Part II of this article series describes the government actions that will be necessary to promote growth in the construction industry, and makes predictions about future builder and homebuyer behavior.

This article is the second in a two-part series. For further analysis, including a review of first tuesday’s current forecasts, take a look at the first part in this series, Factors in construction forecasting.

The need for government action

Like many aspects of real estate, the construction industry in a given area tends to be most reflective of the local economic environment, including the actions of local governments. To meet the expected demand for housing in urban centers, apartment and condominium (condo) builders will need the state legislature to set aside inner city locations for high-density, high-rise residential lodgings.

In fact, for construction to recover most quickly and efficiently, it will be necessary for policy-makers to increase the minimum number of residential units permitted per thousand square feet of ground, and to permit mixed uses (both residential and non-residential) within the same structures. Suburban sprawl has proven to be a poor long-term housing and retail strategy, in spite of the appeal of a mythic stand-alone-home on the prairie.  [For more on the increasing demand for urban rentals, see the May 2010 first tuesday article, The plight of California to be solved by… cities?]

Local governments have a great deal of control over real estate price movement, although that control is rarely the subject of rational discussion in California. As the demand for any type of improved property increases, and prices begin to move upward faster than the rate of consumer inflation (the point in time at which excess asset inflation sets in), local governments must permit the higher and better use of existing subdivided parcels (beginning with the demolition of obsolete structures) so that construction can take place to meet demand without delay. Thus, prices can be kept close to the mean price trendline, avoiding the disruptions inevitably generated by price distortions in the market. [For more information about the historical equilibrium trendline, see the October 2011 first tuesday article, The equilibrium trendline: the mean-price anchor.]

Prompt action on the zoning of city center parcels will prevent the upcoming boomlet in sales volume from turning into a pricing bubble. Rising resale prices of existing SFR housing will be offset if new units can be effectively added at prices lower than those resulting from asset inflation in the existing resale inventory. [For an analysis of inflation’s role in real estate pricing, see the April 2009 first tuesday article, Calculating owner-occupied housing in CPI: a high-stakes and contentious quandary.]

To accomplish these goals efficiently, cities must implement zoning that allows greater height for buildings and higher urban density. Also, smart zoning keeps down the need for new infrastructure to connect existing infrastructure with newly developed properties on peripheral unsubdivided lands. Successful zoning laws will be those that keep demand for government services at a consistent level by allowing builders to demolish obsolete and inefficient structures and construct high density housing on existing blocks and parcels within the cities. Thus, the need to extend roads and utilities (which the cities will then be required to maintain) is avoided.

Local governments’ first responsibility for housing is to revisit current limits on height, density and onsite parking, as well as the mix of unit types (1-, 2- or 3-bedroom units). These limitations need to be modified with an eye toward the best use of inner city parcels, which are now occupied by old, obsolete SFRs.

Intelligent zoning will allow builders to meet the needs of homeowners and renters looking for jobs in the city’s core financial, governmental, educational, medical and other high-end service trades: this century’s growth industries for last century’s loft buildings. The state legislature has already established a pattern of increasing density by adding low-income units to the permitted use, including authorization to construct granny flats (casitas) for SFRs everywhere. [Calif. Government Code §65852.2]

City councils can increase building activity for marketable housing by reducing permit costs for the construction of units on central city parcels where additional infrastructure such as roads, sewers and utilities are not required. Such cost-less policies encourage builders not to jump outward from the urban center into remote unsubdivided lands, and are an intelligent way to make cities more favorably centralized while delivering the convenient apartments and condos urban-dwellers most desire. Given the choice, most prefer to live near to where they work.

Of course, caution and prudence must be the guiding words in all government activity. In recessionary periods (like the present Lesser Depression), local governments tend to want to speed up construction in order to create jobs and support local builders, a good thing.

