Professor Paul Palley's
          Economics Seminars

The future direction of the housing market is being debated today and some are worried that the market is set for continued substantial weakness. This creates a real concern for the strength of the overall economy because the housing market is a very big part of the economy. What is clear is that the housing boom turned in the 2005 to 2006 period into bust. Home prices have fallen in many markets, and the direction that development and construction will take is more uncertain. The question is; are we set for a protracted decline, housing market stability, or the resumption of the boom? What I will present below is an analysis of the factors that affected the supply of and demand for new and existing homes during the boom, the recent downturn, and look at a reasonable forecast.

In order to identify the factors that contributed to the housing boom that started in the 2002-2003 period and peaked in 2005 it is useful to focus on supply and demand. First, I will focus on the demand side. Mortgage rates were generally in the range of 7.0 to 8.0 percent in the 1990s, but declined from over 8.5 percent in 2000 to less than 5.5 percent by 2003 and stayed at rates between 5.5 percent and just over 6.0 percent through 2005 and positively affected the demand for housing.

Economic growth as measured by real GDP exceeded 3.0 percent during every year of the 1990s except 1990-91 (there was a recession in 1991), 1993, and 1995. This economic growth fueled by such factors as the baby boomers entering their prime earning years, increasing productivity, generally low interest rates, and the strong stock market built up a store house of resources including the combination of higher incomes and greater wealth that benefited the housing market during the 2002 to 2005 period.

Demographic factors were also working. The numbers of people over the age of thirty-five, the prime home buying years, swelled during the late 1990s into the first years of this decade. In addition, the baby boomer generation had by 2001 reached the ages of 40 to 55, a time of life when families are more likely to move up to more expensive homes or ready to purchase second homes.

There were two sources of changing expectations related to home prices during the first half of this decade that led to an increase in demand for homes that in turn contributed to rising home prices. One came from the financial markets. The second came from the housing market itself. The relatively poor stock market and lower interest rates encouraged many investors to look for opportunities to find higher returns elsewhere. They increasing looked to real estate. Secondly, as home price appreciation grew from over seven percent in the 2002 to 2003 period to nearly 12 percent in 2004, speculators where increasingly looking to enter the housing market. Home price appreciation exceeded 13 percent nationwide in 2005. These figures are from Freddie Mac.

A key factor on the supply side was related to the cost of building new homes. Based on Producer Price Index (PPI) data extracted on December 27, 2006, the prices of materials and components for construction increased 8.3 percent 2004 and 6.1 percent 2005 versus increases that were generally in the range of 1.0 to 2.0 percent per year from 1996 and 2003 except for a slight decrease in 2001. On balance, the prices of lumber and wood products declined during the period of 1996 to 2003, but there was a 16.8 percent increase in 2005. The same pattern existed for the prices of metals and metal products as there was an increase in prices equal to 33.7 percent in 2004 and 5.4 percent in 2005. The prices of construction machinery and equipment increased only marginally during the 1996 to 2003 period followed by 3.5 percent and 6.2 percent increases in 2004 and 2005 respectively. Outside of sizeable declines in the prices of lumber and wood products, the other prices discussed above have continued their above trend increase into 2006. These increasing prices tend to decrease supply and put upward pressure on home prices.

Many communities around the country have responded to urban sprawl, transportation constraints, and local communities of private and public interests looking to limit new development, by restraining development. The result was blocks of developable land being designated as open space or the enactment of very low density zoning restricting both commercial and residential development. An example is Scottsdale, Arizona designating the vast majority of developable land within its borders as open space, a process that started in the late 1990s. The impact of these policies is a reduction in the amount of land that can effectively be developed resulting in higher prices for raw land, and raising the cost of development and the value of existing homes as well.

Other important contributors on the supply side include interest rates and expectations related to the future strength of the housing market. Lower interest rates lower the cost of doing business by reducing the cost of borrowing money. As many home builders finance a significant percentage of their operations, lower interest rates facilitate investing more money in an effort to build more homes at a faster pace. The effect here is to increase the supply of new homes leading to lower prices than what otherwise would have been the case. Important factors in the calculus businesses work through when making decisions to invest revolve around the following question; do the expected benefits exceed the expected costs? Over time, as housing starts increased from 1.6 million units in 2001 to almost 2.1 million units in 2005, home builders increased their investment in new development projects. Given the time that it takes to plan new developments, secure entitlements, and install infrastructure it is logical that home builders would want to be ahead of the curve. That being said, the expectation that the housing market would continue to be strong has contributed to the excess supply of new and existing homes on the market that became more obvious by the middle of 2006.

