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Multifamily Trends - May/June 2006 - Point of View

Rising home prices and increasing energy costs are straining consumers’ finances, leading to a decrease in the size of new residences.

Size Matters

by John McIlwain and Melissa Floca

Evidence of shifts in housing markets around the country is accumulating. Not surprisingly, the issue that has gotten the attention of economists and the press is the price of housing. Housing has been the mainstay of the U.S. economy in recent years, but today homes are sitting longer on the market, unsold inventory is climbing, and prices are softening. Everyone is wondering what will happen next. What if housing markets collapse?

Another important shift in the U.S. housing market is beginning to appear, however, largely unnoticed but arguably of greater significance over the long term. The size of the new American home has grown steadily since the end of World War II, but census data show that skyrocketing real estate prices over the last few years have been accompanied by a slowdown in size increases. Today, the median size of a new single-family residence is around 2,200 square feet—almost three times the size of the original Levittown homes built during the late 1940s. This inexorable rise is coming to an end; people will still buy 4,000- and 5,000-square-foot McMansions, and there will still be those who build true mansions measuring 10,000 square feet and more, but the median size of the new American home is going to begin to decrease for the first time in over 20 years.

This happened once before—in the early 1980s, when homes became increasingly unaffordable due to double-digit interest rates and rising energy prices. Consumers still bought residences but looked for smaller, more efficient, and more affordable ones. Today, rising home prices and flat wages have made housing as unaffordable as it was in 1979, the year the size of new houses began to shrink. And while energy prices are not as high as they were at that time in real dollars, they have increased substantially over the past couple of years and, by all accounts, are headed even higher in the years to come. Thus, it seems probable that consumers will respond as they did before, and there is early evidence that they are in fact doing so. This can become a major competitive advantage for the multifamily industry, as declining single-family home sizes make apartments and condominiums the more affordable alternative and closer in size to new home products.

A Housing Bubble?

Whether or not there is a “housing bubble” that is about to burst and lead to a collapse of housing prices may depend on which market you look at, and even which economist you ask. Paul Krugman, for instance, the Princeton University economist and New York Times columnist, believes the risk of

a bubble bursting depends on whether one lives in what he calls “the zoned zone”—which includes most of the Northeast Corridor, coastal Florida, much of the West Coast, plus a few other locations—where he says housing prices are largely a result of tight zoning rules that make land scarce. In what he calls “the flatland”—the rest of the country—land for building remains plentiful and affordable. He concludes that there is a bubble in the zoned zone, but not in the flatland.

Robert Shiller, the Yale University economist who accurately predicted the collapse of the stock market in 2000 in his book Irrational Exuberance (which appeared on bookstore shelves in March 2000, coincidentally the very month in which the stock market peaked), also believes there is a speculative bubble in housing prices and that they are in for a major correction. In the second edition of Irrational Exuberance, published last year, he reviews U.S. housing from 1880 until the present, and concludes that any rate of appreciation of prices in real-dollar terms much over 0.04 percent is bound to be short term; when the rate of appreciation in real terms is significantly over this, as it has been in the United States for the last five to seven years, this can only be the result of a speculative bubble that will inevitably collapse in a prolonged and painful return of housing prices to the long-term norm.

While Krugman and Shiller are certainly not alone in their fears, others argue that there is scant risk of a bubble; instead, they predict that prices in most markets will slow their rate of appreciation, with prices in some overheated markets possibly pulling back for a time but not collapsing. Nic Retsinas, the head of the Harvard University Joint Center for Housing Studies, for example, argues that while there may be several small bubbles, there is no national bubble to fear.

The argument for a soft landing of the housing market points to the huge ongoing demand for housing in the United States; the Washington, D.C.–based Brookings Institution, for instance, has projected a need for 2 million new homes per year for the next 20-plus years. Given that it is unlikely the cost of materials or labor will decline, land values would have to collapse to see a major drop in the price of new homes. Steady demand coupled with constraints on development throughout the country makes this improbable.

The Income/Housing Cost Paradox

There does seem to be a correlation between median household income, interest rates, median new home price, and median new home size. In the 29 years from 1975 until 2004, median household income has grown steadily, increasing by 22 percent in real dollars. Over the same period, the price of new homes has roughly doubled. The affordability of homes (the ratio of median prices to median incomes) has fluctuated substantially during this period, however, as interest rates and the median home size rose and fell in close opposition.

From 1975 to 1982, for instance, interest rates climbed from 8.9 percent to 14.7 percent, and then began a 23-year decline. Meanwhile, the median size of a new home peaked in 1978 (at 1,655 square feet) and then dropped to 1,520 square feet in 1982. Since then, it has climbed back up as interest rates declined. Likewise, median new home prices peaked as the size of homes rose and then fell as they became smaller. Since the mid-1980s, home prices have been fairly stable in real-dollar terms until the late 1990s, despite the steady increase in the size of new homes. Since 1999, however, new home prices have risen significantly each year.

During the period in which interest rates climbed and housing size shrank, the ratio of the median household income to the median cost of a new home rose from 4.23 in 1975 to 5.29 in 1980. It then fell to the mid-fours as homes got smaller and less expensive in the early 1980s. It stabilized from the mid-1980s until the late 1990s as interest rates kept declining and homes kept getting larger. Then it began to climb and in 2004 the ratio hit five, the highest since 1983.

In other words, during the late 1970s/early 1980s, homebuyers responded to the declining affordability of new homes by buying smaller ones. Then, as interest rates began a long decline, making homes more affordable again (and energy prices declined as well), consumers tapped their growing purchasing power to buy ever larger new homes. Today, their purchasing power has started to wither again, and the affordability of homes is declining even faster. Expect consumers to respond once again by looking for smaller homes.

The early signs of this trend in fact can be seen today. At a recent ULI panel in Las Vegas, Nevada, Chris Stephens, senior vice president of locally based KB Homes, reported that two years ago his company realized it no longer could build the same homes it had been building in Las Vegas for so many years—costs had risen to the point where they could not deliver a residence the market could afford. They retooled their program, and for the past couple of years have been building smaller houses in denser configurations—and selling them successfully. The same trend can be seen in new townhouses being built in Los Angeles, which measure 800 square feet and less.

In short, rather than a collapse of new home prices, the nation is more likely entering another period of declining sizes for new homes, one that will last as long as interest rates and the costs of materials, labor, and energy climb—for a long time to come, in other words. This could be good news for the multifamily industry over the long term, as smaller single-family homes reduce the advantages of size they have traditionally held over multifamily dwellings. It may take a few years for this trend to show up in the national numbers, but as more and more builders look to downsize their products to meet local market conditions, multifamily will become a more competitive and ever more attractive alternative, market by market. This may be the real story behind all the attention now being paid to the “housing bubble.”

John McIlwain is a ULI senior resident fellow and holds the ULI/J. Ronald Terwilliger Chair for Housing. Melissa Floca is a ULI research associate.