Volume 61 | Number 3
Disaster has struck in the already beleaguered single family housing market. This month, new starts for multi-family construction soared to 233,000 accounting for most of the increase in total starts from 572,000 to 658,000. Yes, we know that multi-family starts is a highly volatile number, but multifamily permits started topping 200,000 back in May, and has averaged exactly that number over the past five months. This housing recovery is different than in 1991, when single family starts soared while multis remained stagnant. Nor is it like 2001, when single and multi family activity rose in tandem. In this albeit muted recovery for the housing sector, it is multi-family activity that is leading the way. Nothing could be worse for the US banking system which is based on residential real estate values.
Schumpeterian Creative Destruction Destroys
The unfortunate reality is that lower interest rates have sparked the new supply of smaller dwelling units far faster than it has generated fresh demand for the vast excess capacity of existing larger single family units. With mortgage rates at record low levels, builders have better access to credit than potential purchasers of single family homes. From each lenders narrow point of view it makes perfect sense: builders who have survived the downturn are the best capitalized and can put down required down payments – while home buyers often cannot. Moreover, while land prices, labor costs, and interest rates are falling, rents are rising making new apartment construction a viable lending opportunity. Banks are scrambling for loan demand, and this is an area where they have traditional expertise. However, for the banking system as a whole, increased competition from apparently more desirable smaller dwelling options means that larger units have further to fall in value – undermining the existing collateral base and making lenders even more reticent to conduct their largest traditional business, making single family mortgages.
We have written at length about the need to correct the imbalance in the housing sector for the economy to have any chance at expansion. If banks won’t lend, it is very hard for an economy to expand. That is the lesson of Japan. It is also the lesson of Reinhart & Rogoff’s This Time It’s Different. We are not worried about housing from an industry point of view. We understand that many construction workers will never again find jobs, but it is not their unemployment that is the vital risk to the US economy. The threat is from an ongoing rebalancing of personal spending patterns that are shifting away from spending on housing in order to preserve buying power for other goods and services. Given that the post-war banking system was built on lending to satisfy consumers apparently endless demand for more single family privately owned housing, the shift in demand is a substantial problem. Unfortunately, we see nothing in the data that suggests consumers are ready to renew their love affair with the single family home.
Affordable, But Undesirable
At current interest rates and home prices, housing is more affordable than ever. Yet, consumers are less willing to spend on new or existing homes. The ratio of median existing home prices to median income has slipped below the levels that prevailed before the housing boom even though mortgage rates today are just a fraction of those in the 1980s. This in part reflects the fact that real median incomes are under pressure again – and credit is not available– so consumers must cut back where they can to sustain living standards. But why is housing taking the brunt of the correction?
The reason is simple: housing is no longer an investment, and so consumers are only paying for shelter. The longstanding conviction that home prices can never fall – at least at the national level – has been shattered by a protracted six year decline that has slashed prices roughly 25%. Consumers looking at real estate as an investment tend to look at the difference between the mortgage rate and the expected appreciation on the property as the real interest rate. When home prices were booming and interest rates falling early in the new millennium, real borrowing costs were actually negative. Today, despite 4% thirty year fixed rate mortgages, the fact that home prices are still falling leaves real rates near the level experienced for most of the 1990s.
With expectations of further declines in home prices widely touted by Case-Shiller and other experts, it is unlikely that consumers will try to pick a bottom and start investing in single family real estate any time soon. When looking at housing as just shelter, the price and flexibility of multi-family arrangements is attractive to the young people who make up the bulk of new household formation. Thus, the units that are in shortest supply in our vast pool of dwelling units are rentals, and developers are more than willing to answer the call — just as they did in the immediate post WWII period with Levittown type starter homes and in the past decade with McMansions.
We applaud Federal Reserve Governor Daniel Tarullo for suggesting more purchases of mortgage backed securities to help drive down mortgage rates. Unfortunately, that primarily frees up income for homeowners to drive the rest of the economy. It does little to correct the excess supply of housing which threatens the banking systems balance sheet – and it reduces the banking systems cash flow. We applaud Senators Shumer and Lee for the concept of allowing more foreign investment to absorb excess housing supply. Unfortunately, like most political solutions it would have no effect. The requirements are not significantly different than those for the EB-5 investor visa program, which attracts well less than the 10,000 a year limit currently imposed on the program. Stimulating housing demand simply won’t work when consumers are downsizing their housing requirements. Even stimulating the entire economy will have a limited impact on housing as that is not where consumers will spend fresh money – unless they see a potential for price appreciation.
The politicos need to concentrate on reducing supply by limiting new construction, enhancing destruction, and converting single family units to rentals. Meanwhile, the banks need to look more to their own self interest, and realize that expanding financing to multifamily developers is pennywise and pound foolish. Left to its own devices, the market will reduce the size and quality of the housing stock by allowing it to deteriorate – which means declining prices. Faced with declining home prices, the banking system needs to shift to a different collateral base – which will happen over time, but measured in decades not years. In the meantime, slow loan growth condemns the US to slow nominal GDP growth and a grinding muddle through economy dominated by low rates and low inflation. Sounds kind of like Japan – with immigration.