There have been both demand and supply side contributors to the recent housing market contraction. On the demand side, the economy has continued to grow despite the housing market downturn, albeit at a slower rate. In addition, the same positive demographic conditions are in place. The question is, then, what has changed? There are expectations that a recession is more possible in the next year or two than what was reasonably expected in the recent past. This combined with higher home prices has reduced the number of potential home buyers because fewer can afford new homes. Incomes have simply not kept up with higher home prices.

Another important demand side factor that has marginally contributed to the recent downturn is interest rates. Short-term interest rates have risen. The Federal Funds rate has increased from the 1.00 percent level in 2003 to over 5.00 percent, and now the target is 4.25 percent. The expectation is that the rate will soon drop to 4.00 percent. Short-term interest rates do not directly correlate with long-term interest rates such as the 10-Year Treasury bond rate and the 30-Year mortgage rate as these rates are more influenced by the bond market and inflation rates. Yet, adjustable rate mortgages can be directly impacted and this has made it more difficult for new home buyers to qualify for loans and some borrowers are seeing the rates they pay increase at the same time. This has directly led to a decrease in demand for homes. The 30-Year mortgage rate dropped from approximately 8.5 percent midway through 2000 to approximately 5.5 percent midway through 2003. This, as indicated above, stimulated the housing market. Since then, rates have increased and the expectation is that these interest rates will average about 6.25 percent through 2008. These rates are low on the basis of recent history.

Despite the above discussion, the most important contributor to the recent downturn has been a change in expectations. As indicated above, housing price appreciation was extraordinary during the first half of this decade. Markets do not go straight up, and if there is not a decline that ensues then at least future increases will be much smaller. Speculators have moved away from housing in force because they can’t count on gains in home prices and rents are not sufficient to cover their borrowing costs. They have had to move fast, leading to a decrease in demand for homes and also an increase in the supply of existing homes on the market. Secondly, the credit crunch we are experiencing today reflects the expectation that subprime mortgages will continue to decline in value, and this has greatly incapacitated the mortgage market. That being said, once the correction in this market unwinds then the mortgage market will regain its life.

Given that home building is a highly leveraged business, financing costs can be significant. In turn, higher interest rates have led to a decrease in supply due to higher borrowing costs. Plus, any well developed expectations that demand will decrease will lead inevitably to a decrease in supply. The problem can be that home builders can be behind the curve leading to a significant over supply. That was the case by the middle of 2006, and the result has been a sharp decrease in supply of new homes. Other supply side factors have also continued to contribute to a decrease in supply; higher prices for materials and components for construction, metals, and concrete. In addition, continued efforts to fight sprawl will tend to reduce the amount of land available for development and higher prices for developable land.

Why will stability take hold in 2009? When looking at the factors above, it is clear that conditions exist that indicate that the housing market will stabilize to what we see under normal conditions. The positive demographic trends will continue to exist in the near future and interest rates are expected to remain relatively low. The 30-Year mortgage rate is expected to remain in the range between 6.00 percent and 6.75 percent through 2009. On the other hand, economic growth will moderate in 2008, and there is some probability that there will be a recession. On the supply side we can continue to see forces in place that will lead to higher construction costs due to high commodities prices and the cost of building materials. Not withstanding recent indications of housing market stability nationally, the consensus is that housing starts and home price appreciation will establish themselves at levels consistent with long-term trends in 2007. Recent forecasts by the National Association of Home Builders and Freddie Mac indicate that housing starts in the range of 1.1 to 1.4 million units in 2008 and 2009. These are totals are consistent with the upper end seen in the 1990s, and the lower end in the first part of this decade. Freddie Mac’s forecast is that housing prices will depreciate about 3.1 percent in 2008 and 1.0 percent in 2009. The results will differ market by market depending on the degree of home price inflation in the recent past. However, these pessimistic outlooks in my view do not account for the strength of the underlying fundamentals related to demographic trends, economic growth, and low interest rates. Instead, I believe that stability will be the word that best describes the housing market in 2009 and with a stronger market likely in 2010.

Firms make a strategic decision to launch a new product, invest in a capital item, or launch a partnership with an eye on its expected profits and return on investment. While it is understood that there are roles for financial professionals and accountants, marketing expertise, and in many cases a lawyer, in evaluating the feasibility of a project, a sound understanding of economics is also important. One effective way to evaluate the feasibility of a new project is through a detailed cash flow analysis that allows the firm the flexibility to evaluate the impact of potential changes in the business climate on the project and the expected internal rate of return generated by the investment. If the project will in all likelihood yield a sufficient return on investment then the firm will make that investment. An example that illustrates the role of economics in this process of evaluating the feasibility of a project follows with a particular focus on the concepts of supply and demand.

