders should rely more on output than price cuts in trimming heavy inventories


UBS 31

We expect housing starts to start a slow, gradual recovery after 1Q07 for a couple of reasons.

■ Quicker and deeper near-term production cuts lessen the time ultimately required to pare excessive inventories.

■ As discussed earlier, job formation should hold up better than it did during most of the past long-lived housing recessions.

■ Rents have been sharply accelerating (Chart 14). This could provide some support, albeit probably limited, for new home demand. In addition, rising rents can enable more investors to hold on to their earlier investments in now-occupied apartments and single-family homes.

In August and September of 2006, nominal (current dollar) sales prices of existing homes already started to decline from a year earlier. As well, the previously discussed history of real home prices in housing recessions reminds us that real prices could fall further. Also, with relatively low inflation outside of shelter, real price declines in a market with excess supply are more likely to be associated with more in the way of absolute declines in nominal home prices.

Excess supply. As discussed earlier, real prices are inversely related to a couple of different statistics depicting months of sales represented by inventories. A measure based on unoccupied inventories has relatively more explanatory power than measures including all inventories.

Rents. Higher rents can contribute some limited support to housing prices.

Chart 13: The months’ supply of unoccupied housing units for sale is soaring. This is the dominant variable influencing real home prices.

Chart 14: Rising rents eventually should somewhat assist in stabilizing new home demand.

1.5

2.5

3.5

4.5

5.5

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04

Q3

months’ supply of unoccupied housing units based on total home sales *

1234

5678

9

82 84 86 88 90 92 94 96 98 00 02 04 06

CPI rent, 2-quarter % change, annual rate

* Unsold new single-family homes under construction plus vacant housing units for sale. Source: U.S. Census Bureau, National Association of Realtors, and UBS

Source: Bureau of Labor Statistics

However, starts should start recovering gradually after 1Q07

How much further could real—and now nominal—home prices decline?

Real (inflation-adjusted) home prices can be partly explained by excess supply and also by rents


UBS 32

UBS House Price Forecasting Methodology Following are some characteristics of our statistical home price equation (Table 13). This equation is an important step in forecasting home prices.

■ We control for overall inflation by assessing real home prices adjusted for inflation of the non-shelter Consumer Price Index (CPI).

■ Volatile reported new and existing home sales price inflation is harder to explain than inflation of the real OFHEO same-property sales price index. That is because the latter is adjusted for the sales mix changes contributing to the volatility of reported changes in median and existing home sales prices. (Note: The OFHEO price index is hardly “perfect,” as it excludes sales of both relatively high-priced and low-priced units as well as all condo sales.)

■ The most statistically important determinant in the model is the month’s supply measure (Chart 13). (Note: This is indicated by it having the highest t-statistic among the two independent variables in the regression.)

Table 13: A statistical model of real home prices

Dependent variable: Real OFHEO home prices*

Independent Variables Coefficient t-statistic Standard Error

Real CPI rents % ch y/y* 0.63 2.07 0.30

Months' supply** -4.56 -5.17 0.88

Intercept 16.99 5.62 3.03

R2 0.62

*Deflated with CPI ex shelter index. ** Calculated as unsold new houses under construction plus vacant housing units for sale versus total single-family home sales. Note: Regression uses annual data from 1982-2005. Source: U.S. Bureau of Census, National Association of Realtors, Bureau of Labor Statistics, OFHEA, and UBS

A quantitative regression model such as ours is one step, but hardly the only way, to forecast home prices. Quantitative guides must be combined with qualitative judgments on other variables that cannot be easily quantified. In the current setting, pricing strategies by large and smaller builders offer a good example of what is very important but cannot be measured.

As mentioned previously, the large homebuilders probably do not want to overly rely on lower prices to generate sales. However, smaller builders experiencing financing pressures may be forced to cut prices now even if it means incurring a net loss after considering the builder’s costs.

