Housing Starts: Good News, but Sustainable?

Housing Starts rose in January to a seasonally adjusted annual rate of just 596,000 from 520,000 in December, a rise of 14.6%. The December numbers were revised lower from 529,000, so it is possible to see the increase as 67,000, or 12.7%. Relative to a year ago they are down 2.6%.

Quite frankly, a year ago was also a pretty lousy time for homebuilders, so the increase is off a pretty easy comp. If one looks at only single-family houses, the picture was worse, falling to 413,000 from 417,000 in December a drop of 1.0%, and down 19.2% from a year ago.

The multi-family (Apartment, Condo and Co-op) sector rose a massive 80.0% to an annual rate of 171,000. Year over year, multi-family starts are up 81.9%.

The total starts number was above consensus expectations of a 540,000 annual rate. While that is good news, all of the beat appears to have come from the very volatile multi-family sector of the market, not from sub-divisions.

Still Very Weak

The extremely weak rate of new home construction is a major drag on the economy. It is the principal reason that this recovery feels so anemic. The silver cloud is that fewer starts means that there are fewer houses added to the inventory of houses looking for buyers. We still face an inventory glut, so a weak homebuilding industry is a key part of the repair process for the housing market.

Housing Starts peaked in June of 2006 at an annual rate of 2.273 million. We are thus still 73.8% off of the peak levels. Single-family starts are 77.3% below peak levels.

Important to the Economy

It is hard to overstate just how important housing starts are to the economy. Yes, at this point, residential investment has declined to the point where it looks almost insignificant — just 2.25% of GDP in the fourth quarter, down from 6.34% of GDP at the height of the housing bubble. However, historically, residential investment — of which new home construction is the largest part — has always been the main locomotive in pulling the economy out of recessions.

Take a good hard look at the first graph below (from http://www.calculatedriskblog.com) and the relationship between when the lines bottom and the light blue recession bars. If you want to know why this recovery seems so anemic, look no further than this graph.

Even the 2001 recession, which was not caused by a housing downturn, saw a sharp acceleration in housing starts as the recession came to an end. Of course, since starts were jumping but were not starting from a depressed level, that boom later became known as the housing bubble that put us in this mess to begin with. Every other recession was preceded by a sharp fall in housing starts.

This is no coincidence. Each new home built generates a huge amount of economic activity. It put construction workers back to work, and construction workers have been particularly hard hit in the Great Recession, accounting for over 25% of the total jobs lost, even thought they were less than 6% of the total workforce when the recession started.

The effects go much further than just the profitability of D.R. Horton (DHI). Each new home requires a lot of lumber from a firm like Plum Creek Timber (PCL), roofing and insulation materials from Johns Manville (part of Berkshire Hathaway, BRK.B) and wallboard from USG (USG).

This list goes on and on, but it also means jobs for the lumberjacks and factory workers in those plants. They are not included in that one-out-of-four-jobs-lost figure. As they and the construction workers go back to work they are also going to have more money to spend, perhaps even go out to eat at Bob Evans (BOBE), thus creating jobs for cooks, waitresses and busboys.

Why is housing so central, as opposed to other industries? Why does it hold the key to the economy booming or busting? Because it is exquisitely sensitive to interest rates, or at least it was — before the avalanche of houses in foreclosure simply swamped the housing market. Even near record low mortgage interest rates don’t seem to be moving the needle.

The simple fact is that during the housing bubble we built far too many homes, and we now have a glut of empty homes around the country. Most estimates put the excess vacancies at between 1.5 to 2 million (including rental units).

The second graph (also from http://www.calculatedriskblog.com) shows the homeowner vacancy rate over time. While it is off its peak, it is still far above normal. In such a situation, it seems economic folly to simply build more houses and add to the glut. But if we don’t build houses, the economy remains stuck in a rut. From a strict “allocation of resources” point of view, we would want to see slow housing starts until the vacancy rate fell back to more normal levels.

Working Off Inventory a Good Thing

Thus, one can argue that in the long term, falling housing starts is a good thing, as it means fewer new homes adding to the glut. That, however, is extremely cold comfort to the millions of construction workers who are out of work. It is also going to be very difficult to create a sustained growing economy if home building continues to be a drag.

If residential investment (of which new home construction is the largest part) had simply remained at the depressed levels of the second quarter, rather than declining further, the economy would have grown at a 3.25% rate in the third quarter rather than at just 2.50%. In the fourth quarter, residential investment was actually very slight positive contributor to growth, adding 0.08 points of the 3.20 total. The residential investment locomotive was not pulling very hard, but at least it was no longer acting as a brake.

