The economist gives us his take on the state of the economy and housing market and what he predicts for the future.
Builder and Developer: How would you describe the current state of the economy and the housing market?
Robert Dietz: The overall economy is strong. In fact, we’ve been revising our GDP outlook. We think this year is likely to be the best year for economic growth since 1984. Housing was a bright spot in the economy in 2020 and that momentum, clearly, has continued into 2021. The challenge, both for the overall economy and, to an even greater extent, the residential construction industry, is that economic activity is running too hot. So the challenges for the overall economy are businesses trying to find workers, which has been a challenge for homebuilders and remodelers and land developers for the last decade.
We’ve also seen some pretty substantial gains in commodity prices, which is typically what happens when we have the economy accelerating. That economic growth has been accelerated by the fact that there is a lot of stimulus financing that’s out there. For the building industry, clearly, structural lumber is a challenge. We’ve seen a more than 320% increase in lumber pricing over the last thirteen months that’s adding, once fully phased in, about $36,000 to the price of a new single-family home and about $13,000 to the cost of a typical apartment, which translates into a rent increase of about $120 a month for renters.
But, it’s not just lumber, 90% of builders, in a recent NAHB survey, indicated that appliance deliveries were increasingly delayed. Anecdotally, I hear about shortages in windows and doors and, literally, the nuts and bolts that go into building housing, even some very specific products like the steel brackets used to lay down foundations and resins that are used to make cushions that go into furniture. I think what we are seeing is the impact from a full reopening of the economy, which we were clearly anticipating due to the success of the vaccine, and some of it is due to blockages in the supply chains, and that’s a global problem right now, not just a national one.
So for lumber itself: imports from Canada are down, that’s where we get about 30% of our lumber supply, and domestic production is up slightly, but its not keeping pace with, for example, the 12% gain in single family construction that we experienced last year. I think the hope for the industry is that we will see some easing of these material constraints. I do believe that they will persist into 2022, unfortunately. But, we do expect many of them to prove transitory, whether it be the overall economy or the building industry, not to be a sign of a permanent inflation cycle. We think these are temporary increases associated with essentially restarting the economy.
BD: What can we expect with home prices and the cost to build a home? Do you think they will just continue to increase?
RD: Yeah, I think we are going to continue to see elevated costs. We’ve talked about materials, but there are also other factors that are increasing the cost of building a home. In particularly hot markets, lot supplies are down. So when building lot supplies are low, that’s another cost factor that has to be considered. We also have an ongoing skilled labor shortage. It continues in the overall construction industry, in both residential and non-residential construction, to be short, in any given month, 300,000 construction workers. That is a limiting factor and whether it means longer construction times or higher costs, time is money, so they both translate into higher development expenses.
What that means for new home pricing, and I think buyers are prepared for this as they’ve certainly heard about it enough in the media, is that new home prices are gonna rise this year. On average, new home pricing was up only about 5% last year, which is striking given the fact that resale pricing of existing homes rose more than 10% year-over-year. My expectation is that we are going to see more than 5% gains in new home pricing this year, on a per square foot, apples-to-apples basis driven by higher costs, whether because of structural, lumber or other kinds of building material components or downstream impacts from labor and lot shortages.
The other challenge, of course, is regulatory burdens. That tends to have a more targeted geographic impact, with some areas being particularly tight when it comes to regulatory policy. My team just published some new estimates indicating that for an average home, this wouldn’t apply to California or the Northeast where regulatory costs tend to be higher, regulatory burdens are now above $90,000 per home. That is a combination of impact fees, land that you have to purchase, but cannot build on and delay costs. It often begets the question of “why isn’t the industry building more $175,000 entry-level housing?” Well, if on average you’ve got about $90,000 or more in regulatory costs, it becomes virtually impossible to build that kind of housing. Of course, those regulatory burdens apply to multifamily as well.
BD: What are some ways that the spikes in material costs can be alleviated and brought back to more conventional levels?
RD: So I think from the macro and the policy world, which is really more where I operate, rather than say the business strategy world, I think it is well past time that the administration suspend, on a temporary basis, the tariffs on Canadian lumber. There is an effective tariff rate of about 9% on lumber, but it was as high as 20% in recent years. It makes absolutely no sense to be taxing lumber imports when the price of lumber is up more than 300% and it appears that the domestic sawmill industry is either unable or unwilling to increase supply. That would not solve the problem, to be clear, but it would provide an additional source of lumber.