Some characteristics of our statistical home price equation

What can’t be measured is still important


UBS 33

Table 14: Real home prices during housing recessions

Cumulative % change in real home prices**(weakest 4-quarter real home price change in given housing

recession period)

Period Duration (years)

Highest Annual Months' Supply for Sale*

existing home prices

new home prices

OFHEO home price measure

1964-1966 3 n/a n/a n/a n/a 1969-1970 2 n/a n/a -13.0 (-15.9) n/a 1973-1975 3 3.3 (1974) -0.8 (-2.8) -1.4 (-3.9) n/a 1979-1982 4 4.7 (1982) -9.8 (-4.7) -19.2 (-11.2) -12.8 (-4.9) 1987-1991 5 4.2 (1990) -2.7 (-7.4) -12.2 (-11.2) -8.9 (-6.3) 1995 1 3.4 (1995) 0.1 (-2.1) -0.3 (-1.6) 0.1 (-2.1) 2000 1 2.8 (2000) 0.7 (0.0) 0.8 (-0.5) 3.4 (2.4)

* Calculated as unsold new houses under construction plus vacant houses for sale versus total single-family home sales. **Calculated as percentage change in annual average home prices from peak to trough, deflated with CPI ex shelter index. Source: U.S. Bureau of Census, National Association of Realtors, OFHEA, and UBS

Historical Prerequisites on Lower Real Prices Over the time spans for which price data are available, there are a few characteristics worth noting. (See Table 14, which displays both the peak-to-trough percentage changes in calendar average price levels, i.e., “how far,” and the weakest four-quarter percent changes, i.e., “how fast.”

It requires more than a minor housing recession to trim real homes sales prices. In the most recently reported quarter, the third quarter of 2006, the 1.74 million unit annualized pace of housing starts already was off 16.1% from the 2.073 million unit peak annual rate last year. And our updated 1.55 million unit housing starts forecast for 2008 is 25% under the peak two years earlier.

The most serious real price declines occurred when the calendar average of months’ supply of unoccupied inventory was in the four to five months range. Already, the latest 4.1 months’ sales represented by unoccupied inventories in 3Q06 was not far from the respective peaks of 4.2% and 4.7% in the last two housing recessions that included serious real price declines. As well, our home price statistical model illustrates the importance of our unoccupied inventory measure in helping to explain past real home price declines.

UBS House Price Forecast We believe that in the current housing recession there could be a roughly 10% peak-to-trough decline in the current dollar median sales price of an existing home. (As earlier discussed, current dollar median new home sales prices in housing recessions become weaker than existing home price gauges—and this volatile price gauge was already off 9.7% from a year earlier in the year ending in September.) Our judgment in making this forecast reflects the following considerations: 1) real home price declines related to overhang of unsold vacant housing units; 2) inflation and real versus nominal (current dollar) home price changes; and 3) the current setting.


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Real Home Price Declines Related to Overhang of Unsold Vacant Housing Units

History. In the 1979-1982 housing recession, the peak calendar average months of sales represented by unoccupied housing units for sale was 4.7 months. During that housing recession, the peak-to-trough declines in real calendar average home sales prices were –19.2% for new homes, –9.8% for existing homes, and –12.8% for the real OFHEO home sales price index. Then, in the subsequent 1986-1991 housing recession, the peak calendar average months of sales represented by unoccupied housing units for sale was a somewhat lower 4.2 months. During that housing recession, the peak-to-trough declines in real calendar average home sales prices were –12.2% for real new home sales prices, –2.7% % for existing homes, and –8.9% for the real OFHEO home sales price index.

Currently. In 3Q06, the unoccupied housing units inventory gauge, at 4.1 months of total home sales, already had entered the four to five months of sales range accompanying the noticeable real home price declines in the last two major housing recessions during 1979-1982 and 1987-1991. And since reported new home sales are based on contracts that are being increasingly cancelled, the actual months’ supply represented by vacant housing units in 3Q06 was even a tad higher. Moreover, the unoccupied housing units inventory gauge could still move higher in coming quarters if home sales weaken much further. Thus, real home prices ultimately could fall somewhere between what was experienced in the last two major housing recessions.

Inflation and Real Versus Nominal (Current Dollar) Home Price Changes

In the past housing recessions, nominal (current dollar) house prices did not decline—notably because overall price inflation was high enough so that real (inflation-adjusted) home prices could decline enough to eliminate excess unit inventories without a drop in nominal prices. Consumer Price Index (CPI) inflation excluding shelter rose at a 9.3 % annual rate in the 1979-1982 housing recession and at a 4.3% pace in the 1987-1991 housing recession. By way of contrast, over the four quarters ending in the third quarter of 2006, the non-shelter CPI inflation index rose just 1.8%, and we expect only around 2.0% of such inflation in 2007. (Note: Home prices are deflated by non-shelter consumer price inflation in order to calculate the relative price of shelter versus other goods and services prices.)