When the Lesser Depression ends, the reverse will be true, as it is the responsibility of local governments to restrain excess and economically misplaced building. However, governments (both local and national) always lag behind the needs of the moment, since their policies, by political necessity, are enacted in reaction to events already in motion.

As such, government policies to prevent construction will often persist when they are no longer helpful, and incentives created during a recession may come too late and remain even when the market has improved, leading to overbuilding and other evils.

Moreover, local governments are motivated by needs other than those of homebuyers or the construction industry. Among their other concerns, governments must always maintain their own revenue from the tax base. One way of ensuring this revenue is to encourage construction during slow times, even in the absence of demand from homebuyers, so that the assessment rolls will grow. Such incentives are welcomed by builders, but excess inventory has in the past led to suburban sprawl, unacceptable designs and failure of onsite and offsite amenities – conditions helpful to no one.

Old loans, savings and mortgage debt

In times of low consumer confidence, purchases go down and the savings rate goes up. Debt that looked unthreatening in boom times becomes a source of constant anxiety. Since 2007, California’s population has been frantically deleveraging – cutting corners in order to reduce overall debt, including mortgage debt. 

The decision to avoid debt is healthy financial management for many families, but it is bad for sales volume and pricing. Deleveraging is even worse for the home construction industry, which depends on new home sales (which are typically financed by purchase-assist mortgages) for its livelihood. While the retiring Boomers generally have the cash reserves (or home equity) to buy new homes without incurring more debt, first-time homebuyers rely on outside financing to support the price of their purchases. Without the willingness to take on financing, even at current low rates, they will remain renters at least until sufficient confidence returns. [For more on the problem of debt for first-time buyers, see the September 2011 first tuesday article, First-time homebuyers stuck and agents derailed.]

Meanwhile, savings rates are weak, and remain around 4% of personal income in late 2011. Such savings are nonetheless up considerably from the mid-2000s when real estate sales volume and prices were at their peak. For comparison, the savings rate going into the 1980s was 10% of personal income, but declined to 0% in the 2005 period. The savings rate was slightly higher, at 5%, in 2010, but has begun to slip as the indebted seek to deleverage their debt and the underemployed draw upon savings to make ends meet. [For an analysis of savings rates and their affect on the homeowner’s ability to make a down payment, see the July 2011 first tuesday article, The 20% solution: personal savings rates and homeownership.]

In the long run, increased savings rates today will benefit homebuyers and home builders alike.  Already, homebuyers expect to put down a 20% down payment when purchasing a home, and are saving to do so. This will enable them to secure the best loan value possible, by avoiding expensive private mortgage insurance (PMI) or government guarantees. [For more on the costs of financing with Federal Housing Administration (FHA)- or PMI-insured loans, see the August 2011 first tuesday article, FHA, PMI, or neither?]

Sales volume and equilibrium pricing

For SFR construction to rise, homeowners must believe that buying a home is an economically beneficial decision.At the moment, home sales remain at a continuing low, thanks to low levels of consumer confidence and ongoing low employment numbers. Sales in 2011 going into 2012 are much closer to the trough of 18,000 monthly in January 2008 than the 70,000 monthly sales peak in 2005 (a monthly average of 34,200 homes has been sold in 2011). [For detailed current home sales numbers, see the first tuesday Market Chart, Home sales volume and price peaks.]

Residential renters and owners work in a sort of pricing equilibrium. Renters’ monthly rent payments are driven up when the demand for rentals increases over the demand for homeownership, as is now happening. Soon, the costs of paying rent are greater than the total costs of home loan payments and the expenses of homeownership. When this balance is tipped in favor of homeownership, renters with cash on hand for a down payment make the financially reasonable choice and shift to homeownership, unless some other influence interferes. Thus, although rental construction is on the rise at the moment, circumstances are paving the way for improved SFR buying conditions.