Then we need to find whatever policy actions need to be undertaken, whether its regulatory policy or workforce development, to increase domestic sawmill capacity in the United States. The industry has not expanded output sufficiently over the last 12 months. Commentary from the lumber industry indicates that they are not prepared to do so and that they are willing to, as a Wall Street Journal article recently indicated, rake in the cash.
That’s not the best economic outcome for home buyers and renters and, ultimately, that’s who our industry is responsible to, the Americans buying and renting homes. Increasing production capacity domestically is ultimately the long-run solution. It’s not gonna be quick, but it would be really useful for the White House and the Biden administration to convene a summit on lumber issues and other building materials used for home building, in the same way that they did for the semiconductor industry, to collect ideas and identify policy solutions. In the meantime, I think suspending the tariffs on Canadian lumber makes a great deal of sense.
Now, I said that was the macro and policy answer, if you are thinking in terms of how builders are responding to increases in lumber prices and declines in building material availability, in an April NAHB survey of the industry, we found that about 47% of builders were including price escalation clauses in sales contracts, so that when those higher costs arrived, the buyer is incorporating some of that higher cost in development. Some other impacts that we’ve found: 19% of home builders were indicating that they were delaying construction or sales, whether just putting off sales or reaching a certain amount each month and then stopping. That was occurring among about a fifth of builders as a way to manage supply chains. Then, we saw a bit of a dip in single-family starts, a monthly decline of 9% in April compared to the March pace and that was likely connected to, what we have also found, which was 15% of builders said that they, in some cases, had laid a foundation, but had paused framing of the house; so that’s a specific example of what is a broader phenomenon, which is in some cases construction projects actually pausing. In fact, in the census report this morning, there was about a 47% gain year-over-year by-the-count in single-family homes that had been authorized by building permit, but had not started construction. Some of that is expansion of the industry, the industry was up 12% last year, but the fact that permits are being pulled and construction start is not beginning is an indication that builders are pulling back and trying to identify the best solution for the enterprise and for their customers.
BD: Builder confidence remained steady in the latest NAHB/Wells Fargo HMI despite the materials/lumber issue our industry is going through. What are some factors keeping builders optimistic?
RD: It’s a really strong demand environment. Whether its: historically low interest rates; the housing deficit from under building over the last decade, which has left a deficit of probably about three million single-family homes, according to estimates by Freddie Mac; favorable demographics for single-family housing; the bleeding edge of millennials turning 41, so all those other millennials in their thirties are in their prime first-time home buying years and that means that demand has shifted somewhat from urban core multifamily to inner suburb and outer suburb single-family.
That’s not to say that multifamily has seen a big drop in demand. There were some disruption effects when it came to apartments last year, but multifamily is actually performing strongly here at the start of 2021. In our quarterly multifamily sentiment indicator, it’s gonna go positive in the next edition. So we’ve actually raised our forecast for multifamily construction and are seeing a gain for this year as some of the demand rolls back into those urban-core areas with the deployment of the vaccine.
The reason for strong builder confidence is demand is strong, even though supply is low and inventory is low. It feels like for the past four or five years, we call it the five L’s that are the limiting factors when it comes to homebuilding: lack of labor, lots, lending to builders, lumber and building materials, and laws and regulatory burdens. Right now, lumber and building materials is on top and labor is a long run challenge that will continue. As I said before, some local markets are seeing some shortages in regards to building lots.
Combined they do represent challenges, but the demand is just so strong that while they represent limitations on how much additional supply the industry can add, our forecast is positive for single-family construction. We just think we could be growing faster if not for some of these challenges.
To wrap it all up, if you look at the HMI, it peaked at a level of 90 last November, and then as we continued to see higher lumber prices and additional material challenges, the HMI has remained in positive territory, which is anything above a level of 50, but it has trended somewhat lower to a level of 83 and that’s consistent with what we say with single-family construction activity. But that fourth quarter was stronger than the first quarter of 2021, so there was a bit of a dip in that level of activity. It’s still strong and still above a million single-family starts pace, but a little bit slower than what we saw in the fourth quarter of 2020.
