Friday, 4 May 2012

The US Housing Market - Recession and Recovery

Building a new house generates a lot of economic activity.  Before a shovel breaks ground, architects, developers and banks get some business.  A realtor may take a commission.  The physical substances of the house are cut down in forests, quarried in gypsum mines etc.  From there, they're hauled to mills and factories, where workers transform them from raw materials into finished goods.  Once manufactured, transportation firms again act as a middleman, delivering them to the construction site.  When the building phase begins, well-paid laborers and skilled tradesmen pour the foundation, erect the frame, run wire, fit pipe, top it off with a roof, and so on.  Clearly, it's a major undertaking, and this isn't even an exhaustive list.
A major reason for the US economy's lackluster recovery is the stubborn lack of a rebound in housing.  While the economy went through a Great Recession, the housing market has suffered a Great Depression.  After a crazed period of overbuilding, the housing bubble popped; housing starts have plummeted, as empty homes are slowly filled.  A look at historical housing starts is striking.  From 1959-2007, housing starts averaged around 1.5 million per year, albeit on a cyclical basis.  Until 2008, the number never fell below 1 million.  However, from 2008-2011, household starts averaged just 664 000 (starts) (1).  Early indications suggest the number may be around 750 000 or so for 2012, about half the historical rate.
Household formation is mostly composed of two groups of people: immigrants and young people leaving home.  To a lesser extent, it also includes people living with roommates, siblings and extended family that decide to settle on their own, as well as divorcees, and a few other small cohorts.  Many immigrants continue to dream about moving to the US, but few young people fantasize about living with their parents forever (Warren Buffett has joked that "hormones" will heal the housing bust).  As the economy picks up, and the jobs market recovers, pent-up demand - of both kinds - will be released and homes will be built to accommodate it. 
Once the excess supply of homes is filled and the market is back in balance, housing starts will match household formation over time.  A report from the Harvard Joint Center for Housing Studies projects that 2010-2020 household formation will likely average 1.18-1.38 million per year (2).  Whether it happens in a few weeks, months or years, housing starts will nearly double from recent levels, and create tremendous amounts of economic activity in the process.  Though lower than past levels of household formation, projections for the next decade remain 600 000-800 000 higher than starts in recent years. 
How much economic activity will result as this gap closes?  Here's a crude, back-of-the-envelope estimate, designed not to be precise, but to make a broad point.  Assuming housing starts that are 700 000 higher than in recent years, and assuming a cost of $200 000 per house, $140 billion of additional economic activity would be created per year, which would add nearly a full percentage point to GDP.  Keep in mind, this assumes no multiplier effect at all, and ignores add-on purchases, such as new furniture and yard equipment, that often coincide with new construction. 
More aid will come to the economy when real estate prices resume their rise (over the very long-term, the price of real estate tends to rise at, or slightly ahead of, the rate of inflation).  Homeowners tend to consume more as property values appreciate, a confidence-related phenomenon known as the "wealth effect."  One estimate holds that for every dollar in increased wealth, consumers spend 6 extra cents (3).  Given that consumer spending accounts for 70% of US GDP, wealth’s effect on the economy is considerable.  And banks, which in recent years have suffered heavy mortagage-related losses, will become more profitable, prompting them to lend to consumers and businesses, and bolstering the economy in the process.  Banks, after all, lend in proportion to their assets.
There's no water-tight way to predict when the housing recovery will arrive, but eventually it will, likely on a city-by-city basis.  Though the housing bubble was national in scope, real estate remains mostly a local market.  When housing comes back in most major markets, the US economy is likely to enter a strong, self-sustaining recovery.  A word of warning, though: shy investors that take a wait-and-see approach may find that stocks have made most of their gains by the time the long-awaited recovery appears.


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