Last month, MRP made the case that U.S. housing construction is on the verge of a major second leg up. We believe the surge in household formations to levels last seen over a decade ago sets the stage for a multi-year boom in new home activity, which will lift home builders and producers of everything that goes into homes. But the construction boom is just half the story. The rise in formations, driven by late-blooming Millennials, will also have a powerful impact on U.S. home prices.
We’ve seen this before. In the aftermath of WWII, strong housing formations pushed U.S. live births to 4 million a year for the first time ever, creating the Baby Boomer generation. When Baby Boomers hit their late 20s, they began forming families and making babies of their own … lots of them. The number of live births in the ‘80s and ‘90s rose again to over 4 million a year for the first time since the early ‘60s. The age cohort referred to as the Echo Boomers or, more commonly, the Millennials is now the largest in the U.S., and accounts for roughly a third of the entire population. The oldest of the Millennials are already at an age where they should be moving out on their own and buying their first homes.
Instead, the strong household formations that might have been expected to emerge as Millennials approached their late 20s failed to materialize. Over the past decade many remained living with their parents or doubled up with siblings, friends, or strangers. Some observers cite changed attitudes and student debt as reasons why many Millennials simply can’t afford to move out on their own. But history suggests otherwise: Household formations have always been cyclical, weakening during recessions and regaining momentum during expansions. After all, when jobs are scarce, who wants to rush out and start a new household?
This cycle just took a lot longer. Coming out of the recession, employment recovered at a much slower pace, and jobs for Millennials were especially hard to come by. In fact, the unemployment rate for Millennials was higher than for the general population, contributing to the “Failure to Launch” syndrome. Now, more recently, the trends have reversed. As labor markets have tightened, the share of 25-34 year olds with jobs has been rising faster than that of the rest of the workforce. With better employment prospects, the Millennials have now begun to move on. Household formations, which prior to the recession averaged 1.25 million a year and then bumped along a bottom of 500,000 to 600,000 for the next seven years, have surged to a 2 million annual rate, back above pre-crisis levels over the past six months.
Meanwhile, this tsunami of demand is swamping the supply of housing units. Rental vacancy rates have plunged to the lowest levels since the early ‘90s as rental costs continue to rise. New home inventories are close to normal but the inventory of existing homes for sale is down 0.5% from a year ago. The industry has not been building nearly enough units, for sale or rent, relative to potential long-term demand. Altogether, in this cycle, there has been a cumulative new home construction deficit of almost 5 million units below the long-term trend. This pent-up demand will boost house prices sharply higher from current levels over the next several years as Millennials catch up on forming new households.
Already, home prices have recovered 28% from the trough set in early 2012, according to Case-Shiller –- without the help of a household formations recovery. But we believe prices have a similar gain ahead of them over the next several years. Many are skeptical and still dwelling on research that showed a hockey stick picture of U.S. house prices over the past two centuries, creating the impression that, even after the big bust, prices are still way out of line with historical averages. More recent research, however, has shown that most of the rise in the past 50 years has been due to rising land prices. Furthermore over the past decade, rents have continued to rise; by some measure, it costs 28% more now to rent than it did when house prices hit their 2006 peak.
Meanwhile, actual building costs in nominal dollars have not gone down. Indeed, a good proxy for residential construction costs is the average hourly wage of workers in that field, which also has risen over 20% since home prices peaked in 2006. Of course, no one knows where home prices will wind up. But our best guess is that they might be 20% above the prior peak within the next 3-5 years.
As pent-up demand enters the market, higher house prices will have knock-on effects on the U.S. economy as a whole, from the balance sheets of consumers and financial institutions, to existing home turnover, to relocation activities. Millions of homeowners who previously had negative equity are already back above water: according to CoreLogic, as of the fourth quarter 2014, just 10% are under water, down sharply from 31% in 2012. As prices recover further, these households should qualify for home equity lines that were out of the question a short time ago. The legions of banks that had written down their real estate assets will need to write them back up. Finally, as higher prices feed into appraisals, cash-strapped local and state governments will be lifted out of the red as property tax revenues rise.
Some experts say home prices are already peaking and the U.S. housing story has all but run its course. Indeed, a forthcoming issue of Barron’s reportedly suggests that "home prices are nearing their peak." We at MRP believe home prices are poised for major gains that will radiate throughout the economy. The second leg of the housing recovery is already showing up in stronger home sales, as the Millennials contribute to a resurgence in housing formation, boosting corporate earnings throughout the housing supply chain. The home price recovery that MRP forecasts will spread that positive impact, improving the fortunes of muni bonds, consumer durables, bank stocks, residential REITs, and other securities with exposure to stronger home prices. The housing story still has a lot more to go.