Housing Was Not Massively Overbuilt

It’s widely taken as a given that because we have too many empty housing units now and because prices have collapsed, that housing was overbuilt. For example, from Unnatural Rent:

In addition, the recession and rising unemployment have slowed down new household formation, encouraging people to live with roommates. In many markets, apartment rents are unlikely to post any growth during this year, and some may even see declines.
This drop in demand has been combined with a massive increase in the supply of housing (both single family and multifamily) over the past decade. While office and industrial did not experience a huge wave of overbuilding, that isn't quite the case for retail and multifamily.

This is true in a sense – if we had fewer housing units now the situation would be better.  However, throughout the bubble years supply and demand were balanced. My argument is premised on the idea that additions to housing supply should roughly correspond to additions to employment:

1 new job = 1 additional unit

Obviously, not every person who gets a job creates a new household, but households are also created without jobs, and in my experience nothing too bad happens to housing markets where job growth exceeds new housing additions. The data for job creation and residential permits issued since 2004 is summarized below:

Supply and demand were in synch until 2007. In 2008, demand went off a cliff, which goes to show that jobs can be lost faster than residential development can wind down.

I think this data also supports the notion that the bubble price escalation was driven by easy financing, and not fundamental demand.

Employment data is from this BLS website, permit data at this Census Department website.

Where Do Tenants Go in a Down Market?

Everyone knows multifamily vacancy rates increase during a recession. Where do these tenants go for housing?

I’ve not seen any studies on this topic, but the obvious explanations are they move back in with families (children back to their parents, parents and grandparents move in with their children), and doubling up (unrelated households combine to share space). And, some drop out of the housing market altogether. Here are some links to stories which explore what’s happening this time around:

Rooms for Rent. From the Seattle Times, In tough times, the rented room is resurgent:

Because most of the arrangements are informal, it's hard to assess just how many people now share their homes with strangers for money. But as the economy plummeted during the past year, mortgage foreclosures soared and layoffs became common, the ads for people seeking roommates increased by more than 70 percent nationwide on craigslist.com.

Homeless Shelters. From TimesOnline:

Joan Burke, director of advocacy for the homeless charity Loaves and Fishes, said: “The folks we deal with typically are the working poor. But right now the economy is in such turmoil that it is affecting a new layer of middle-class earners - construction workers, farm labourers, retail workers, restaurant staff.

Shantytowns. From the New York Times, Cities Deal With a Surge in Shanty Towns:

While encampments and street living have always been a part of the landscape in big cities like Los Angeles and New York, these new tent cities have taken root — or grown from smaller enclaves of the homeless as more people lose jobs and housing — in such disparate places as Nashville, Olympia, Wash., and St. Petersburg, Fla.

Squatting. From Slate, Homesteaders in the HoodSquatters are multiplying in the recession—what should cities do?:

As the current recession picks up speed, we are again confronted with the ingredients for a squatting boom. Unemployment is closing in on double digits nationally, and homelessness is on the rise. Between late 2007 and late 2008, the number of families presenting themselves at homeless shelters in New York City increased by 40 percent. In Massachusetts during the same period, the statewide increase was more than 30 percent. At the same time, housing vacancy rates are at all-time highs. According to the Census Bureau, about 15 percent of housing units in the United States were vacant during the last quarter of 2008. That's 19 million homes sitting idle, largely in the hands of banks. The difference between the 1970s and today is that the crisis last time was focused on the urban centers, while this time around the suburbs are the site of the greatest mismatch between people without homes and homes without occupants.

And so, the squatters are squatting.

Will We have a Commercial Real Estate Crisis?

Casey Mulligan thinks probably not. From his New York Times piece:

For months now, experts have been predicting that commercial real estate will be “the other shoe to drop.” But in fact, non-residential building fell far behind housing construction during the housing boom. This shortage of commercial buildings relative to housing suggests that a commercial real estate crisis will not occur, or that at worst it will occur with much less severity than did the housing crash.