That resulted in a 0.83 point swing in growth contribution, which was more than the total acceleration of 0.60 points from the third quarter to the fourth quarter. The January starts numbers suggest that residential investment might even be a somewhat bigger positive contributor in the first quarter. However, this is simply the first month out of three, and other parts of this report make it prudent not to get too excited about that prospect.

Results by Region

Regionally, housing starts numbers were all over the lot. On a month-to-month basis, the Northeast was the strongest, with total starts rising 41.8% on the month, and up 11.4% year over year. The Midwest was also strong with a 34.4% increase, but is down 1.1% year over year.

The South, which is by far the largest of the four regions, accounting for 49.5% of all starts, was up 15.8% on the month but is down 5.8% from a year ago. The West, on the other hand, was down 9.7% on the month and off 3.2% year over year.

The reason the Northeast was so strong is that it has a higher proportion of multi-family housing. Single family starts in the Northeast were actually down 12.8% on the month, and off 29.3% year over year.

Building Permits

While the bounce in starts is encouraging, it does not seem destined to last. The best leading indicator of housing starts are Building Permits. There the news was significantly worse, at least from a near-term economic growth point of view (or significantly better from a long-term repair of the housing market point of view).

For the month, total permits fell 10.4% to an annual rate of 562,000 and were down 10.7% year over year. That was below the consensus expectations for a 575,000 rate. Also, December was revised down, from a 634,000 rate to 627,000.

The weakness, however, was mostly — but not exclusively — in the volatile multi-family segment. Single-family permits were down 4.8% on the month, and down 17.3% year over year. Multi-family permits fell 22.4% on the month but are up 23.8% year over year. Also, the permit rate is below the start rate, so we can probably look forward to at least a bit of a decline in starts in February or March.

Regionally, the Northeast was the weakest, with permits down 38.5% on the month and off 2.7% year over year. The West saw permits drop 27.3% for the month and off 18.2% from a year ago. In the Midwest, permits fell 5.6% for the month and were down 6.3% from a year ago. The South, the largest of the four regions, was the only one with an increase for the month, up 11.4% from December, but down 10.4% from a year ago.

There is a certain level of ambiguity about if a rise in starts is good news or bad. We need less supply to help the market clear. In the meantime the economy is going to be stuck in limbo, unless we can find another locomotive to help pull us forward.

Infrastructure Spending?

Additional government spending on infrastructure would be the logical solution. After all, we have huge needs to rebuild out crumbling infrastructure. Better infrastructure would enhance our long-term economic competitiveness. The government would not be competing for resources with the private sector, it would be competing with idleness.

Even with the recent rebound in interest rates, the cost of financing the infrastructure rebuild would be extremely low, give that T-note yields are in any historic perspective, low across the yield curve.

However, in the current political environment, that is not going to happen. Congress is more likely to slash existing infrastructure spending rather than increase it. This is following the absolutely daft economic theory that putting an incremental $100,000 into the after-tax income of a mid level Wall Street investment banker will instill enough confidence in the economy that they will produce more jobs, than putting an unemployed construction worker back to work fixing our bridges so they don’t collapse on us. Well, whoever said that Congress is logical?

Eventually, the combination of a rising population and higher household formation will absorb the excess inventory, and we will be able to once again increase housing construction. Household formation is economist speak for kids moving out of their parents houses and getting a place of their own. To do so takes a job, and one that pays enough to support having your own place.

In the past, residential construction itself provided a lot of those jobs. That produced an upward spiral. This time around, the jobs have to be created in other parts of the economy to increase the household formation rate, and absorb the excess inventory, which makes the process slower.

Good News, but Sustainable?

At first blush, the better than expected level of starts looks like very good news for short-term earnings growth. It does not, however, appear to be sustainable. All of the increase was due to the extremely volatile multi-family segment. That huge 80% month-to-month increase could easily be reversed next month.

The weak building permits data also suggest that starts will slip again next month. While that might be a good thing over the long term, it is bad news in the short term. Part of the month-to-month increase simply came from the previous month being revised lower, which is not what I would call a high-quality form of growth.

The day will come when housing is once again a big positive contributor to economic growth. It is not really sustainable over the long term to have total housing starts running at substantially lower levels than we saw in the 1960’s. Back then the population of the country was around 200 million, now it is north of 300 million.

That day, however, is neither today nor in the near future. It is possible that it might happen in the second half of 2011, but more likely in 2012. For the time being, the best we can really hope for is that it stops being a brake on the economy.

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