Thursday, May 24, 2012

Will housing support growth?

Guest post by Greg Trotter

A great deal is still being said about the state of the housing market, with lingering excess inventories cited as the main reason for caution. These excess inventories are expected to still weigh on prices, particularly due to distressed sales, and have obviously pressured new housing starts. Fears of “shadow inventory” from severely delinquent borrowers and foreclosed properties sitting on bank balance sheets are of particular concern. While these concerns represent the current state of supply, what should we expect of the future?

The housing boom (from 2000) saw in excess of 2.8MM homes built over and above the 20 year average (through April 2012). However, the housing bust (from mid-2007) has seen 3.2MM fewer homes built than the 20 year average would imply. So, is the housing market under-supplied by 400k homes? Inventories, particularly “shadow inventories” would say no.

US New Privately Owned Housing Units Started by Structure Total SAAR  (click to enlarge)

Using the argument that lower new housing starts should have “eaten up” the excess from the housing boom, where has excess supply come from? The answer is lower household formation. With an abysmal job market, kids are moving back in with parents or not leaving home at all. People aren't getting married and are probably letting annoying roommates stick around. So, based on history what are these people waiting to do? The answer is “move out.” These people aren’t a reason that housing should be getting worse. They are a reason that housing is currently bad, but they should also be a reason that housing should get better. They are “shadow demand.” "

Angry Bear turns the household formation hypothesis around for a terrifying conclusion. Housing completions have completely overwhelmed household formation. Are housing completions too high, or are household formations too low? Housing starts are ½ the historical average.

What is holding “shadow demand” back? There are certainly at least two reasons, affordability and jobs. Housing affordability, by many metrics, has never been better, and some measures suggest that households have room for new debt service. That is just one side of the coin, though. The housing affordability metrics assume that borrowers have access to credit while, in reality, credit standards are very tight. And, while debt service cost may be low compared to recent history, it is held back by low interest rates—not low levels, and consumers, with worries about jobs and income growth, are likely loath to add to debt levels. On the jobs front, no one is going to kick out a roommate or move out on their own if they can’t cover the bills. While unemployment has come down from its peak, it has fallen more from people leaving the workforce than getting new jobs.

 Ratio of debt payments to disposable personal income (click to enlarge)

Household debt to personal disposable income (click to enlarge)

So, how does this mess get fixed? It requires jobs. Jobs are needed to pull “shadow demand” out of the woodwork and soak up excess inventory. If you argue that it is a problem with people wanting to rent instead of buy, there is a landlord for every renter. If you argue that no one wants the gutted and moldy houses that make up the shadow inventory, so much the better, it means more building activity. The argument here is that we are building up a supply/demand mismatch. Conventional wisdom says that it is an excess of supply, and, at today’s level of employment, that is right. However, as (if) employment improves, we could quickly move to a point of excess demand. So, if we get the economic spark, housing could be a real growth driver.

Now, here is one for the “structural decay” crowd. Yes, the idea that we have “shadow demand” to offset “shadow supply” assumes that employment improves. I’m not trying to argue that the economy has been cured of all its ills. I won’t even argue that it is definitely improving, although I believe that it is. I’m just going to argue that 1) low new housing starts have compensated for the excess supply from the boom years and 2) with improved employment, housing will support growth.
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