Here is the chart purporting to support this argument:

(Click on image for a larger version in a new window)

The error Dr. Mulligan makes is the belief that the housing bubble and future CRE performance was/is primarily a function of inventory. The chart suggests housing prices have collapsed because too many residential structures were built. That’s like saying Citibank’s stock price has collapsed because too many shares have been issued. Home prices have dropped because the financing that people used to buy homes at an inflated price is no longer available, not because there are more homes than people are willing to occupy. To the extent CRE inventories were tight, values were inflated, which won’t help us now if the deals were leveraged based on the higher values.

For example, look at Miami, a residential bubble market. The graph below shows the number residential permits issued in relation to the number of new jobs created on a rolling 12 month basis. The secondary axis is the OFHEO Housing Price Index year over year change.

(Click on image for a larger version in a new window)

Home price increases began decelerating in late 2005, but at the time Miami was creating twice as many jobs as new units, so if anything the market was undersupplied. Something else was clearly dragging prices down, and in retrospect we know it was the withdrawal of aggressive lending parameters.

Now, of course, most markets are losing jobs, and most markets are still adding units (and commercial real estate) as projects work there way through the development pipeline. We won’t see a recovery until the employment situation turns around.

What does this mean for CRE? We don’t know for sure how many deals were done with aggressive underwriting during the peak years, but we know there were quite a few and so we can expect some decline in values related to the withdrawal of aggressive leverage similar to what’s happened in the residential market. We also know that CRE is sensitive to employment trends, and those are very negative. The CRE situation may not become as bad as residential, but if it doesn’t it will be because the underwriting was better and employment improves. It won’t be because there was a lack of inventory.

The Lumpiness of Housing Inventory

There is an excellent post on TraderFeed describing variations in housing inventory between markets and price ranges:

Someone recently told me that my own local housing market in Naperville, IL is in relatively good shape because there is only about one year of inventory for sale based on 2008 sales figures. If, however, we break down the inventory by price (see chart above), we again see evidence of lumpiness. There is little inventory problem at the lower end of the housing spectrum; speculation in that market had centered on the luxury end, where there is more than 3 years of inventory. At year end 2008, annual sales of homes above $1,200,000 in Naperville were 36, but 114 homes were on the market. Stated otherwise, about 3% of housing sales in that market have been above $1,200,000, but 15% of the inventory is priced at that level.

I touched on this point in my post suggesting we can't just assume excess inventory is a result of overbuilding, but Brett provides much more detail on the variable mismatch between supply and demand between and within markets.

Is Overbuilding Responsible for Excess Housing Inventory?

The President of the National Association of Home Builders says “The excess housing inventory in today’s market is the result of unprecedented foreclosures, not overbuilding.” Paul Jackson, Housing Wire, suggests this statement “borders on the certifiably insane ." I may be certifiably insane, but I think the NAHB position is closer to the truth.

Obviously, we have excess inventory. The amount is subject to debate, but arguments can be made for between 1.75 to 4 million excess units (see this Calculated Risk post, for example). Obviously, many of the excess homes are newly completed builder inventory. You can read the story behind the pictured subdivision here.  So, in a sense builders are responsible for at least a portion of the excess inventory. They built it, it’s empty, end of story.

But, of course, it’s not that simple. There are a lot of people who are living in substandard housing, in apartments, with their parents, with roommates, etc. who would be delighted to be living in these “excess” units. The problem is much of the excess is located in places people don’t want to live or can’t find jobs (read, for example, these depressing posts about Detroit in The Big Picture and The Weekly Standard). And, much of the excess is not affordable even at today’s depressed prices to the people who want the units.

I think Miami is a good example of what actually occurred. Here is a chart of residential permits issued in Miami between 1999 and November, 2008:

(click on images to open larger versions in a new window)

On it’s own, this is about as clear a case as you can get of overbuilding – permits obviously spiked between 2004 and 2006, which nicely dovetails with the peak of the subprime craziness. But, consider employment growth in Miami during the same period:

At the same time permits were peaking at around 45K per year, Miami was adding jobs at 100K a year. Can you really say builders were overbuilding when there are twice as many people with new jobs as units being added to supply? If anything, the numbers imply a housing shortage in the peak period. Here is a chart showing the ratio between new jobs and residential permits:

From mid-2002 through 2007 Miami was adding more jobs than housing units, and for most of this period it was adding around two jobs for every new housing unit. This was not an overbuilt market during that period.

