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Multifamily Trends - November/December 2007 - Point of View

It is entirely possible that once the housing markets emerge from their present turmoil they will look different from before.

The Age of Turbulence: Housing in a New World

With apologies to former Federal Reserve Chairman Alan Greenspan, the title of his new book aptly sums up both the short-and long-term future of housing. In the short term, residential markets clearly are softening and in some cases collapsing while mortgage markets are experiencing more turmoil than they have in decades. Past experience suggests that, in time, both of these markets will once again stabilize, at which point builders, developers, lenders, and homebuyers will resume business as usual. This may take a few years, but the housing markets will once again become normal. Or will they?

While life exhibits an inherent momentum—the odds being in favor of tomorrow looking a whole lot like today—discontinuities do occur. It is entirely possible that once the housing markets emerge from their present turmoil they will look different from before. Over time, trends that are now emerging are likely to significantly reshape the world of housing in the years ahead. While not everyone will agree that we are about to embark on a new trajectory, it is certainly worth exploring this alternative future. After all, even though the housing industry has been conservative and resistant to change in modern times, it is wise to keep in mind the words of management guru W. Edwards Deming: “It is not necessary to change. Survival is not mandatory.”

The first of a two-part series, the discussion below considers the nature of housing markets as they slowly emerge from the current downturn. Next issue’s essay will explore how the growing cost and volatility of energy supplies coupled with the need to severely restrict greenhouse gas emissions may affect housing well into the future.

Current Affairs

At the time of press, the Federal Reserve has dropped the Fed Funds rate by three quarters of 1 percent since this past summer, sparking the stock market. Meanwhile, investment banks are reporting reduced earnings due in large part to marking down hundreds of billions of dollars of mortgage securities. The clogged mortgage market has overflowed into other credit markets, and the problems are not yet over. Most experts agree that billions of dollars of writedowns in various forms of mortgage-backed securities are still to come.

Out in the housing markets, delinquencies and foreclosures are at long-term highs and rising. During the fall, some $300 billion worth of adjustable-rate mortgages will have their interest rates reset. It has been estimated that the average loan reset will raise the monthly cost of these mortgages by an average of nearly $250 a month—enough to throw many a tight budget out of balance. In addition, some report that as much as another $1 trillion of mortgages are due to reset in the next couple of years, and there are predictions of another 2 million foreclosures ahead in 2008.

Many homes have declined in value to the point where homeowners will not be able to refinance in today’s tightened credit world, despite the Fed doing what it can to lower rates. Also, it has been estimated that up to 70 percent of all adjustable-rate mortgages have early prepayment penalties, which all but prevent refinancing.

As for homebuyers, only those able to make a significant downpayment and who have a strong credit record will be able to get a mortgage. All others will be locked out of the housing market, cutting well into the effective demand for homeownership. Meanwhile, housing inventories are increasing; starts have yet to fall enough to reduce the backlog of unsold homes.

The housing slide is also beginning to affect the job market. Cutbacks in construction obviously result in layoffs for construction workers as well as those working in the supply chain for construction materials, equipment, home furnishings, and the mortgage business. Falling home values and tightened credit have also curtailed the ability and willingness of homeowners to use equity in their homes (if they still have any) to buy new cars and boats, leading to slowdowns in these and other areas as well.

The converse is also true: while the housing slide in the “bubble” states such as California, Arizona, Nevada, and Florida is hurting the local job markets, weak job markets in the Midwest are hurting the housing markets there. A shortage of well-paying jobs in the industrial Rustbelt is forcing an increase in delinquencies and foreclosures in this region, weakening local housing prices.

A vicious cycle may begin, where declining housing prices and stalling markets lead to layoffs, which in turn hurt housing markets further. Lower interest rates from the Fed can help soften this, but can they prevent it? It’ll take at least a year to find out.

Taken together, the short-term picture—i.e., the next couple of years—for housing is grim in most markets. It will take time for the markets to work through the increasing supply and decreasing effective demand to regain balance. In some markets, prices by then may have fallen 20 percent or more from their 2006 highs, although some markets will hold their values or even see modest increases.

Looking Ahead

On the other side of every cloud the sun shines, right? That would mean that things will look up after the present storm passes. There are, in fact, reasons to be hopeful. Overall, the U.S. population continues to increase by 3 million people each year. And, in particular, the oldest of the echo boomers—whose generation, estimated to number 75 million, is larger than their parents’ generation, the baby boomers—are now in their late 20s, forming their first households and looking to buy their first homes. To house its growing population in addition to providing replacement homes and second and third homes for wealthier families for whom one home is not enough, the United States needs to add 1.5 million to 1.8 million new units a year. By all rights, housing should boom after the current mess is sorted out.

There is, however, an unfortunate but critical distinction between demand and effective demand: just because a young family wants to buy a new home does not mean they can afford to. During the early part of this decade, historically low interest rates and the arsenal of exotic and subprime mortgages enabled many young families to become homeowners. Today’s rates are not high by historical standards but are higher than they were earlier in the decade during the housing boom. Meanwhile, bankers have had a brutal lesson in loan underwriting, with the result that homebuyers will once again be required to make downpayments, prove their income, have a decent credit rating, and review and sign thick packages of documents. This may seem conservative, even a bit stuffy and old fashioned, but the old ways are back. Real loan underwriting is in, subprime loans are out, and a large segment of demand will be excluded from the market.

