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The recovery of real estate markets remains one of the principal goals of economic policy. In earlier downturns, housing recovered with the broader economy and has been an engine of growth because of the major role it plays in the monetary transmission mechanism. According to the National Income and Product Account Tables (NIPA) published by the Bureau of Economic Analysis, residential real estate has contributed, on average, twenty percent and ten percent of GDP growth in the first and second year of the last three economic recoveries. However, in this great recession, it has remained the major laggard, creating a negative feedback loop with unemployment to impede consumer spending and the overall growth of the United States. Lower home prices also impact the capital of financial institutions which take part in the real estate markets through direct lending or ownership of securities.

As a result, financial markets closely monitor the evolution of housing related indexes for improvement signals. In this context, positive data on September housing starts provided partial relief to some market participants. NAHB/Wells Fargo and Census Bureau/HUD figures showed a total gain of 15%. Nonetheless, to get an accurate assessment of the market’s direction, it’s worthwhile to understand three factors, namely: the forces underlying recent patterns in housing start figures, homeownership and rental demand. The resumption of foreclosure proceedings, which were mired down since October 2010, is also a major indicator shedding light on these trends. The aggregation of all these components reveals the importance of dissecting the gross housing starts figures. Such an analysis substantiates a momentous change of preferences from home ownership to renting. It will shape housing construction in the near term.

Housing starts measure the number of residential units where construction began for the said month. The total number only includes new housing units. It is, therefore, a partial gauge of demand and supply dynamics within real estate markets. In principle, a sustained increase in new construction signals stronger demand which, in turn, pushes home prices higher. With this logic, September housing starts constituted positive news for the broader financial markets as they were surprisingly strong. As Figure 1 indicates, the month-over-month change was 15%, the highest growth since January of this year. Despite this surge, Figure 1 also illustrates the volatility of the month-to-month statistic. In comparison to pre-recession years, the absolute level of housing starts remains low. Hence, the positive month-over-month growth, which is an encouraging sign, needs to be analyzed in a new market environment.

The breakdown of the gross figures reveals dynamic favorable to multifamily properties. The units counted include detached and semi-detached properties, rowhouses and townhouses, apartments, a group of rooms or a single room intended for occupancy as separate living quarters. Therefore, it is natural to divide the aggregate figures between single and multifamily units. With this partition, the data reveals that single family starts have been flat for the last two years, leaving multifamily construction as the major driver of the index.

As illustrated in Figure 2, single unit construction reached a peak in early 2007 and has followed an overall declining trend since then, the first-time home buyer tax credit period providing a slight nod between Q2 2009 and Q2 2010. Figure 2 also reveals that single unit starts have stagnated since the summer of 2010. On the other hand, multifamily construction reached a minimum in October 2009 and has gained significant strength up to now.

Figure 3 illustrates an even more dramatic pattern. Year-over-year multifamily changes have been mostly positive since March 2007, while the same statistic for single unit construction was largely negative. This trend reflects a fundamental change from pre-recession times. Real estate market participants need to understand the economic and demographic forces behind these trends.

Whether the upward pattern in multifamily construction will positively affect housing prices depends on the attitude of buyers. Is the surge driven by rental demand or purchases for owner occupancy? The latter hypothesis is less probable as home purchase applications are still impaired and strict underwriting guidelines have restricted the opportunities to purchase new homes.

And even if, in theory, these new multifamily units are designed for purchases, data on rental prices suggest otherwise. The median asking sales price has been steadily dropping since 2008 while median asking rent has not Figure 4.

In all likelihood, stronger demand for rental properties has increased rent prices which, in turn, incented an upswing in multifamily construction. The latest Current Price Index (CPI) figures published by the Bureau of Labor Statistics corroborate this hypothesis. Between August and September, the cost of primary residence rent has increased 0.2% and 2.1% year-to-year. The seasonally adjusted percent changes from the summer months were positive as well.

In addition, multifamily vacancy rates published by the US Census Bureau illustrate an interesting development. As illustrated in Figure 5, due to the foreclosure activity of recent years, homeowner vacancies increased to levels that surpassed the last three recessions. Meanwhile, there was a pervasive increase in rental vacancy rates up to the fourth quarter of 2006, after which it stagnated below 10 percent.

The decline in rental vacancies could have two causes: a halt in multifamily construction and/or an increase in rental demand. The former is less plausible as we have previously shown that housing starts show a sustained growth in multifamily construction. Then the answer lies within rental demand. Data on homeownership support this point. Absent significant declines in key demographic measures such as population and income growth, the level of homeownership has a negative correlation with rental demand. This scenario is concomitant to the current situation of the real estate market because the demographic picture of the United States has not changed since the crisis hit. The Census Bureau’s monthly population estimates point to a population growth rate hovering between 0.79% and 0.91% for the 2006-2010 periods, hardly an indication of significant population growth. Likewise, U.S. Bureau of Economic Analysis data on personal income per capita indicate no material change in the last four years.

Figure 6 shows that homeownership rates reached a peak of 69.4% in the third quarter of 2009 and have declined by 310 basis points, to 66.3% in the same period of 2011. Recalling the aforementioned conditions on population and income growth, it is safe to conclude that higher rental demand is in fact the main force behind the decrease in rental vacancies and, by extension, on the pervasive hike in multifamily construction.

Another confounding effect on housing starts in the medium term is the uptick in foreclosures. They have been mired down since the robo-signing controversy broke in October 2010. But, third quarter foreclosure activity has marginally increased, halting a trend of three consecutive decreases which date back to Q4 2010. In fact, the processing of the backlog of foreclosure properties will further reduce home prices and potentially reduce the profit margins in single family construction. This will reinforce the movement toward multifamily construction, for which demand depends on rent.

In summary, it is important to consider the demand and supply dynamics that underlie the overall figure of housing starts. Construction in single family units will decrease while servicers clear the foreclosure inventory. Hence, supply of newly constructed single unit houses will continue to slump while multifamily construction drives the housing starts index. An unprecedented upswing in rental demand will drive a momentous change in homeownership and housing starts. As the US economy emerges out of recession, for the foreseeable future, the fabric of residential housing will be tilted toward development in multifamily construction.

Bassirou Sarr, Research Analyst
Capital Markets Group

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