In contrast, here is an equivalent chart for Houston:

Housing prices have held up relatively well in Houston, and most people do not consider it to have been one of the bubble markets. But, note Miami had substantially more jobs added per new unit than Houston did during this period. The data suggest Houston was relatively overbuilt compared to Miami.

In fact, the data suggest that maybe part of the problem in the bubble markets was builders didn’t build fast enough to keep pace with the demand created by new jobs (you can see similar charts for Los Angeles, San Diego, Las Vegas, and many more markets here). I’m not ready to go so far as to suggest they should have done so – had lenders stuck to reasonable underwriting standards more of that demand would have shifted to the rental market and we would have seen higher rents and less vacancy in that segment, which I think we all agree in hindsight would have been better than putting people in houses they couldn’t afford.

Does the Housing Market Benefit When Investors Buy Foreclosed Homes and Rent Them to Tenants?

Yes, it does. I wouldn’t have thought this question worth posting about since it seems so obviously true, but since Nobel laureate economist Joseph Stiglitz and Yale University Professor Robert Shiller apparently disagree (see this Bloomberg article), maybe I should explain my reasoning. Calculated Risk agrees with me for some good reasons, but I have a couple more.

The Schiller and Stiglitz argument is that the speculators will sell the homes when prices recover, and the reentry of these homes into the for sale market will be a drag on price recovery. There’s no data in the Bloomberg piece, and the anecdotes all involve buyers who are renting out the houses they’ve acquired. Apparently, we would be better off if lenders held the properties vacant until owner occupant buyers can be found rather than sell the properties to landlords.

Everybody including me loves owner occupants, but the day when residential REO can be absorbed by owner occupant purchasers is a long way away. Employment is falling sharply in all the distressed markets: for example, here’s what’s happening in LA:

You are not going to have much residential demand in LA until employment is trending up again no matter what you do to incentivize owner occupant buyers (we could waive down payment and credit requirements, of course, but we know where that got us). It does neighborhoods no good to have lots of boarded up houses for years (just ask someone from Detroit what 60,000 vacant units have done for them).

My second objection is more subtle. I have previously argued that a relatively high percentage of single unit rental housing correlated with the size of the housing bubble in that market. For example, of the markets tracked in the Case Schiller Price Index, Los Angeles, San Francisco, and San Diego had the highest percentage of single unit rentals in 2000.

I believe the investors that owned those units were probably sellers during the bubble days, and that the purchase of REO by investors is a return back to the previous equilibrium rather than a new direction. Unfortunately, we’ll have to wait a while for data and there are a lot of moving parts so we may never know conclusively.

Making the Neighborhood Stabilization Program Work

The Wall Street Journal reports local jurisdictions are having a hard time figuring out how best to spend the $4B HUD is distributing to them to help stabilize neighborhoods experiencing high level of foreclosures. Here are my suggestions, based on my experience at the Los Angeles Housing Department helping rebuild neighborhoods devastated by the Northridge earthquake.

The Northridge quake left tens of thousands of homes and rental units vacant and damaged. Some neighborhoods were affected much more than others, but in every neighborhood there were owners whose housing was not damaged, so comprehensive redevelopment was not an option. There was a real possibility some of the neighborhoods would remain blighted indefinitely if dramatic steps weren’t taken. Many homes and apartment buildings were either foreclosed upon or required lender cooperation in the reconstruction. The quake occurred in January, 1994, a time in Los Angeles when many residents and apartment owners had lost all the equity in their units due to economic conditions even before the earthquake. The parallels between this situation and foreclosure blighted neighborhoods is obvious.

In an effort to preserve the damaged housing HUD provided the City of Los Angeles with $400M in CDBG and HOME funds. The Los Angeles Housing Department developed programs which were extremely successful, and two years later almost all the affected properties in the target areas were back on line. Here's a link to a study published in 2000 which summarized the reconstruction.

The most important decision made was to leverage rather than replace private sector funding sources. The mechanism to accomplish this was to offer subordinate loans at 0% interest payable over 30 years with no payments for the first five years. The amount of the loan was capped at $35,000 per unit, the loans were only available in target areas (described below), and became due when the property was sold. This approach had several benefits:

• The very favorable terms concentrated private sector reinvestment in the target areas
• The predictable loan amount allowed buyers and sellers to factor the financing into their negotiations
• The loan structure (as opposed to direct investment or a grant) created an annuity for the Housing Department; as the loans have been repaid the money is available for recycling into new programs.
• Between three and four times as many units were assisted as would have been possible if only public funds were involved.