The Current Setting

During the third quarter of 2006, median existing home sales prices from a year earlier already were off 2.5% in nominal terms and 4.3% on a real basis. Nevertheless, there was a continued buildup of unsold and unoccupied inventories. This suggests that the recently declining home sales prices have not been enough to make much difference yet. Also, numerous homebuilders and


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sellers of existing properties probably are only gradually and reluctantly lowering prices to test demand in a very unfamiliar market.

In our view, the various studies on whether surging home prices in this decade have represented serious overvaluation are not particularly decisive. Nevertheless, the unusually low current levels of the National Association of Realtors Housing Affordability Index (HAI), which reflects home prices, interest rates, and incomes, do lend support to the idea that home prices may well have become at least somewhat more overvalued than in past housing booms.

Combining our expectations for inflation with the history of real existing home prices in periods of a roughly similar inventory overhang suggests that an approximate 6.75% to 9.50% range of four-quarter nominal sales price declines are possible. Allowing for a period of declining four-quarter changes somewhat longer than a year, the cumulative peak-to-trough change could be as much as 10%.

Expectations for the Federal Reserve Most important, we expect the Fed to cut short-term interest rates by 100 basis points in 2007, with an accompanying 50 basis point decline in calendar average longer-term interest rates. And if that is not enough to “nip home price deflation in the bud,” the Fed should be prepared to ease even further than we currently predict.

Why we do not foresee a more severe price collapse


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Intentionally Blank


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Margaret Whelan UBS Housing Analyst


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Housing: The Big Picture Demand Drivers To quantify future incremental demand, we start by examining drivers and trends over the past 30 years. These include population growth and new household formation, with further granularity on important lead indicators such as established baby boomers, more affluent echo boomers, accelerating immigration levels, and growth in non-traditional households. A steady rise in second home purchases is also contributing to demand. When these variables are positive and converge, the home ownership rate rises, and vice versa.

Although these factors directly influence the timing and volume of incremental unit demand, it is housing affordability—a function of income levels, home prices, and mortgage rates relative to the individual’s financial health and employment status—that ultimately determines the style and size of the home purchased. Below, we provide a detailed overview of the most important demand drivers, historical trends, and forecast growth for the future.

Chart 15: U.S. Population and Housing Unit Growth by Decade

0

10

20

30

40

1940s 1950s 1960s 1970s 1980s 1990s 2010E

millio

ns

U.S. Population Total Housing Units

Source: U.S. Census Bureau, UBS estimates

Population Growth Through the 1990s, the U.S. population grew faster than demographers anticipated, with an incremental 33 million people recorded, for a 13% growth rate and the largest-ever documented increase. This even surpassed the previous record of 28 million people during the 1950s, when the population grew by 18%, primarily a result of the baby boom. This recent trend has continued into the 21st century, with a steady increase of 1% annually through 2005, on track to meet our estimate for an incremental increase of approximately 30 million people, or decennial growth of 10%, by 2010.

Population growth is a function of U.S. births plus immigration, less deaths. Below, we detail the drivers and trends around each of these factors.


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Birth Rate

Forecasting demand is facilitated by the long lead time available on many of the key drivers. For example, in tracking the birth rate and age of the population relative to typical homeownership trends, we can determine incremental demand for housing with a low margin of error. The baby boom generation began after the end of World War II in 1945. In 1946, the birth rate had been below 3 million for 40 years, but it spiked to a peak of 4.3 million by 1957 and remained elevated above 4 million annual births until 1964. The reason for the increase was twofold: one, more families were created; and two, there were more births per family, up to 3-plus from 1-2 before 1945.

After 1964, the annual rate fell back to close to 3 million, and only started to increase again in 1978, as the echo boomers entered their child-rearing years. The annual birth rate rose to above 4 million by 1989, and it remained above this level for four years, as the echo boomers followed in their parents’ footsteps. The more recent decline in U.S. births is being partly offset by the acceleration in the rate of immigration.

Chart 16: Live Births Since 1909 (000s)

2,000

3,000

4,000

5,000

1909 1921 1933 1945 1957 1969 1981 1993 2005

Tota

l Birth

s (00

0s)

Source: National Center for Health Statistics


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Chart 17: Total Fertility Rate Since 1940

1

2

3

4

1940 1948 1956 1964 1972 1980 1988 1996 2004

Births

per

Wom

en


Baby Boomers

As referenced above, the 78 million baby boomers have been a critical demographic driver of incremental housing demand. This started in the early 1970s, when baby boomers entered the housing market for the first time, as reflected by a spike in annualized starts to a record 2.9 million in 1972, which has never been exceeded.

