Economist's Commentary: June 12, 2008
The Rising Tide of Demand
By Ken Fears, Manager of Regional Economics
Home purchases are driven by a number of factors which can be broken down into two main categories: affordability and demographics. Declining prices, falling mortgage rates, lower taxes and tax credits can all stimulate demand by improving affordability. But population changes can also have a meaningful effect on the demand for housing by increasing or decreasing the need for housing. A surge in the number of persons who require housing, via immigration or a higher birth rate, results in increased demand for housing space be it for rent or purchase. When two people choose to start a family, the pressure to own versus rent is intensified. Consequently household formation is also an important determinant of future home sales.
Between 1981 and 2007, the number of new households formed each year averaged roughly 1.3 million units (the pink line pictured below). Household formation averaged roughly 1.72 million units per year from 1997 through 2001. The pace slowed to 1.28 million units per year during the subsequent 4 years, yet these were years in which home sales set consecutive annual records.
On the face of it, this pattern suggests that household formation precedes home sales growth. It is true that homes are large expenditures and therefore purchases are rarely made impulsively. This lag between pent up demand and the sales boom suggests that it takes not only equity, but confidence in one's employment and income stream before a buyer will jump into the market. However, mortgage rates fell sharply from 2002 through 2005. Taken together, these facts suggest that household formation and confidence may not be enough for buyers to make the choice to jump into the market. Rather, it suggests that there is an affordability hurdle that precludes buyers from entering the market even if they have the confidence to buy.
Since 2005, household formation has jumped back above the historic norm to 1.38 million units per year, with 1.63 of them coming in 2007. However, sales levels have fallen to their lowest levels in nearly 10 years. This recent trend suggests two things. First, a reserve of pent-up demand is being built up. Second, there is some factor precluding these would-be buyers from entering the market. With the economy slowing, employment and income fears may be weighing on potential buyers. Financing has improved at the lower price-range of the market, but jumbo rates are artificially high, and lending standards have tightened. Uncertainty over both issues as well as the foreclosure situation has likely created much consternation. Regardless of the reason, would-be buyers are sitting on the side-lines, but the steady march of an expanding demand base will not allow them to rest there for long. This pent-up demand will begin to strain the relatively tight rental market, forcing up rents until households opt to reconsider their confidence, reevaluate their affordability, and decide to jump back into the market.
1. Tastes no doubt play a role but enter demand through changes in demographics and affordability. For example, baby-boomers may desire to have two homes, their current home and a retirement home, but can only afford one. This shift in tastes limited by a finite budget might then create greater demand for condos in both locals as these boomers sell their more expensive single family homes and buy smaller condos in multiple locations.
This is one in a series of commentaries by the Research staff of the National Association of REALTORS®. Read more commentaries >
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