BD: Mortgage rates reached historic lows during the pandemic and have slowly begun to rise. Do you foresee them rising higher or staying at a lower level for the rest of the year?
RD: I do think they are gonna gradually increase. When we say gradual, it means there will be starts and stops and some retreats, but I think the overall trend, if we look out quarter-by-quarter over the next two to three years, is higher interest rates. The reason why is because the macroeconomics of credit markets and the overall economy. Faster GDP growth means higher interest rates because when the demand for capital goes up, which is what happens during a growth cycle, and as I’ve said before, 2021 is gonna see the strongest year for economic growth since 1984, that means higher interest rates.
The other factor is that there is going to be some pressure on what we call nominal interest rates, which is interest rates before you make an inflation adjustment, which are what we call real interest rates. Nominal interest rates are likely to trend higher due to the fact that, there is going to be, in the short run, increases in inflation, which the building community is already seeing the seeds of through higher building material costs.
So, whether it’s due to inflation pressure or faster economic growth, both of those factors would tend to raise interest rates. Our forecast is that with the 30-year fixed rate mortgage right now a smidge below 3%, according to Freddie Mac data, our expectation is that as we enter into 2022 it will likely still be below 4%, but closer to 4% than 3%. By the time we get into 2023, I do think it will get up above 4% for the average 30-year fixed rate mortgage. Now, what does that mean? We learned in late 2018, when the 30-year fixed rate mortgage approached 5%, it kinda peeked out around 4.9%, that it was high enough to cause a housing soft patch, in terms of a reduction of housing demand. In fact, when interest rates got up above 4 3/4% we had about six or seven month where home sales activities were flat and builder confidence weakened.
Some of that was due to looking down the road and anticipating because, at that time, the fed was tightly monitoring policy and putting upward pressure on rates and policy, but if that late 2018 experience is a lesson of how the market can enter into a housing soft patch, we think that the rate at which a future housing soft patch would occur would be lower. The reason that the rate would be lower is that home prices are higher now than they were in late 2018. I think now it could occur between 4% and 4 1/4% given the fact that we saw more than 10% growth rate in home prices last year. So, higher price level homes means a lower interest rate at which buyer demand will pull back and we’re likely to see that, based on those economics, in the second half of 2022.
BD: Home buying also soared due to the pandemic. With the vaccine roll-outs widened and restrictions being lifted, do you think we are going to see an influx of buyers moving back to urban areas?
RD: Urban flight or urban exodus was always a straw man. People like to introduce that and bash it as if it were wrong, but no one was really making that argument. Now we did see, in the construction data, what we call the suburban shift. For example, the growth rate for single-family home construction in the outer suburbs and medium sized cities for 2020 was about 23%, whereas the growth rate for single-family home building in the inner suburbs and high-density, large metros was only about 9%. That was a remarkable divide. So that suburban shift applied through most of 2020.
As you said, with the deployment of the vaccine and with reopening, as people begin to commute to the office more, we think some of that demand is gonna roll back. In fact, I published some data on our Eye on Housing blog on townhouse construction. The fourth quarter of 2020 was the best quarter for townhouse construction in 2 1/2 years. The first quarter for 2021 wasn’t as good, but it was still pretty strong. So we had two strong quarters in a row for townhouse construction. Now why is that important? Townhouse construction is a pretty good proxy for inner suburb and medium-density development. Those are hints that we are starting to see some roll back in that demand. Builders always anticipate where demand is going and so they are building towards that, those medium-density, walkable urban villages.
The question becomes: given the suburban shift that took place, which, by the way, we saw for both single-family and multi-family construction, which was higher in lower-density outlying areas, which was really remarkable in terms of density, how much will the effect that we saw in 2020 is gonna persist?
I believe it will be a partial persistence. I think there will be a permanent change in the American work model. No, it doesn’t mean that you are gonna have a huge percentage of people living in a different metro from their employer; however, I think it’s reasonable to estimate, and we’ve included this in our forecast assumptions, that 30-40% of the American workforce are going to probably work under some kind of hybrid model, like a 3-2-2 model. So, if you think about commutes not in terms of daily estimates, but rather weekly, someone working under a 3-2-2 model, from a weekly commute perspective, could live further out because they are only doing that commute 3 days a week as opposed to five. So the larger impact is not this sort of unshackling people from high-cost metros off to the beach. The larger impact is that within metros, if people are making a weekly commute calculation, I could live further out. Of course outlying areas new construction is going to be relatively a greater source of inventory, so you’ll get this partial persistence of the suburban shift that’s a generally bullish indicator for new construction.
