Over at their Free Exchange blog, The Economist has a post from earlier this week titled “Will housing save America’s economy?” The post runs through an interesting thought-exercise on how, even in an under-performing economy, housing (and/or automobile sales) can and will increase and help drive the recovery in the near future. The reduced form story is as follows.
The collapse of the housing bubble and the financial crisis has left financing availability and consumer demand for housing suppressed. Even though there was over-building during the housing boom, the collapse in new construction is of a much larger magnitude than the overbuilding during the past decade. In fact, Residential Investment as been a net drag on GDP for a record five years in a row (2006-2010) and during this time population continued to grow. The combination of the excess supply of housing from the boom and the increase in persons per household during the recession (as individuals and families doubled-up to save on housing costs as jobs and income fell) allows for such a low level of new construction in recent years (not to mention the credit/supply constraints for developers). As the economy continues to grow and jobs increase, demand for housing will return. First multi-family housing will see an uptick both in rising rents and then in new construction (note, we’re already at this stage, see, for example, HERE). This effect then moves into the single family portion of construction and a positive, reinforcing construction cycle is underway. As The Economist writes:
“… [this] should spark a period of catch-up household growth, which should in turn spark a large rise in rents and new construction. A recovering construction industry would help soak up unemployed workers, continuing a virtuous cycle of recovery. After five long years, housing may finally start pulling its economic weight again, or so many Americans must hope.”
I highly encourage you to read the article and follow the links to the other pieces referenced.
We can see a similar story unfolding in Oregon. The first graph below shows housing permits in the state on a seasonally-adjusted, 3 month moving average basis – used to smooth the data so individual monthly fluctuations do not distort the picture . The blue represents single family homes, while the red represents multi-family housing. Oregon’s housing industry has undergone a number of cycles over the past 40 years including our state’s Great Recession of the early 1980s. The level of permits currently being issued is extremely low relative to historical data.
I would like to focus on the steady/stable permitting levels for single family homes during the 1990s (actually 1993-2001). As can be seen above, the blue line barely moves during this nine year time period just prior to the housing bubble. To continue the thought-exercise of trying to figure out if Oregon is currently underbuilding and/or when construction needs to increase to meet pent-up demand, one needs to calculate how much excess housing was built during the boom and then how far under “normal” Oregon housing is. The following calculations are designed solely as a thought-exercise, or a “What if?” scenario. The conclusions reached are based on the initial assumptions made and altering these assumptions will change the outcome.
First, we take the 1993-2001 average as the baseline level of permitting. Any permits above this level are considered excess or bubble building. If you sum the bubble building permits above the baseline over the 2002-mid 2007 period, they equal approximately an extra 5 years of building. Next, as permits have fallen substantially during recent years, we need to establish a reasonable baseline of building in today’s environment. Given that population growth in Oregon has slowed down considerably from the 1990s and expectations are for the demand of and purchases of second homes to remain subdued, this baseline needs to be lower than the 1993-2001 trend. For this example, we choose a baseline of 15 percent below the 1993-2001 trend. This percent is chosen somewhat arbitrarily but is at least in the ballpark of reasonable assumptions.
Since the state just went through a period of over-building, going through a period of under-building of the same magnitude and duration will leave the state at the same place it would have expected, just taking a different (more volatile) path. To calculate how large the under-building period is, we take the actual level of permits issued since they fell below trend (mid-2007 through current) and subtract these from the new/updated baseline. In total, over the past 44 months, permits have fallen below trend by slightly more than they were above trend during the boom. This indicates that the state is currently (or at least very close to) underbuilding single family homes. In the graph below, the light blue portion, titled “Moved Bubble Building”, is calculated to equal the green “Bubble Building”, or the point at which the overbuilding from the boom is completely offset by the underbuilding from the recession. Based on this, we have been underbuiliding for the past four months (the red portion).
With the continued distress in the housing market (declining prices, excess inventory, REO inventory, foreclosures, short sales, etc), the market obviously is not clearing. The glut of homes available for sale will take time to work through, along with the shadow inventory. Calculated Risk estimates it will take until 2015-16 until normal construction returns, given how much excess inventory needs to be absorbed. These issues lessen the need for new construction today as the current market is not functioning perfectly nor is there enough housing demand. Moving forward there is likely to be pent-up demand from households and an undersupply of homes available once the excess inventory is absorbed and demand returns. This will lead to rebound in construction, which will aid the economic recovery, much like the scenario discussed in The Economist post. This may be hard to believe, but at some point, housing will be a positive contributor to the economy and that point is closer than many realize. Housing construction cannot realistically fall further, thus it cannot negatively impact the economy. It will take at least a few more years before the level of construction approaches anything resembling normal however, through the mechanics of how economic growth is calculated, it is the change from one period to the next that matters. From this perspective, housing can only be looking up, even if it stumbles for another year or so.
The last two graphs illustrate our office’s latest (May 2011) housing starts forecast (these are total housing starts, not just single family). The first graph is indexed to each series’ long-run average, which is set to equal 100. Currently both the U.S. and Oregon housing starts are about 65 percent below their long run averages. IHS Global Insight is much more optimistic about the current state of the housing market, however our office’s expectations are for a more protracted return to average levels of housing starts.
The final graph overlays the two housing busts Oregon has undergone in the past 40 years. In the late 1970s, Oregon underwent a significant housing expansion which collapsed along with the economy in the early 1980s (not to mention the double digit interest rates and nearly 20 percent mortgage rates). The path Oregon housing starts took during the past decade follows an eerily similar pattern, as does the forecast.