Sluggish Construction Portends Steady Price Growth



  • Supply remains constrained
  • Construction has not kept up with long-term demand
  • Affordability concerns appear to be driving builder pensiveness rather than REO patterns

Much has been made of the drop in existing home sales this spring. The weather played a role in the Northern Midwest and Northeast and affordability concerns had a coast-to-coast impact, particularly in the Western markets. However, inventories remain low with the months supply averaging 6 months or less for 20 consecutive months. All of these factors contributed to the decline in sales, but it is difficult to sell homes when you don’t have homes for sale.

What drives supply? Traditionally homeowner turnover and new construction. However, the number of owners who owe more on their home than their home is worth ballooned in recent years and stood at 6.3 million as of the first quarter of 2014. Though this figure is down from 11.8 million in the first quarter of 2011, it remains well above the historic norm, preventing some would-be sellers from entering the market. But these transactions would only add to inventory if the seller is downsizing or moving in with another household as the seller would otherwise buy another home.

New construction on the other hand has been sluggish for several years. A simple measure of the impact of construction on supply is whether new construction has kept up with job creation. To this end, the ratio of jobs created over the 3-year period ending in the first quarter of 2014 relative to new single-family construction starts over this same period is graphed below. The disparity was greatest in Florida, Utah, California, Montana and Indiana where job creation has been particularly strong. In the chart below, 40 states as well as the District of Columbia have a ratio greater than 1 indicating that there were more jobs created over the last 3 years than housing starts; 32 states and the District of Columbia had a ratio greater than 1.5, the long-term average. Not all new jobs result in a new household and an increase in demand for housing, but that relationship is strong and the implication is that the lack of construction has hamstrung supply and thus home sales.


A lagging expansion of supply relative to demand growth implies price pressure. Indeed, over the last two years there has been steady price appreciation, but the current 3-year deficit in the employment to starts ratio implies a continued imbalance. Intuitively, states with tight supply would expect more robust price growth. A simple scatter plot of the ratio of 3-year employment gains to starts against price expectations from REALTORS® in the first quarter of 2014 [1] suggests a correlation between stronger price expectations and a long-term imbalance between employment and housing starts. The lone anomaly is Hawaii with its strong investor demand and limited construction potential.


What do builder’s plans tell us about their response to tight inventories? If REALTORS®’ price expectations are well correlated with the long-term balance between employment and construction, then the REALTORS®’ price expectations should be correlated with builders’ response to a supply shortage. Indeed, there is a strong, positive correlation between the change in permits in the first quarter of 2014 as compared to the same period in 2013 and the price expectations of REALTORS®, graphed below. As Price expectations increase, so do plans for construction. This pattern is particularly evident in states that have a non-judicial foreclosure process.


At first blush, this trend is not as robust in states with a judicial foreclosure process. Though the trend is still positive, the correlation is not as tight and more outliers are present. What’s more, the bulk of price expectations are clustered between 2% and 4%, rather than between 3% and 6% for non-judicial states. The judicial states, such as Florida, New Jersey, Pennsylvania, New York, and Connecticut, have been slower to process their foreclosure inventories which would account for the weaker price expectations. Builders’ response in these states may reflect the same supply concerns affecting REALTORS’ price expectations: greater REO inventory, longer foreclosure time-lines, and higher delinquency rates. The anomalies likely reflect state-specific patterns such as strong vacation and foreign buyer demand in coastal markets of Hawaii and Florida which sit on the zero access for permit growth despite having price expectations of roughly 5.5% and 7%, respectively. Plans to build in North Dakota despite slow price growth reflect that state’s unique oil boom and plentiful land to build, while the jump in New Jersey likely reflects reconstruction efforts in the wake of Hurricane Sandy.


Builders’ plans for construction appear well anchored around inventory and price expectations, but the size of permits growth is roughly the same in judicial and non-judicial states despite the stronger price expectations in non-judicial areas. This uniform pensiveness in response to a long-term shortage suggests that some other factor(s) present in both judicial and non-judicial states, a non-distressed supply story, is affecting builders’ response. Several other issues could explain this pattern; limited access to credit for smaller builders, builder concerns about the re-emergence of entry-level consumers to the market in the face of student debt and a tight credit box, and the general decline in affordability and purchase power over the last year.

Prices rose mostly rapidly in the West at 14.0% over the 4-quarter period ending in the first quarter of 2014. The South, Midwest, and Northeast followed at 7.7%, 6.75%, and 2.25%, respectively. When the skater plot is displayed by region, the pattern is telling. Charting a line trend line of the Western states shows a nearly flat line suggesting an inelastic response by builders in response to greater price expectations. This slope for the Midwest and South is more pronounced, while that of the Northeast is most pronounced, though price expectations are weakest in there. The implication is that builders’ recent permitting pattern reflects concerns about recent price patterns and affordability. This trend might also reflect concerns about the role of investors in certain markets, though this would not fully explain the pattern in the Midwest and South.


While tight inventories will help to sustain price growth, it also limits turnover and could further erode affordability. Without a stronger response from home builders, consumers may struggle with options and affordability if income growth cannot compensate. It is difficult to discern whether builders can produce at a lower price point given frictions in the current market.

[1] Based on survey responses in the REALTOR Confidence Index