Overbuilding, or are there too many houses in the US?

Story told by an old investor on CNBC (more or less accurate): I was golfing near New York City one day and the caddy knew I was a famous investor. The caddy asked me about the real estate market in San Diego; I asked him why he was so interested. He told me he owned six condominiums and was trying to decide what to do with them. I replied that it depended on where they were and whether the buildings were managed well. He replied that he had never been to San Diego.

After the attacks of September 11, 2001 and the collapse of the NASDAQ, American investors were wary of the stock markets; with low short and long-term interest rates (partly due to the Fed’s rate cuts, partly due to a world wide saving boom that lowered long-term rates around the world), Americans started to invest in something they thought they knew better, housing. As home buyers started to buy larger houses prices for existing homes started to rise, and home builders tried to meet the new demand.

The first attempt to meet growing demand was to convert rental housing into condominiums (with better kitchens and bathrooms). There is a several year lag between planning a new house and the time it is ready for a new occupant (due to the time required to acquire the land, obtain local government permission to build, and the time required to build the house), so the initial rise in prices resulted in increased homebuilding a few years later (see here for price data and here for construction data).

Year Median Price Average price Houses Built
2001 $175,000 $213,000 1.57m
2002 $188,000 $229,000 1.65m
2003 $195,000 $246,000 1.68m
2004 $221,000 $274,000 1.84m
2005 $241,000 $297,000 1.93m
2006 $247,000 $305,000 1.98m
March 2007 (peak price) $262,000 $329,000 1.61m
December 2007 (lowest price) $226,000 $283,000 1.33m
January 2008 $2226,000 $283,000 1.34m
February 2008 $244,000 $296,000 1.25m
March 2008 NA NA 1.22m

Source: Census Department.

A few points on the data before the analysis starts: first, the U.S. housing market is fairly seasonal, with more transactions in spring and summer than during the rest of the year, so it is hard to put too much weight on any specific monthly number. Second, the price data is at best an indication of what is going on; the purchase of a house is a very complex transaction and the price is one number among many that determine the actual cost of the house. But other fees, interest rates (some homebuilders offer financing too) and other attributes of the house can change the deal significantly. There were many reports of homebuilders offering upgrades (i.e., nicer kitchens or bathrooms) in order to stimulate sales.

Was there too much building? One way to examine this question is to look at the number of homes built relative to the demographic demand. A crude estimate is that the demand for new homes in the US equals the number of new households and the desired number of homes per household. The number of new households in turn depends on the population and average household size. The Census Department provides some data here.

Economists and demographers have estimated that given the rate of population growth, the average size of households and the desired number of homes per household (some households own multiple homes, including seasonal or vacation homes) that the demand for homes would be around 1.5 million homes per year in the current decade.

Looking at the table above, you can see that more than 1.5 million houses were build every year from 2001 until 2006 (in 2007, total annual home construction was almost exactly 1.5 million). These numbers imply that there were roughly 2 million “extra” houses built between 2001 and 2006; to return to equilibrium, home building must remain under 1.5 million per year for several years. The adjustment does not occur all at once (home building going to zero) because the extra houses are not distributed equally in all states and cities. A family looking for a new house in Pittsburgh is not affected by the hundreds (or thousands) of extra homes in Miami or San Diego.

The most recent data imply that home construction numbers should continue to decline; the most recent housing starts data reveal that at current rates fewer than 950,000 homes will be built in the next 12 months. Housing starts have been below the 1.5 million level for one year, reducing the overbuilding by around 250,000 homes. It is impossible to know how many houses there should be in the U.S. at any time, but we can say that the gap between demographic demand and the supply of homes has been getting smaller.

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