Up until Americans reach their mid-to-late 60s, the home ownership rate increases steadily to over 80%. After that point, it only declines modestly to the high 70% vicinity above the age of 70. This pattern has remained steady for the past 20 years. For example, in 2005, the overall ownership rate for those who were 25-29 years old was 41%, whereas the rate was 81% for those aged 55-59. The reason for the higher home ownership rate as people age may be explained by the fact that we become more settled and are less likely to move; as such, the up-front transaction costs associated with home ownership are justifiable.

Chart 18: Home Ownership by Age, Total Population

20%

40%

60%

80%

100%

Under 25 25-29 30-34 35-44 45-54 55-64 65 andolder

Source: U.S. Census Bureau


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Lessening Impact on Homeownership Rate

By 2010, all 78 million baby boomers will be over the age of 45, and at that point, their impact on the rate of growth in the home ownership rate will be more modest. As older baby boomers start to reach the age of retirement and have more leisure time, however, they should remain a driving force for second and retirement homes, albeit with less impact on incremental housing demand. For example, at 3.8 million in 2005, the number of seasonal second homes is at an all-time high, and has risen 29% since 1990. Baby boomers are also driving changes in the character of some new homes, as demand for age-restricted active adult communities is growing, while boomers’ overall need for starter homes or apartments has clearly dissipated. Assuming the wealth of the baby boomers is not negatively impacted by an economic recession, and the attractiveness of owning a second home does not deteriorate significantly, the boomers should provide significant demand support over the next decade. Chart 19: Percentage of Population Age 55 or Older

15%

20%

25%

30%

2002 2005 2008E 2010E 2015E 2020E


Echo Boomers

Baby boomers have also made another contribution to the incremental housing demand: their children. The baby boom echo, which began in the late 1970s, reached 4.1 million births at its peak in 1990, a 25% increase from 1977, or the nadir of the baby bust. This generation has started to contribute to household formation, since they began to graduate from college around 2000, and should swell the ranks of homebuyers over the next 20 years.

As the following chart shows, the age groups in their prime home-buying years are expected to steadily increase over time, until 2020, with immigrants and the echo boom providing long-term support for housing demand.


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Chart 20: Composition of U.S. Population by Age

20

40

60

80

100

2002 2005 2010E 2015E 2020E

20-39 yrs old 40-59 yrs old 60+ yrs old


Death Rate

Forecasting the death rate is also facilitated by a long lead time, with the added nuance that Americans are getting older and living longer. As such, life expectancy has risen 10% since 1970, to an average of 78 years.

Chart 21: Life Expectancy (Years)

70

72

74

76

78

80

1970 1978 1986 1994 2002



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Net Immigration Trends Elevated Immigration Persists Contributing to demand growth is a wave of net immigration that began around 1990, at a run rate of just under 1 million net immigrants per year. As a result, there are now a record 36 million foreign-born residents in the United States. Given the nature of immigrants, who can take years to be immunized before settling in one region, growth in this segment of the population is the most difficult to forecast, and even historical data is subject to dramatic revisions. The most recent surge started in 1989, largely the result of changes in immigration rules that allowed more people into this country to work.

Chart 22: Legal Annual Immigration

0

500

1,000

1,500

2,000

1970 1975 1980 1985 1990 1995 2000 2005

Lega

l Ann

ual U

.S. I

mmigr

ation

(000

)

Source: U.S. Department of Homeland Security

Forecast in Line With Historical Average

Our forecast of 1.3 million immigrants annually is in line with the 17-year trend. This forecast may prove conservative if favorable changes to legislation are introduced to allow immigrants to enter the work force to replace retiring baby boomers. Additionally, while immigrants are more likely to emigrate than U.S. nationals, they are also more likely to encourage their family and friends to come to the U.S., often through sponsorship, which is not subject to typical immigration quotas.

Immigration Drives Adult Population Growth—and Home Ownership

Immigrants increase the adult population, as they usually enter the U.S. between the ages of 15 and 34. Furthermore, there is a strong positive correlation between the length of time immigrants who become citizens have been in the country and their home ownership rate. As such, minority groups, which previously have not held especially high rates of home ownership, are beginning to buy more homes, driving up the national ownership rate.


