In 2001, strength in the housing market was evidenced by sales of existing-family homes reaching an all time high of 5.3 million units and sales of new homes grew by approximately 3% to 906,000 units. From my perspective, these results exemplify the housing market’s underlying strength. During 2002, the housing market continues to exhibit strength, according to the National Association of Realtors, which during May reported that existing home sales posted their fourth strongest showing on record. Additional evidence comes from the Commerce Department, which reported that sales of new homes surged to a record level in May, reaching a seasonally adjusted annual rate of 1,028,000 units. This is the first time ever that the pace of new home sales exceeded 1 million units.

This insight will describe the market drivers that have and will continue to provide a growth platform for the U.S. housing market. It is my belief that the housing market will continue to exhibit sustained growth over the next three years. Also, this insight will touch on the housing market’s impact on the economy and highlight some of the publicly traded microcap companies that are potential beneficiaries.

Primary Market Drivers

It is my belief that the housing market will remain a pocket of strength for the U.S. economy with the following market drivers supporting this view:

Demographic: In 2002, The Joint Center for Housing Studies of Harvard University published a report that projects that the number of homeowners in the United States could rise by an average of 1.1 million annually over the next two decades, with much of the growth reflected in a dramatic rise in the foreign-born population, particularly from the Latin American and Asian communities. The primary impact for the housing market from these communities will likely be for starter homes. Since growth of the immigrant population is likely to continue, it is estimated that minority households could rise by approximately 15.3 million over the next twenty years, thus making up approximately 64% of household growth.

Additional demographic factors are:

• The growth of non-family households, which consist of a single person or two or more unrelated individuals, which rose 11%, while single parent households increased by 8.2%, during the period of 1996 – 2001. During the same period, married-couples experienced growth of 2.5%. Similar growth should occur in future periods.
• The transfer of wealth from seniors to their children. Parents are making a significant difference when it comes time for younger people to make the home buying decision versus being a long-term renter. The Joint Center for Housing Studies research indicates that as many as one in five first-time homebuyers receive funds from a relative or friend for the down payment. The research also indicates that many younger homebuyers often receive financial support from their parents beyond just the initial down payment (i.e. mortgage assistance).

Mortgage Rates and Affordability: The Federal Housing Finance Board reported that the rate on a 30-year fixed mortgage averaged 7% in 2001, which was the lowest fixed rate since the mid 1960s. The fixed mortgage rate environment has remained favorable, with rates at or below 7% for a 30-year fixed mortgage so far in 2002. My expectation is that mortgage interest rates are likely to remain at or below 7% for the balance of the year, primarily as a result of the Federal Reserve not raising interest rates anytime soon. Also, I concur with the view that the historically low mortgage rates will bode well for the continued strength being exhibited by the housing market, since it provides new homeowners with an opportunity to purchase a home even though prices have risen sharply over the last twelve months. Supporting future growth in the housing market is the affordability trend, as noted by The National Association of Realtors™ (see table below), which indicates that a household earning the median income can currently afford to purchase approximately 140% of the median priced existing home at prevailing mortgage rates:

Mortgage Lending Practices: It is almost inevitable that mortgage lending practices will eventually lead to excesses within the housing market. My view is that the buildup of such excesses will likely occur over the course of the next three years before it has any impact. In a report from the homeownership alliance, it is estimated that high loan-to-value lending programs account for nearly $1.5 trillion in mortgage debt outstanding. This is approximately one-quarter of total mortgage loans outstanding. The high loan-to-value programs allow lenders to lower their underwriting standards. The lowering of lending standards by financial institutions is currently being offset in part through the adoption of risk-based pricing and securitization, which should mitigate risk over time.

Economic Impact

In 2001, nationwide home prices grew an average of 5.7% from 2000 levels. This translates to some 70 million homeowners building equity. These homeowners helped contribute to what many economists call the wealth effect. The wealth effect refers to the propensity of people to spend more if they have or feel they have more assets. The data that supports the wealth effect in the United States were gleaned from a speech given by Federal Reserve Board Governor Edward M. Gramlich in February 2002:

• The average ratio of household wealth to disposable income was about 4.5 from 1970 to 1995;
• Fueled by a modest boom in real estate values and a huge boom in equity values, the wealth income ratio shot up to more than 6 from 1996 – 2000, which is the highest recorded value in the fifty years for which wealth data has been collected;
• Since 2000, the wealth income ratio remained over 5, even with the retreat of equity prices, most likely due to the continued surge in the value of housing.

The primary economic areas that the strong housing market impacts are:

• New homebuilding;
• Home improvement and remodeling;
• Home furnishing purchases;
• Local government spending due to increased property tax revenues;
• Improving financials of financial institutions.

The direct and indirect contribution of housing is estimated to be one-half of one percentage point to real Gross Domestic Product growth in 2001. According to the Federal Reserve Board’s Flow of Funds (obtained from the Homeownership Alliance 2002 June report), households own over $12 trillion worth of housing and have $6.6 trillion in homeowners equity, which translates to an average household having approximately $90,000 in homeowners’ equity. The wealth that homeowners feel they have is in my view one reason why they are likely to continue spending on their most important asset in either making improvements on their existing home or trading up to an even larger home.

Microcap Beneficiaries

I believe that four companies in the Taglich Brothers’ coverage universe should benefit from continued strength in the housing market. American National Financial and Capital Title Group are directly impacted by the housing market as both companies are involved in the title insurance industry, thus benefiting from increased activity in the housing market. Craftmade International and U.S. Home Systems are at the other end of the spending spectrum, since these companies are likely to benefit once the homeowner has moved into their new home or obtained money from refinancing an existing house so that they can make improvements to increase the value of their asset. Below is a brief description of each company and following the descriptions is a table that provides certain outlook and financial information.

American National Financial, Inc. (ANFI) – Based in Orange County, California, provides title insurance services and other ancillary real estate related financial and informational services through its various subsidiaries, which include American Title Company, National Title Insurance of New York, and Pioneer National Title of Nevada, Inc.

Capital Title Group, Inc. (CTGI) – Based in Phoenix, Arizona is a holding Company for Capital Title Agency Inc. in Arizona and New Century Title Company in California. The Arizona subsidiary is an independent title agency that provides escrow and title insurance services to Maricopa, Yavapai, Mohave and Pinal Counties. The California subsidiary currently provides escrow and title services to the real estate industry in San Diego, Los Angles, San Bernardino, Santa Clara, San Mateo and Sacramento, Orange, Riverside, Sonoma, Contra Costa and Alameda Counties in California.

Craftmade International Inc. (CRFT) – Based in Coppell, Texas, designs, distributes, and markets ceiling fans, lighting products, and accessories to a nationwide network. The Company, through its TSI subsidiary, distributes and markets outdoor lighting fixtures to home improvement chains.

U.S. Home Systems, Inc. (USHS) – Based in Lewisville, Texas, designs, manufactures, sells and installs specialty home improvement products. The Company’s product lines include kitchen cabinet refacing and countertop products utilized in kitchen remodeling, bathroom refacing and related products utilized in bathroom remodeling, and replacement windows. U.S. Home Systems also provides consumer financing services to the home improvement and remodeling industry through its wholly owned subsidiary, First Consumer Credit (FCC).