Another key decision was making the funds available for rental housing. When the loan was made on a rental unit, an income restriction was placed on the unit which at that time was above market, so there was no impact on the rent charged or the value of the unit. However, as rents have increased in Los Angeles these units have become an important component of the affordable housing stock. A restriction limiting the unit to tenants making 60% or less of the area median income would not have an immediate impact in most low and moderate income foreclosure neighborhoods, and would help ensure housing affordability in the years to come.

Other key components of the programs were:

• A detailed inventory of the affected housing. An inventory is necessary both to select target areas and to monitor progress. This step is particularly important if there’s a possibility of getting more money if your programs are successful (which is probably going to be the case with the Neighborhood Stabilization Program). Information on foreclosures is readily available but constantly changing, so an active database (as opposed to a static snapshot) is necessary.
• A focus on the areas which are most seriously affected, while paying attention to political geography. The Los Angeles Housing Department designated 17 neighborhoods as “Ghost Towns”, which were characterized by high concentrations of damage. Although these areas were primarily determined by need, a secondary consideration was to identify at least one neighborhood in each city council district that would receive funds. This was an important step to ensure broad political support in Los Angeles’ often fractious local government. Again, the foreclosure data is readily available but needs to be analyzed and monitored.
• A multi-department effort. Although the Housing Department had primary responsibility for the effort, other departments played important roles. For example, the Department of Building and Safety, Public Works, and General Services played an important role in boarding up and securing vacant buildings, and the Los Angeles Police Department stepped up patrols to deal with disorder issues and squatters in the affected neighborhoods. Foreclosure-ravaged neighborhoods have similar needs.

Additional information on the programs is described in this report by the LA Housing Department. Compare this effort to the dismal housing reconstruction progress in New Orleans, where, for example, only 82 of an estimated 10,000 damaged rental homes have been brought back on line in the three years since the disaster.

The is an unfortunate tendency to want to treat each disaster as unique and to create new solutions, as opposed to adopting proven approaches which were created elsewhere. I hope this housing disaster will be different.

Which Markets have the Strongest Housing Fundamentals?

Although all markets are experiencing the effects of tighter mortgage underwriting, there are a number of markets which have very strong demand - supply fundamentals. The chart at left ranks the markets tracked by Residential Property Analytics. The numerical rating is the number of jobs created in the market over the last year divided by the number of residential permits issued. In other words, Denver added more than 2 jobs for each residential unit permitted, while Detroit lost more than 8 jobs for each unit permitted. In our experience, when the ratio falls below 1.0 markets start to soften. A full explanation of the data and how it is calculated can be found in the free sample market report which can be downloaded at our website. Obviously this ratio is not the only factor affecting markets - there are plenty of foreclosures attributable to the subprime mess which are acting as a drag on markets everywhere. Still, the markets with good underlying fundamentals should recover first, while the markets with poor employment growth are going to suffer longer.

WSJ Housing Inventory Story turns Up into Down

You may have seen the Wall Street Journal story headlined "Housing Supply Lower, Yet Ample" on January 8, 2008. A lot of people (including me) often just read headlines and would draw the conclusion that the housing market is still soft but might be improving because inventories are down. That conclusion doesn't square with other information I've seen, so I kept reading. The third paragraph contains this tidbit; "The decline is roughly in line with the usual pattern for December, when many potential sellers keep their homes off the market because of the holidays."

To their credit, the Journal did include this information, but it makes you wonder if the person who wrote the headline read that far into the story. Housing inventory is seasonal, and you need to adjust for that. One way to do that is to compare to the previous year's period (e.g., compare December 2006 inventory to December 2007). That information is in the fourth paragraph; "Total listings at the end of December were still up about 23% from a year earlier in the 17 metro areas for which comparable figures from December 2006 were available."

In my book "up about 23%" does not equate to "roughly in line." The headline for this story should be something like, "Housing Inventory Up Substantially Over Prior Year."