Thursday, November 29, 2012

Rebalancing the Housing Market: Renters Welcome

One of the conclusions drawn in last week’s posting was that with excess inventory still hanging over both residential real estate and retail properties, the economy cannot count on new construction in these sectors to be positive contributors to growth anytime soon. But that is not to say that there are no rays of light in the real estate space. The same loose credit standards that distorted the market for home ownership and personal consumption, also threw a wrench in the residential rental market, but sending it in the opposite direction: down. Fast forward five years we see that as new, higher, credit standards become entrenched, the housing market must seek a new equilibrium, one in which marginal home-buyers return to rentals. With much of the emphasis in construction shifting to single family units (largely the domain of owners) during the housing bubble, multi-family unit construction (e.g. apartments inhabited by renters) accounted for a smaller slice of the pie. The crisis flipped that trend on its head. In the face of new demand for rentals, builders must now play catch up. In the past we have argued that a robust housing market should not be the source of economic growth but rather the consequence of healthy expansion in other sectors, like manufacturing. In this case, however, given the need for the rental market to make up ground for past neglect, the recent boost in multi-unit construction activity represents a potential short-term catalyst to the broader economy. We’ll take the good news anywhere we can find it.

One Segment’s Bubble is Another Segment’s Neglect
By now we are well aware that successive administrations’ misguided attempts to create an equity society backfired in the most catastrophic way. Mortgages were offered to potential homebuyers who had neither the means to service them nor the understanding of the (often) convoluted/misleading/sleazy terms extended. When left to their own devises, markets tend to find a happy equilibrium. As seen in the chart below, from 1980 through the late ‘90s, the rate of home ownership in the U.S.  was mostly steady at slightly north of 64%. We are not saying there weren’t market distortions during that time. After all, the mortgage interest deduction incents people towards purchases. But that inducement was small potatoes compared to opening the subprime credit spigot that occurred as originators’ were able to move sketchy loans off their books via securitization. By 2004 the rate of ownership reached 69%.

It should come as no surprise that with a huge slice of renters qualifying for mortgages, the rental vacancy rate surged above its 1990-2002 average of 7.8%. Since peaking in 2009, vacancies have dipped back towards 8% as former owners are foreclosed upon, walk away from underwater properties or in the case of younger people just starting out, fail to qualify for a mortgage. The new normal of tighter lending standards illustrated in the Fed’s Senior Loan Officer’s Survey (below) infers that more people will continue to be pushed back into the rental market.


Multi-Unit Construction: A Painful, but Possibly Necessary, Reversion to Mean
Builders too noticed the trend towards ownership, and being rational players, shifted their activity to meet demand. In the U.S. single-units dominate new construction, accounting on average for 80% of building starts between 1990 and 2001. But during the height of the bubble years, single family homes ticked up to over 82% of all starts for the period, with some years seeing the figure higher. Just as telling is the fact that from 1990 to 2001 the annual growth rate of single family homes was slightly negative while the multi-unit dwelling rate was 1.3%. At the height of the bubble, that rate stayed constant, but single family units surged, averaging nearly 1% YOY growth. In real terms that meant a difference between an average of 1.15 million new units annually from 1990 to 2001 and an average of 1.5 million during the ensuing four years.


But all good things must come to an end. As seen above, starts for single family construction have plummeted. Given the outsized role construction had on overall economic growth during the bubble, the seizing of that market kicked the growth stool out from under the rest of the economy to a detrimental effect. The charts also show….fortunately… that the multi-unit segment is now playing catch up to the increased demand from individuals returning voluntarily or otherwise….likely otherwise…. to the rental market. While rentals don’t add the same bump to growth that home purchases do, especially when one uses his house as an ATM machine, the uptick should have a positive impact on construction jobs and ancillary industries. It also may represent a return to the aforementioned market equilibrium, where expanding homeownership is not seen as a panacea by policy makers. After all, Germany’s homeownership rate is chronically sub 50%, and its economy is a veritable rock star when compared to the basket cases that are housing-centric advanced economies (e.g. U.S., Ireland, Spain).

Home Prices See Rebound….Partly Due to Investor Demand
Other recent data may also reflect the shift in the housing market away from the recent concentration on homeownership. Historically, newly constructed homes have accounted for 15% of the market. That figure has dipped to under 7%, with the existing homes accounting for the remainder. This reiterates builders’ hesitation to add inventory with so many homes in various stages of foreclosure or held off the market as would-be sellers wait for prices to stabilize.

As seen in the chart below, home prices are still sputtering around their 2003 level. That’s nearly a decade of lost appreciation to most families’ largest source of net worth. Yearly increases have finally turned positive after a lull in 2011. Even here a possible shift towards renting may be evident. Many buyers are seeking investment property, which they can then rent out. Given the meager returns on bonds and jitteriness of the stock market in the face of slowing growth and potential hikes in dividend and capital gains tax rates, these investors may be onto something.

The Downer: Putting Multi-Family Units in Perspective
While the shift towards rental construction may become a needed contributor to economic growth, our belief still holds true that home construction is not the source of sustainable expansion; it should reflect sound fundamentals in other parts of the economy (wage growth, household formation). Construction is not a perpetual motion machine. It cannot exceed population growth over a long period as that will simply lead to the inventory hangover (and consequent recession) that the U.S. has recently experienced. Rentals also remain a small share of the overall market, and being rentals, are not the targets of projects that make the folks at home improvement stores, furniture outlets and landscapers sing all the way to the bank.



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