Household formations then and now

Although somewhat counterintuitive, households typically form prior to the occurrence of homeownership.

Think of rentals as incubators for eventual homeownership — often a kind of walk-before-you-run scenario. Thus, it makes sense to study household formation as a leading indicator of housing demand.

During the Millennium Boom about 1.35 million households were formed in the U.S. each year. From 2006 to 2011, the rate of household formation declined precipitously, falling to about 550,000 each year, according to researchers at the Federal Reserve Bank of Atlanta.

This may seem like an unfair comparison, pitting two extremes in the housing market against one another. However, the rate of household formation over the last five years has been lower than any previous five-year period, including other recessionary periods.

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The economics of household formation

Aside from its obvious effects on housing demand, retarded household formation has affected overall economic growth considerably. During previous recoveries, demand for new homes contributed upwards of 1% to 1.5% to GDP.

During this recovery, the average has been close to zero.

Although it’s difficult to link specific credit circumstances to the decline in household formations over the last five years, it goes without saying that the global credit crunch has severely limited mortgage originations. This axiomatically hinders housing demand. In fact, one could argue the lack of demand for housing over the last five years is entirely a problem of restricted credit availability, just as the Millennium Boom resulted from too much credit availability.

Recall that demand is not simply the willingness to buy, but also the ability. In absence of this ability, which only cash-flush investors and speculators have of late, household formations and housing demand has maintained a consistent decline as Americans have learned to live with less — a declining standard of living with a simultaneous decline in incomes and credit availability.

That’s right. In spite of the recent resurgence in housing demand reported in the over-zealous media, it is abundantly clear this so-called “demand” is none but real estate speculators recycling properties. They are essentially creating a new brand of shadow inventory, replacing REOs and short sales with single-family residence (SFR) rentals. Keep in mind most will stay rentals only temporarily. A vast majority will be returned to the market en masse for sale — increasing supply in an environment of low demand, driving prices downward.

Will demographics save us?

Demographics are the leading cause of household formation over the long run, according to the Fed’s study. All other factors remaining equal, household formation increases in tandem primarily with age.

The most dramatic spike in formations takes place between the ages of 18 and 30, jumping from a 20 percent head-of-household rate to 50 percent. From age 30 on, the rate of household formation slows but continues at a steady pace.

As a general rule, older populations will have a greater rate of household formation since older people typically reside in smaller households. The aging U.S. population, which has been on a steady and inevitable incline since the post-war Baby Boom, has resulted in a steady growth of household formation. Census bureau data suggests the Baby Boomer generation will continue to add to household formations as they age, creating smaller and thus a greater number of households at least through 2020.

The question remains however, will this increase in household formation take place by way of homeownership or by way of rentals in urban city centers?

Although historical data suggests that when given a choice, previous homeowners do not go back to renting, it may be the case in this epoch of California real estate history that downsizing Boomers will be renting apartments rather than buying condos.

Once again, the ratio of incomes to home prices comes in to play here. Many Boomers looking to downsize do so on a fixed income. At least in the case of social security, this income keeps pace with inflation at best, and shrinks at the rate of inflation annually at worst.

Income disparity and home prices

In recent years, despite the lack of organic end-user demand, housing prices have been consistently inflating above their mean price, which is effectively benchmarked to the rate of inflation, plus one percent or so for average appreciation brought on by increases in population density.

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Real estate speculation is artificially inflating real estate prices on the cusp of the Boomer generation’s retirement — just as they may be reentering the market looking to downsize. Their decision may well be to rent, not own, if builders are quick to the drawing board with amenities for multiple unit construction.

While the foregoing market factors discussed certainly go far in presenting a future picture of the California market, the x-factor of emotional motivation must also be considered.

The key here is that this confidence, as some call it, is also determined by very concrete material factors as well — namely jobs. The longer this Lesser Depression in job recovery drags on, the more confidence will be held down long term. True irrational exuberance among the underclasses will be inhibited for years to come as we slowly heal from the 2008 recession.

This is precisely why the issue of income disparity and employment remain paramount in today’s discussion regarding future predictions of the real estate market. In previous years, particularly the Millennium Boom, income and general wealth disparity was as much of a reality as it is today. However, the ease and availability of credit closed that gap, sending our massive debtor class into an unrecoverable tailspin.

The debtor class, especially in California, crashed into an abyss of negative equity, job loss and lower incomes and they have yet to recover. Let’s be clear, the spike in home sales volume of late is not commensurate with past household formation trends! The simple reason for this is that properties are currently being shuffled from owner-to–bank- to-speculator, still with no true end-user on the scene.

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Don’t forget interest rates

It’s clear the California real estate housing market will eventually benefit from the demographic drivers of an aging population and steadily improving jobs market.

But the two financial barriers to these two potential panaceas are incomes and interest rates. The abysmally low savings rate might also be considered among this list.

In practice, not much can be done directly about income disparity. This is an issue that can only work itself out after we reach near-full employment. There must be an unfulfilled demand for labor before workers have any leverage to demand wage increases and a redistribution of company profits.

At present, California has an over-abundance of qualified workers in all sectors of the labor market and lack of demand for their services — not a particularly rich environment to encourage corporate sharing, pardon the pun.

Interest rates, however, are a different story. The problem of rising mortgage rates and commensurately lower home prices might be mitigated by a revival of loan assumptions on acquisition by buyers looking to keep the 3.5% interest rate of yesterday’s mortgage originations.

California, by its sheer size in the mortgage market, is especially poised to make this possible, but it would take the political and legal will of the real estate community and Attorney General.

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