Conservative loan underwriting will expose a fundamental problem in the housing markets that low interest rates and fancy mortgages had largely covered over, namely the relationship between income and price. Real incomes for all but the top 20 percent of the population have been stagnant over the past few decades while the cost of housing has skyrocketed. Even a 20 to 30 percent drop in home prices will not correct for the recent doubling of prices witnessed in many markets. Something will have to give, but what?

Barring a long-term global recession, lumber, steel, and concrete prices will continue to increase, driven in no small part by the ongoing construction boom in China. Rising energy prices will drive up the costs of producing and transporting everything that goes into making a home. Interest rates, already fairly low, can come down only a little without stirring the demons of inflation and further weakening the dollar. That leaves land. It remains to be seen if there is enough give in land prices to bring the cost of producing new homes down to an affordable price for a financially constrained generation of new homebuyers.

In short, the cost of producing the average modern American home has grown beyond the reach of a large portion of the next generation of buyers. Homebuilders have been responding to this by building on smaller lots and even constructing smaller homes. Cost has also pushed demand to the condo markets as people try to get on that first rung of the housing ladder.

As a result, the future may bring more small homes in compact configurations, a declining U.S. homeownership rate, and more demand for rental housing. This is not necessarily a bad outcome, as smaller residences and higher densities are important ways to reduce energy use and carbon emissions, issues that are becoming vital to everyone. Indeed, it may bode well for the long-term future of the multifamily industry. Unfortunately, though, most of these new residences are going to continue to be developed on the suburban fringe, where land is cheaper and building is easier than in more urbanized settings, hence offsetting the potential reductions in energy use and greenhouse emissions that would be achieved if more centrally located.

Demographic Changes

Demography, always a driver in housing, is experiencing big changes. Everyone in the housing business is watching the aging of the baby boomers. Like King Midas, baby boomers have transformed everything they have touched at each stage of their lives—and not always for the best. Their next stage of life will be no different. The best prediction that can be made at this point about how they will age is that they will not do so in the same way as today’s aged population. This means, unfortunately, that much of the research being conducted today on people in their 70s and 80s is of little value in predicting how the oldest boomers will act when they reach 70 in eight years.

The first challenge will be to convince boomers that they are indeed getting older and will at some point, if they are fortunate, move into their 70s. But if 60 is the new 40, then 70 may be their new 50. This means that a larger percentage of boomers in their 70s are likely to continue working—because their retirement savings are not enough to support their desired lifestyle, because they are having fun, or because they feel that they still have a contribution to make to the world.

The American Association of Retired People (AARP) reports that today 89 percent of the elderly want to age in place—in other words, grow older in their homes. This, however, begs the question of where those homes are to be located. According to a recent Washington Post study, today’s elderly are doing their best to remain in the suburbs despite the need to drive everywhere.

Will the boomers do the same? It hardly seems likely. Already many are selling their large suburban homes once the kids have finally moved out (after the inevitable postcollege bounce back). Many are moving into urban areas, whether the central city or a new or refurbished suburban town center.

Also in contrast to the previous generation, baby boomers likely will want to live near their kids for at least two reasons. First, boomers are personally closer to their children than they were to their parents. (Remember, the boomers, who challenged their parents, are a rebel generation while the echo boomers, though they are independent and think in new ways, are an evolutionary generation.) Second, boomers have seen what happens when grandparents retire to Florida or Phoenix and wait—typically for too long a time—for their hardworking and extremely busy kids to get an opportunity to visit with the grandkids. Don’t be surprised if the boomers move from the big suburban home to an apartment or condo near where their kids settle. It may be just as important, therefore, to find out where the echo boomers are moving.

Of course, anyone who tries to predict where people in their 20s are going to eventually settle needs to have his or her head examined. So what can be said about the housing choices of this huge generational tranche just now moving into the housing markets? So far they are showing a desire to be in urban areas, but this is before they have school-age kids.

The desire to find good schools for their kids will likely lead them to the suburbs just as it did their parents, though maybe kicking and screaming. But if and when they move to the suburbs, it is possible, some would say probable, that they won’t be looking for a large house on a two-acre lot. Instead, they are likely to want a smaller, more open home, with high-quality design and finishes, located on a small, easy-to-maintain lot within walking distance of a park and services—a suburban town center, in other words.

The question of what the echo boomers can afford will be a key determinant as well. They say now that they are willing to trade size for quality and a walkable location. They are also much more attuned to the imperatives of global warming and climate change than their parents are, so a more compact location that necessitates less driving may be desirable to them if they can afford it.

A lot can change for them in a few years, however. The fact is that the next wave of householders is going to have a hard time finding housing it can afford in locations it likes, and will find homeownership harder to come by than prior generations. The impact of where they settle, though, will be magnified as many of their parents follow them (and the grandkids).

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