The developer of a master planned community can use cash flow forecasts that are flexible enough to evaluate the impact of changing scenarios to make strategic investment decisions. On the revenue side of such a model will be details related to expected sales of new homes and the prices of these homes, and expected sales of commercial parcels and the prices of those parcels. Variations in the rate at which these sales occur and the prices paid for new homes and commercial parcels will affect the developer’s rate of return. The cost side of these models will include the prices paid for the land, financing, planning, engineering, zoning, and legal costs. Other very important variables will include, among others, the cost of constructing infrastructure, building materials, and marketing. We can see the role for economics in the evaluation of each of these revenue and cost items.

The rates of new home sales and the prices of new homes are directly affected by changes in the market for new homes. Demand side factors include; incomes; the mortgage rate; rents, population growth; and expected price increases. A stronger local and national economy leads to greater population and employment growth, higher incomes, and the expectation that home prices will increase. Each of these events leads to an increase on demand for new homes and as a result higher home prices and an increase in the rate of sales of new homes. On the other hand, lower incomes and higher interest rates lead to a decrease in demand and as a result slow the pace at which homes sales will occur. Another important factor affecting this picture is the presence of competing developments in the neighborhood. This increase in supply will adversely affect the developer by reducing the rate at which they can sell new homes and will potentially reduce home price increases or even lead to lower home prices.

The rate of sales and prices paid for commercial parcels will depend on the rate at which new homes and other forms of housing are built in the area. As a result, any factors that affect the demand for homes and the supply of homes will affect the commercial developer. Fluctuations in interest rates will also be an important factor for the commercial developer as higher interest rates increase the costs of financing the construction of shopping centers and office buildings and can adversely affect the feasibility of the development. Higher interest rates will also slow the rate of home building. This will delay the time in which a shopping center or office building will become financially viable.

Expanding these points, the costs associated with financing the purchase of new homes and also the development and construction of a master planned community are greatly affected by fluctuations in interest rates. Interest rates are determined in the money market, and the single most important factor affecting the supply and demand of money is inflation expectations. For example, higher expected rates of inflation lead to an increase in demand for money as borrowers will want to borrow now rather than later. In addition, higher rates of inflation are often associated with a stronger economy, and this strength leads to an increase in demand for money. On the other hand, higher inflation expectations lead to a decrease in supply as lenders would prefer to lend in the future rather than today. The combination of this increase in demand for money combined with a decrease in supply leads to higher interest rates.

The value of a parcel of land depends on the profits that will be generated by the land use. In the case we are looking at here, the land use is the development of a master planned community. That being said, using supply and a demand as a framework for analysis is appropriate. Demand for land by developers and home builders will be dependent on the profits they anticipate and this is a function of the expected revenues produced by the project and the expected costs. The supply side is dictated by existing land owners. Their decision calculation will be based on a cost and benefit analysis; how much will I realize from selling the land versus the cost or in this case opportunity cost based on the return they would earn from using the land for another purpose.

Planning, engineering, legal, and zoning costs are associated very closely with the salaries paid to the professionals who are responsible with for completing these critical tasks. As with the salaries paid to all workers in the labor market, the salaries paid to the engineers, planners, and lawyers are also market determined. The same is also true for the accounting and marketing staff as well. During a strong economy when the demand for labor is increasing. As a result, these professionals will demand higher salaries. On the other hand, during a weak economy the salaries for these professionals will be more static.

In recent years we have seen some very large increases in the cost of infrastructure and building materials. The Bureau of Labor Statistics producer price index data indicates that the price of lumber and wood products increased 16.8 percent in 2004. The price of materials and components for construction increased 8.3 percent in 2004. This contrasts with little real change in these prices during the period of 1998 to 2003 for both the prices of lumber and wood products and materials and components for construction. The price pf construction machinery and equipment increased by 6.2 percent in 2005 when the greatest increase in the period of 1997 to 2004 was 3.5 percent in 2004. Price increases for construction machinery and equipment were in the range of 0.3 percent and 2.1 percent in prior years. The reason for these larger price adjustments were large increases in demand for housing and related construction during the recent housing boom. Plus, globalization facilitates exports of building materials and equipment to the rapidly growing economies of China, India, and other countries. The economic growth in these countries leads to new development and construction projects and an increase in demand for all building materials.

This example illustrates the point that underlying each component in the process of analyzing the financial viability of the development of a master planned community is the concept of supply and demand analysis and economics. The cash flow analysis that is done requires the analyst to project the revenues that will be earned by the development of the master planned community, the costs they will incur, and the resulting profits. The analyst can then calculate the resulting expected internal rate of return generated by the project and determine if it meets the developer’s feasibility standard. The rate at which the development generates revenues and incurs costs, and the amount of profits that result, are dependent on market forces. It is the interaction between supply and demand that leads to the prices, costs, and revenues that then result in the necessary data to facilitate making an investment decision like this.