However, keep in mind that the last time this equilibrium pricing point for rent and homeownership costs crossed over was in the early 1970s. Since then, homebuyers have become accustomed to paying far more for a home than they would pay to rent the same or equivalent property. For this, you can thank the common idea, developed over the past 30 years, that the family home is a growth investment capable of delivering more than just shelter. That investment-centered thinking was mostly washed away by the recent economic tsunami, and will be kept in large part at bay for as long as job growth remains tepid in the continuing Lesser Depression.

Now… the costs of homeownership for low-tier properties have approached the rental rates for equivalent property for the first time in 40 years.

Former owners, now tenants-by-foreclosure, are understandably disillusioned and reluctant to take on the risk of homeownership again soon, if ever. Now, as home prices continue to erratically slip in almost all areas, and homes are made even more accessible due to low interest rates, the costs of homeownership for low-tier properties have approached the rental rates for equivalent property for the first time in 40 years. This is a huge change in value analysis, since the income approach to evaluating a home is once again functioning. If they are prudent, appraisers will continue to incorporate this technique into their methods. [For an assessment of the harm done by other valuation techniques, see the February 2011 first tuesday article, Lenders vs. owners and the real estate interest of each: 2000-2011 and beyond.]

Moreover, current market factors will combine to keep home prices at reasonable levels in upcoming years. A change in pricing trends occurred in 2008, when interest rates finished dropping and hit bottom, from nearly 20% in 1980, to essentially zero. Going forward, the Federal Reserve (the Fed) will be unable to use interest rate movement to sustain or drive up asset prices, including the prices in real estate and the stock market, as they have in the past.

The path to personal wealth through home price appreciation will thus be largely beyond the Fed’s control through the end of this decade. The upcoming recovery in gross domestic product (GDP) which will add to pricing of property is likely to follow the pattern set following World War II, after the Great Depression. Accordingly, look for home prices to rise through 2020 as they did between 1945 and 1964 (the years the Boomers were born) – at the rate of consumer inflation, a heady 2% to 2.5% annually.

Construction in the future

The rate of homeownership in California has declined dramatically in recent years, from 60% in 2006 to 56% in 2010 (that rate is likely to be 55% in 2011, and still dropping fast). Anticipate a bottoming of this trend at around 50% homeownership in California by 2017. This drop in the population’s homeownership rate represents 1,020,000 families who had owned and occupied homes in California, and who are now renters due to the housing crash. Almost all of these former owners will continue renting until the Lesser Depression is over and their credit scores have been repaired, sometime around 2017.

While much of this shift is due to the challenges presented by failed job opportunities in the Great Recession and ongoing Lesser Depression, many foreclosed and shortsale homeowners have left homeownership of SFRs permanently. Those prior homeowners will continue to rent once the current period of economic stagnation is over. This shift away from homeownership will interfere with detached SFR starts for a long time, although it will bolster construction and investment in multi-family units (rentals). [For more on current homeownership rates, see the first tuesday Market Chart, Rentals: the future of real estate in CA?]

Construction will first begin to blossom in the communities of coastal California, where high-tech information and service jobs are increasingly centered. Coastal communities also have the benefit of appealing to the retiring population, due to their temperate climate and reputation for comfort. Anticipate increased construction along the coast, especially of multi-family units located in core urban centers, beginning as early as 2012 and climbing steadily, and possibly quite rapidly, throughout the decade. The pace of SFR starts will be slower to increase, but will follow with an upturn in demand around 2016.

The inland valleys, on the other hand, will remain burdened by excess housing for some time to come.  Their current populations are likely to flee in large numbers to the cities, to be closer to jobs and civic amenities, to be replaced with lower-earning, unskilled and immigrant populations.

It will be far into the future before the Inland Empire and the Central Valley are able to return to the construction levels of the boom years. They will, however, be helped by an increase in industrial employment, as industries move inland to take advantage of the readily available low-income labor. The highway and airport infrastructure already exists. [For more on the divergent demographics of California’s coasts and valleys, see the first tuesday Market Chart, The distribution of California’s human resources, and Age and education in the golden state.]