Housing always goes two ways at once

How to know how far housing prices might decline in each metro area.

Since housing is largely a sort of strange version of domestic production (most is owner-occupied, so that tenants are both the owner - or “producer” - and the consumer of the shelter the home provides), we have a hard time thinking about it coherently. Is growth in residential construction an unsustainable commitment to rising consumption (going deep into hock to move into the new McMansion) or a rise in investment that will be crucial to making homes more affordable.

We don’t seem to have the same misgivings about, say, building a new car factory. But, isn’t building a car factory just as much of a commitment to increasing our consumption of cars as building a home is a commitment to increasing our consumption of shelter? So, I wonder if our intuition overstates these contradictions in housing just because we can see the connection between production and consumption more clearly in housing. But, in any case, the contradictions are there.

And, one of the ideas I hope my newsletter can get across is that a sector defined by contradictions should not be a sector that is characterized by deep cyclical upheavals. There are always factors pulling in two directions in housing, which should moderate cyclicality. As I mentioned in a previous post, the reason you hear the common refrain that irrational buyers are too complacent because they mistakenly think home prices can’t go down is because there is a decent fundamental reason to think home prices usually shouldn’t really go down. And, in fact, it was the 2008 debacle that was weird. That’s the episode we shouldn’t “overlearn” from. And, for the most part, it can’t be easily repeated.

This doesn’t mean there aren’t pockets of potential cyclical overheating. But it does mean they are probably more the exception than the rule. My housing tracker can help spot the exceptionally risky spots by clearly identifying price changes that are fueled by rising rents and constrained supply vs. those that are fueled by temporary spikes in buyer demand.

2022 is a challenging period for housing, with housing starts potentially at a turning point and rent inflation pushing higher. At the macro-level, the question is, how do we bring down inflation - specifically in housing, rent inflation. And, that presents one of housing’s contradictions. Rising interest rates will likely slow new construction activity. How exactly is that going to bring down rent inflation? We don’t try to lower the cost of cars by slowing down the construction of car factories. The housing tracker can break down the influence of home prices between the need for more supply and short term changes in prices that might be more likely to reverse if the market cools down.

Figure 1

Figure 1 shows the range of price factors across the 30 largest metros since 2002. The supply component is much larger, and there is much more variance between metros. Cities like Boston and New York are at the top of the range and cities like San Antonio and Cincinnati are at the bottom. (As I frequently point out, it is easy to assume that there is more demand for living in New York City or Boston, and that the high costs are just a natural result of that. If New York or Boston ever permit as many new homes per capita as San Antonio and Cincinnati, we can confirm that. Until then, when the supply component identifies higher prices in places that permit fewer homes, we should call it a supply problem.)

The cyclical component isn’t as large, and has less variance*. And shifts in general valuation trends happen more often.

The supply component (which as shown here accounts for the 2008-2010 credit shock) has three basic periods - the 2002-2007 boom, the 2009-2012 bust, which I think we can roughly attribute to the decline in housing demand associated with the foreclosure crisis, etc., and the 2012-2022 very tepid growth period in housing starts. (This is an unweighted cross-sectional average of metro areas, so there will be some minor differences between this and, say, an average of ZIP codes.)

The cyclical component moves more through short term boom and bust impulses.

Figure 2

Figure 2 shows an estimate of the correlation between the components and forward price changes. In, say, June of 2004, if a metro had a 10% cyclical price inflation, it was associated with an additional 5% of price inflation over the next 2 years. The boom cycle continued to have momentum over that period. By June 2007, however, a 10% deviation above neutral in the cyclical component was associated with an 8% decline in prices over the next 2 years.

Using this specification, a 10% deviation above neutral in June 2020 was associated with a 10% additional price increase between then and today. So, we are still at the tail end of a period of positive momentum.

There is little question that that momentum will have to end. I think federal policymakers have some discretion over whether that momentum shifts like a whip or slowly reverts to the mean without much disruption. But, in either case, that cyclical sensitivity will be an important element in a city’s coming housing experience.

As figure 2 shows, the effect of supply is much smaller and more slow moving. Most of the time, it has little correlation with short-term price shifts. The scale of the supply component is large enough that there are times when it has been important. A 10% deviation above neutral in 2007 was associated with about a 3% decline in price over the next 2 years. When there are cities with a 60% deviation, that can add up to something big. But, cities with a 70% supply price inflation aren’t going to suddenly reverse.

So, we have two components, and thinking about those components separately can help to understand the cyclical risks of housing in a city. If a city is 70% overpriced, and 50% of that is from supply while 20% is cyclical, then most of the price deviation is unlikely to reverse from a cyclical contraction. Yet, 20% is still a lot to worry about, and there are cities that have experienced a significant cyclical inflation over the past two years.

Some bonus analysis below the fold for paid subscribers.