Categories of Housing Contraction, Part 3

A National Capacity Condition

In Parts 1 & 2, I have been using this framework for thinking about housing cycles.

Figure 1

Today, we are firmly in a national Capacity Condition. It is possible that extra demand during the Covid pandemic would have pressed us into this condition on its own, but the apparent effect of Covid on supply chains definitely did. So, from the Capacity Condition, we have the following 4 stages of potential contraction.

1. Demand outstripping capacity. Sales high, homes under construction increasing.

2. Demand normalizing. Sales declining, homes under construction high but decreasing.

3. Demand overcorrecting. Sales declining, homes under construction declining.

4. Demand excessively overcorrecting. Sales bottoming, homes under construction declining, prices declining.

From a public policy standpoint, Moving at least to stage 2, and even tempting stage 3 is prudent. Recent sharp declines in sales suggest that we have moved into stage 2. We are already seeing some natural responses to this stage. Homebuilders don’t like losing the power over sales that they have had in stage 1, so homebuilder sentiment has declined. That is understandable. They have plenty of homes to build, and also plenty of reasons to be nervous about a continuation of declining sales in the future.

There is one aspect of this new national Capacity Condition that could add volatility. Previously, in the semi-capacity condition of pre-2007, the aggregate market was a product of substitutions. There were markets that were at capacity, and prices increased in those markets. But, at the end of the day, that capacity was driving substitution into markets that weren’t at capacity. The high prices in constrained city reflected the amount of pain residents were willing to take before moving away, so those price increases flowed to local land values. Today, since generalized supply chain issues are constraining the market, there is no substitution to make. There is no market where a home can be constructed in 6 months at a normal cost of materials and labor, so price increases are flowing to input costs and builder margins.

This will probably make new sales and average prices of new sales somewhat volatile as we move to stage 2 or 3.

Figure 2

In stage 1, volatile sales and prices represented a negotiation between builders and buyers, where builders agreed to sell homes with longer construction times and higher potential costs in exchange for higher prices that included higher margins. There are a number of dimensions through which that process could reverse, and presumably, at some point in stage 2, builders will revert back to a normal backlog with more manageable costs and more normal margins. At the same time, there is retracting demand, higher interest rates, etc. So, if sales and average prices decline, how much of that will be through a change in the composition of homes sold versus the prices and the margins captured by the builders? And how much will flow out into the value of existing homes?

I’m not sure I have a good sense of how it will happen, and I’m not sure anyone else does. There will be a lot of fear mongering about homes selling at a discount, buyers trading down to lower price points, etc. but more than ever, those stories will not necessarily relate to distressed conditions for either builders, buyers, or homeowners. There will be a lot more “bad news” than there will be bad news. But, we haven’t been living in Normal world any more, so maybe Leamer’s rule (from part 2) doesn’t apply here - maybe some more price correction will occur early on than is normal, because some of the price appreciation has been from this novel new capacity condition.

Those issues are probably limited to a few percentage points of value here and there that will not lead to some new cyclical chaos in aggregate national trends. There will be a lot of Youtube videos identifying a seller moving their asking price down 10% or a builder offering incentives, and they will be described as the first step to another 2008 - maybe even bigger this time! There may be a lot of fodder for fear-mongering. But, a lot of that can happen with a return to lower costs and normal margins before it’s really a problem for the builders. It is hard to know how much that will bleed into existing home prices. And, further, if it does, it is unlikely that some small declines in prices will continue into a cyclical slippery slope. We are months, if not years, away from a condition where something like 2007-2010 could happen, if it could happen at all.

From a public policy point of view, the same context does apply as did in 2007. There is absolutely no reason to move any further into the active, strong edge of a Normal Condition than we need to. There is no reason to slow demand enough to reduce construction below our capacity. There is no reason to expect or engineer a disruptive amount of broad price reversal. Maybe there are other aspects of the economy that call for contraction, but there is no reason within the housing sector itself to push demand any lower than the capacity to build right now.

Below the fold, I will look at this situation using the Housing Tracker.