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Real estate: Time for a housing diet

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Note: LONG.

Note 2: I know there are problems with the images.

Until recently, the US has been quite good about self-regulating its demand for new housing units. The number of houses and apartments that we need corresponds to the number of households in the US, a number that changes as the number of people in different age brackets changes. For instance, when the baby boomers left home and got married, housing demand soared again. When housing demand went up, so did prices and then builders went crazy building until demand was sated and prices came back down (at least on an inflation adjusted basis).

Below is a chart from a famous paper published in the late 1980s that shows how changes in price closely followed changes in housing demand during the preceding 40 years. While the paper’s conclusion that real housing prices would sink through 2010 as the baby bust generation (i.e. me) left home was controversial, the paper was convincing on the relationship between changes in price and demographically determined demand.


from: Greg Mankiw’s website

There are always a certain percentage of houses that are sitting around empty – some because they are second homes hardly ever lived in, some because they have been abandoned, and some because the owner has moved away / died and no one has bought the house yet. The census bureau does its best to keep track of these numbers and the consistency in the percentage of homes that are empty because they are being sold (the “vacancy rate”) is remarkable.

Take your average toddler and their food consumption. There may seem to be no rhyme or reason to individual feeding decisions, but they seem to end up eating just the right number of calories over a week. If you think of hunger being the signal our body gives us to tell us how much to eat, price has been a reliable signal to home builders about demand for houses. And historically, it has worked fairly well.


Original data source: US Census Graph:

Well, something happened over the last decade. We had rising prices without a corresponding increase in household driven demand for housing. Odder still, prices continued to rise over the last 2 years while increasing numbers of houses stood empty. This is the equivalent of deciding to eat Thanksgiving dinner every night, for a month. Maybe a year.

There will be fodder for many a Ph.d as to what kicked off this episode in American history. It may have been the stock market boom (the initial jump in prices could have just been Northern California and New York), it may have been some interest in vacation homes, it may have been the re-emergence of builders after their bankruptcies in the late 1980s, who knows. It definitely got major support from a combination of 1% short term interest rates, ARMs and securitization. The ability of speculators to buy up houses with only minuscule deposits may have been what turned excess into a full-fledged bubble. An estimated 25% of homes purchased in 2005 were for investment purposes.

What did the big residential builders do, faced with growing inventories? They kept building more houses. As a matter of fact, housing units are still being built. Yes, some projects are on hold but many others are still moving toward the finish line.

A couple of things are clear.

America will have to go on a housing diet. In combination with high levels of vacancy among rental properties, we are several (3-4) years away from growing our population and households enough to get back down to a normal level of house vacancies even with a drastically reduced run rate of home building. Normal would mean that if you price your house at market, you can expect to sell it in a couple of months.

A slight lowering of interest rates will not do anything. There are just more houses than people at this point. And there are a lot more houses than people who can afford them.

Prices are generally too high. They make no sense versus the cost of new building, they make no sense relative to rents, they make no sense in terms of affordability, they make no sense given inventory levels.

Prices could fall a lot. First there are the people who cannot afford to keep their homes at their current interest rates. Then there are the banks whose inventory of repossessed homes is growing. Countrywide alone already owns $2.5 billion of real estate, much of it in California. Then there are the speculators who cannot afford to pay any mortgage without a renter. Then there is the problem of home builders who NEED to sell or face bankruptcy. Hovnanian Homes just had the “sale of the century” to try and clear out inventory, a requirement to survive through this market cycle.

Real estate markets tend to work a little differently than stock markets. Prices take a while to adjust as many people will decide to just wait to sell their house until they can sell not a loss. The first sign of a troubled market is usually slowing sales. Then you see a buildup in number of homes for sale and homes take longer to sell. If it is really bad, sales continue to slow. The number of homes technically on the market may actually go down as discouraged sellers just decide to wait it out. Then, based on how desperate the homeowners are (home builders and banks tend to be impatient owners), prices may go down.

In this case, prices in some markets may go down a lot. In the worst markets in California it may be 50% plus. As a country, it could be 30% on average.

Then, we have the problem of mortgage equity withdrawal, better known as MEW. MEW is the net amount of money that people borrow against the equity in their homes – think home equity loans, cash out refinances. It is arguable that most of the economic gains of the last 5 years have been due to the spending binge of consumers on home improvements, cars, vacations, and even meals out using money from their homes.

First, imagine what happens to Home Depot and GM as that tap is turned off and the credit cards are eventually maxed out.

Then, imagine the potential losses of people who bought their homes anytime during the boom. Some of these losses will be borne by the lenders, some losses will mean the loss of life savings and some losses, for those who can sit tight over the next 10 years, may just be paper.

Then, imagine the loss of wealth felt by everyone. Despite the huge increase in home values, so little equity was put into new houses and so much money was borrowed against old homes that home equity as a percentage of home value is at record lows. If home prices fall back down to trend prices, and there is absolutely nothing I have heard that makes me think they won’t, a large percentage of American homeowners will be underwater. This undermines confidence, alters retirement calculus and presents a major problem for anyone who needs to move.

Please do remember that real estate is local and this reappraisal of American real estate will not be uniform. The most important variable in real estate is always supply versus jobs. Markets with a lot of empty homes where prices went stratospheric and are not consistent with local incomes will be hit hard. Places like Orange County who meet that criteria and will suffer a lot of job loss because of a downturn in the mortgage market will be disasters. Cities like Austin which did not experience a big boom and who have diversified local economies will be fine. Places like Silicon Valley with very little inventory at the moment will be okay, for the moment.

Looking out on the horizon, the good news is that the baby boomers kids are becoming adults and there will be an increase in households down the road to live in all the extra homes we built. The other good news is that homes may become affordable again for the average young family. There will eventually be some excellent investment opportunities.

If someone just gets a little overweight, they can increase their exercise a little bit or diet for a short period. If someone has become obese and wants to get back in shape, the measures required are more extreme. America, get prepared to count calories.

Topics: Economy, Real estate | 1 Comment »

One Response to “Real estate: Time for a housing diet”

  1. David Goldstein Says:
    September 25th, 2007 at 2:28 pm

    Very interesting and timely discussion of the very messy real estate situation. You’ve persuaded me that we have a major problem on our hands.


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