By Oren Jacobson, Market Analyst - New Home Star //
Homeownership rates are far below pre-recession peaks, and the same is true for unit sales of new construction and existing homes. However, prices continue to rise, and median new and used home prices are both well ahead of their pre-recession highs. Here lies the puzzle. Why do prices keep going up, including to above pre-recession peaks, while demand is well below those peaks and has largely returned to a pre-recession baseline? The answer to this question can be identified in three specific shortages in the market.
The first shortage is a labor shortage. Specifically, builders across the country continue to struggle to find the labor force necessary in the local trade base to ensure consistent production. This labor shortage drives up production costs. Two factors contribute most to this situation, and both of them are structural in nature and thus harder to fix. First, the housing crisis drove many people away from the industry who are unlikely to return because of a lack of trust in the industry and the availability of “better” options. The second factor is that net migration has been essentially flat for years as a byproduct of the last recession. Hence, housing costs go up and so do prices.
The second shortage is a land shortage. Specifically, a finished lot shortage. Even in places like Colorado or Texas where there is so much undeveloped land, builders can no longer quickly and easily find finished lots. Moreover, builders have largely moved away from acting as the developer of their own land. This means developers get to control the land pipeline and can create a bottleneck. This reduces supply and drives up lot costs in spite of overall decreased new construction demand relative to prior periods. In turn, lot costs go up and so do prices.
All of this makes total sense and is what you would expect given the lessons and incentives in the market. Let’s break down what happened step by step:
- Developers initially had to sell off significant amounts of land as values fell and their financial situation was weighed down by toxic assets.
- Their lesson was to make sure they didn’t get caught again with too much finished land on their books.
- This also aligned with their natural incentives to maximize profit. By controlling the supply of finished lots, they can drive prices and profits up.
- Following the recession, there was a substantial supply of finished lots and builders became far more cash sensitive so the need/incentive to develop their own land went away.
- At first, builders could get plenty of affordable land because finished supply was heavy. Yet as the supply of finished lots dwindled, developers moved back into a position of power.
- The lessons and incentives for both parties are to keep finished lots limited in the market, drive up competition amongst builders, and send lot costs up.
The third shortage is an overall housing supply shortage. That’s both a function of decreased new construction and a decrease in used home listings. The conditions above describe the supply shortage on the new construction side of the equation. On the resale side, the answers are a little less obvious, and the full explanation is beyond the scope of this article but to put it simply, supply shortages also mean fewer options for people moving up. Combine that with the fact that they are likely to have a mortgage with a lower interest rate and you have two good reasons not to move. This shortage means less competition for new construction and lower total market supply. Further, we’re now about ten years from the recession itself which indicates a growing gap in the age of new to used which for many justifies the price jump to new construction and thus pushes up prices.
These three shortages answer the puzzle outlined at the top of this article and explain why prices have gone up beyond pre-recession peaks while demand is still well below. Even if we take the peak out of the equation, we still have a situation in which price is increasing at a far greater pace than demand is.
To simplify all of this, the housing market is being driven up by supply-side economic factors, not demand factors. This is a problem, not in an immediate sense but rather in a mid to long-term sense. The problem with the shortages outlined above is that they’re exactly what you would expect to happen given the incentives in the marketplace and those incentives make it tough for the shortage issue to get solved. For example, there is no reason to expect land developers to take a different strategy as profit maximizers. Thus, we’re left with a question about what will happen if demand retreats. What’s worse is that the only way to solve the problem may actually be for a market correction spurred on by demand retreating to help the market reset to a new and more appropriate equilibrium. When pricing is being driven by supply, and not demand, you end up with artificially inflated pricing beyond “real” valuation. That appears to be where we are today. The question is whether demand will catch up or will a future market correction with a demand drop force a change in some of the structural factors outlined above?
