Understanding Months-of-Supply

This morning, NAR will release the Existing Home Sales figures for he month of July. Analysts expect homes to be selling at a seasonally-adjusted rate (SAAR) of about 4.65 million homes, but regional reports suggest much lower figures, perhaps even under 4 million.

July marks the first month where homes closed were not eligible for the federal homebuyer tax credits and will give us a hint of exactly how well the housing market is able to stand on it’s own, without as much government support. The report should be ugly, prompting fears of a double-dip recession, additional declines in house prices, and lots of chatter about whether the tax credits actually accomplished anything.

Regarding home prices, the most important part of the NAR release will be Months-of-Supply. This figure is calculated by taking the number of homes actively for sale, divided by the number sold in the last month. Months-of-Supply is a powerful predictor of how home prices will change in the coming months. Here’s why:

Pretend that in a given neighborhood, there are 10 homes for sale, and 2 are selling each month. In this example, there are four unsold homes each month for every sale. That means there are only four homes that could potentially lower their price to increase their odds of selling the next month. This is a pretty stable or even bullish scenario.

Now, imagine the same neighborhood a few months later. Pretend there are now 12 homes for sale, but only one home is selling per month. That’s a whopping 12-Months-of-Supply with eleven homes potentially lowering their prices. With only one home selling, sellers would need to cut their prices to ensure that they were the best, or one of the best deals available. You can imagine that the higher the Months-of-Supply goes, the more fierce the price reductions are.

During the peak of the housing bust (before government foreclosure, tax credit, and interest rate intervention), national Months-of-Supply reached a high in July of 2008 at 11.2 months. National home prices were tumbling at about a 20% per year pace.

Record Months-of-Supply?

Today’s Existing Home Sales figure could push Months-of-Supply over that 11.2 level, an ominous sign for housing going forward.

If there were just 4 million home sold (SAAR) and inventory held steady at 4 million units, we would have a record 12 Months of Supply.