But, as I said before, the townhouse exercise makes me see good signs for those medium-density, closer-in neighborhoods as well. In fact, one of the really strong trends that I think is gonna play out over the next couple years is the striking number of tear down construction that’s taking place, even just within my own neighborhood. It’s only about 6% of single family starts, but we’ve got an aging housing stock. The typical home in the United States is right around, I believe, age 40, so there is going to be a growing share of new construction that is attributable to essentially replacing older stock. Again, the kinds of neighborhoods that tends to occur in are medium-density, closer-in neighborhoods. There are definitely factors that are gonna help drive the exiters, but there are also factors that are gonna help sustain demand and inventory from builders in those medium-density inner suburbs.
BD: President Biden’s new American Jobs Plan details massive investments in clean energy and housing, how would this plan affect the nation’s economy and housing market?
RD: Let’s look back first. I think the stimulus actions that were undertaken by Congress in the prior administration in 2020 combined with accommodative monetary policy from the federal reserve were critical and necessary. If you think back to the second quarter of 2020, with the GDP growth rate at a negative 30%, the worst quarter in modern american economic history, a significant amount of stimulus was needed to make sure that people could pay bills. We were looking at potential unemployment rates of 20-25%. So the feds, Congress and the administration really needed to act.
Now that we’ve had multiple stimulus rounds, we are definitely at the point of diminishing marginal returns when it comes to fiscal policy. I think accommodative monetary policy does need to be sustained over the next year or two, so that we can make sure that the credit is available to businesses, particularly small businesses looking to restart, but also credit remaining available to homebuyers, for example, to allow for those low interest rates to allow a growing and more diverse set of buyers to attain and benefit from home ownership.
When it comes to fiscal policies, the challenges right now are additional unpaid for spending, which, without a doubt, will be inflationary. We are right there now. We’ve revised up our inflation expectation so we do think that inflation is going to be higher this year, between 2-3%, above the federal reserve’s target of 2%. Additional government spending, economic theory tells us, will further boost inflation, which means hotter commodity prices and higher cost of doing business for small and large businesses alike. So if that’s the case, then additional government action will have to be paid for by higher taxes.
Then you get into the more traditional policy environment, which is debating the pros and cons of fiscal legislation by examining the costs of higher taxes versus the benefits that come from government spending. That’s gonna be a tough calculation on individual items like, for example, infrastructure build. There are certainly fiscal policies that could be undertaken that would help housing, workforce development being a key one like finding ways to train additional construction workers. Infrastructure itself that complements housing construction. Maybe providing sources of financing so that local governments don’t have to raise impact fees and permit fees on builders.
At the same time, we are also looking at potentially destructive tax policies, elimination of like kind exchange, higher taxes on C corps and small business, etc. All those have to be taken into account. So it becomes a matter of examining specific proposals and trying to find where the net benefits are, but the period of time where we essentially have unpaid for government spending bills is now over because of the fact that we risk higher inflation. As we said earlier, higher inflation means higher nominal interest rates and that would be a net negative for housing demand.
BD: Is there anything we didn’t go over that you’d like to touch on?
RD: So we’ve been talking about a huge number of topics, but the remodeling market is really hot. We expect the gains for home improvement to continue just because of the fact that people need more space and are investing in their homes.
The other submarket worth mentioning is single-family rentals. I expect the single-family built-for-rent market to grow. We haven’t quite seen the take off yet, in terms of direct single-family build-for-rent units, direct meaning units built and then held by a builder rather than a unit that is built then sold to a company to be used as rental housing, but the reason why I expect some growth in single-family built-for-rent housing is that we see this preference shift for larger housing, houses that have their own yard, but not everyone can afford to buy, particularly in high cost areas where the down payment requirements can be overwhelming. So a rental tenure option makes a good deal of sense and, given the overall shortage in single-family housing, that single-family built-for-rent provides a source of supply for a much in-demand submarket within the housing industry. I think we will see it particularly in high cost areas that lack housing supply.