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On average, when foreign-born citizens have been in the country for approximately six years, their ownership rate is about 21%. This rate jumps dramatically to the mid-40% area when they have been in the country for at least seven years, and to over 50% when they have been in the country for 17 years or more, as reported by the Census Bureau. This propensity to purchase is a critical factor to forecasting incremental housing demand, since those born overseas now account for over 12% of the U.S. population, up from about 6% in 1980.

Since the time lag between entering the country and buying a home is seven to 12 years, we expect this trend to continue to boost demand and the home ownership rate throughout the next decade. Furthermore, immigrants currently represent 15% of the population aged 15-34 versus 12% of the total, so we expect the homeownership rate among minorities to continue to rise.

Chart 23: Foreign-Born U.S. Citizens’ Home Ownership Rates, Measured by Years in the United States

0%

20%

40%

60%

80%

100%

6 or less 7-16 17-26 27-36 37+

Home

owne

rship

Rate


Regional Concentration Among Immigrants

Immigrants tend to settle close to the coasts. Our data show that Asians are more likely to settle in California, while Hispanics also settle in California, but also along the border and into Florida. This is not only because of the proximity to their homeland, but also because these areas offer greater employment opportunity. Regions with above-average employment opportunities also tend to have wider availability of housing, as well as higher vacancy rates, which facilitates a smooth transition. On the other hand, these areas also have lower than average affordability, which in part contributes to the lower than average home ownership rate among minorities. Parenthetically, among foreign-born immigrants who have lived in the U.S. for more than 26 years, the home ownership rate is greater than the national rate.


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Table 15: Legal Immigration Flow by State

State of Residence 2005 % of Total

California 232,023 21%

New York 136,828 12%

Florida 122,918 11%

Texas 95,958 9%

New Jersey 56,180 5%

Illinois 52,419 5%

All Other States 426,047 38%

Total 1,122,373

Source: U.S. Department of Homeland Security

Growth in Hispanics Leading the Charge

Hispanics are now the largest minority group, with 43 million in 2005 representing 14% of the U.S. total, and Mexicans representing 60% of the Hispanic share. According to the Census Bureau, Hispanics may represent some 50% of the 27 million forecast population growth through 2020. Looking forward, the home ownership rate should be lifted by second-generation wealth, as growth in the Hispanic population has been steady since the 1970s. Hispanics marry earlier and have higher fertility rates, which also drives the desire for home ownership.

Chart 24: Household Size by Race and Ethnicity, Total Members

0%

20%

40%

60%

80%

100%

Hispanic Asian Other Black White1 2 3-5 6+

-Source: U.S. Census Bureau


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Characteristics of New Supply Single-family homes represent a greater percentage of total new supply than ever before, as most of the new supply is targeted to market segments that are not being served by the existing housing stock, be it regional, product breadth, or price point. Even in addressing mix changes, the absolute supply of new homes brought to the market annually is still 25% lower than the prior peak.

Rising Share for Single Family

In 2005, single-family homes represented 77% of the total, flat since 2003 but a jump of 400 basis points from the 2002 level. This is a significant spike from the 67% average in the 1990s and the 57% average in the 1980s. Because of the underlying changes in demand, the mix toward more single-family homes reflects the increase in households relative to the increase in population.

That said, although we believe that the single-family share will remain above 70%, we also note that it was elevated between 2004 and 2006 as a result of speculators favoring single-family homes as an investment vehicle. As such, the rate is likely to normalize closer to 75% in 2007.

What’s Driving the Change?

We believe the long-term positive trend is a function of the older population, attributable to aging baby boomers and the increase in immigration, as older households favor single-family residences. Changes in household characteristics are also influencing the mix, as the growth in individual households is significantly exceeding that of population growth because of the higher divorce rate and higher average age of marriage.

The trend of aging baby boomers is also contributing to demand for single-family homes, as individuals who live in a single-family home earlier in life are much more likely to continue to live in a single-family home rather than a multifamily dwelling. In addition, lower mortgage rates and the benefit of wealth created from home ownership as individuals move up on the property ladder are contributing to the trend. Among the benefits of owning a single-family home is the ability to customize and add amenities, which may not be as readily available with multifamily construction.


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Chart 25: Single-Family Starts as % of Total Supply

20%

40%

60%

80%

1970 1980 1990 2000 2005


Multifamily

Multifamily housing supply has dropped to 16% of the total in 2005, from 36% in 1990. However, we note that

Documents

Americas UBS Investment Research Building & Building ... Housing report.pdfThis report is a collaboration between Maury Harris, UBS Chief U.S. Economist, and Margaret Whelan and David