What I said in July 2005.....

Assessing the Demand for Residential Real Estate
(originally published on PrudentBear.com in July 2005)

Recently the CEOs of some residential construction companies have been on television’s “financial news” networks taking about their companies and emphasizing the following two points.
1. This time, the housing market is not as sensitive to increases in interest rates as in the past, especially since the rates are at historically low levels. The point being emphasized is that the rates can go higher (another 200 basis points?) before having a significant impact on home sales.
2. The housing market is all about SUPPLY and DEMAND.

Point 1 is related, in part, to the “Greenspan’s Conundrum” that writers on this site and elsewhere have explained using a “supply and demand” scenario for dollar denominated debt, with contribution from foreign buying of the intermediate-to-long end of the yield curve. This article examines the second point made above, especially the demand side of the housing market. Demand For Residential Housing can be classified into two categories. The first covers houses (or condos) purchased for buyer-occupancy as primary residence (PFR). All other purchases can be categorized as Purchases for Investment (PFI). Vacation homes which are not the primary residence of the owner will be included in the PFI bucket. The next two sections examine the demand in these two groups. Only net demand is considered here- someone selling a house to buy another does not create net incremental demand.

House Purchase for primary residence
Buying a house has traditionally been a big part of the American dream. As students graduate and enter the workforce some of their primary goals are to find a job or be an entrepreneur, find a spouse, and buy a house, not necessarily in that order. From the data reported by Census Bureau homeownership rates for the United States went from 65.5% in 1980 to 69.1% in 1Q 2005 . As the number of household units reported is approximately 106 million, this leaves nearly 33 million householders (renters) who are potential “owners.”

The desire to own a home is not new or unique to the 21st century, but what is new is the suppliers’ emphasis on “satisfying the customer’s needs.” Freddie Mac states that its mission is to “Make Home Possible.” Fannie Mae states that it is “in the American Dream business.” How are the customer’s housing needs being met? It is illustrative at this point to look at the historical growth in the ownership of TVs (or VCRs) to more than 98% of households today from about 9% in 1950. This growth was driven primarily by technical and process innovations, especially in electronics and in electrical engineering. These innovations along with economies of scale allowed the vendors to reduce the unit price to customers (as a percent of their after-tax incomes), thus satisfying customer demand. The current growth in homeownership is also driven by innovations, primarily in the lending industry. Lenders are creating customized innovative products like no down-payment loans, interest-only loans, and the like that let customers own the home of their dreams. This, along with a supply constrained situation, has led to yearly housing price increases running in double digits in many areas. It is anticipated that those among the nearly 33 million “renters” who desire to own their home can work with the lending community for a mortgage product that satisfies their unique needs.

Then there are roughly 16 million students enrolled in post-secondary education in the United States . Those who are living in dorms can, with the right kind of financial product, move out of the dorms and “own” their quarters. They also have the potential to extract equity gains when they graduate and pay off their student loans.

Another source of demand comes from immigration, both legal and illegal. A recent Business Week article cites estimates of nearly 11 million illegal aliens and also provides examples of how service firms are innovating to meet the needs of this class. Those illegal aliens who are not covered in the Census data and who currently do not own a home can also contribute to incremental demand. Even if 20% of this group is looking to buy homes, that is an additional demand of more than two million. In addition, legal and illegal immigration together is expected to contribute more than a million new potential arrivals per year. Immigrants might be expected to rent initially and then move towards home ownership, thus providing some level of support to rental units. However, greater controls on immigration in the aftermath of the London bombings could reduce this demand.

It should be noted that higher divorce rates can also create more households and drive incremental demand. But recent research indicates that directionally, divorce rates are inching down.

Assuming that the supply of new homes and condos is between two to three million units per year, it will take a few years to provide the physical product to meet the above demand for primary residence. The question is whether financial innovation at lending institutions will continue to meet customer needs, as the customer profile changes.

House Purchases for Investment

Recent reports indicate that in certain areas more than twenty percent of house purchases are being made purely for investment, with the buyer not residing in the house. Part of this is being attributed to foreign buying of American housing. While the demand in this category is hard to assess, it can be inferred that a further weakness in the dollar vis-à-vis other major currencies will be positive for incremental demand. If the Yuan strengthens by nearly 40% relative to the dollar, as many China-critics want, this will enable greater purchases of American real estate by the Chinese. One point to note about real-estate investment is that unlike paper investments such as equities or bonds, there is a “real” outflow of money during the time of ownership of real-estate. This includes taxes and maintenance costs. A house purchased as an investment can be rented out for income, but there may be downward pressure on rents if the rate of homeownership among the “renters” goes up relative to the rate of conversion of apartment units into condos or other units meant for sale.


In summary, the magnitude of the unfulfilled demand for housing combined with financial “new product development” can keep the current housing boom going for a few more years. However these new financial products have yet to stand the test of the vagaries of the environment- an economic downturn or an interest rate spike or other events that may cause lenders to pull in the reins. To understand the magnitude of the impact of a constrained lending environment it is useful to look at the sharp decline in prices of telecommunications stocks in 2001-2002 when investors became more risk-averse. Some companies went bankrupt and those left holding the bag (like the author) did not receive any bailout from the government. Others like Lucent and Nortel are currently trading at less than 5% of their peak values. The expectation with the housing market now is quite different. Despite the new bankruptcy law that makes filing Chapter 7 more difficult, house buyers are purchasing financial products with greater risk on the downside. Investors are pouring more money into the homebuilders and the lenders. Part of the bet is that with the scale of liabilities of the mortgage industry, especially the GSEs, the Fed and the government will bail out the financial sector from any disasters, shifting the burden to the public. As alluded to by others, ‘character’ is being tested- that of buyers, lenders, builders, investors, and the public at large.