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The US Census Bureau reported that new residential housing units were started at an annual rate of 1.549 million in May, a whopping 14.4% decline from April and 3.5% below the rate of starts in May 2021. The sudden cooling off was attributed to both rapid price appreciation and a sharp spike in mortgage rates moving affordability beyond the reach of many buyers.

Single family home prices rose by nearly 20% in 2021 driven by strong demand and exacerbated by critical shortages of materials and labor in the wake of the pandemic. But the housing crunch is not merely an artifact of the Covid supply chain disruption or the improvement in consumer debt profile and savings rates. The shortage of US housing has been building for nearly four decades and the market is still suffering a major hangover from the 2006 financial collapse.

The fact is that American housing construction has simply not kept pace with population growth since the 1980s. The April housing starts of 1.8 million units at an annual rate only just got us back to the 1998 level of new home construction and lags well behind the 2.5 million annual rate of the early 1970s. Meanwhile, the US population has grown by over 50% during that same period. And even though the Fed's ongoing rate hikes are dampening demand for now, the long-term imbalance will take many more years to abate.

While many remember the early 2000s as a period of excess in the residential real estate market, the fact is that construction of new dwelling units was just beginning to ramp up to meet population growth before the bottom fell out. It was not overbuilding per se but a confluence of factors relating to how the building expansion was financed that led to the catastrophic collapse that nearly took down the entire US economy. Persistent changes resulting from the crash have continued to hinder a full recovery in new construction ever since.

The factors leading to the 2006 crash are legion, including misguided government policy, the rise of nonbank lending, securitization of mortgage loans including subprime loans with lax underwriting, regulatory gaps, as well as greed and deceit by mortgage originators. It is estimated that $14 trillion in American wealth was destroyed, and that the average family suffered a 39% decline in net worth. Several reforms to mortgage lending and securitization were adopted in the aftermath of the carnage that made it more difficult to qualify for a home loan but also pushed some potential buyers out of the market.

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New privately-owned housing units started

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Perhaps the most significant factor in the underbuilding of residential units is the carnage suffered by homebuilders during the crash. Prior to the Great Recession, the direct and indirect impact of residential construction and sales accounted for 15%-20% of US GDP. As the result of the ensuing crash into 2007-2009, over half of all residential builders left the industry due to financial stress or bankruptcy. Nearly one quarter of all US mortgages went underwater, leading millions of homeowners to mail in their keys to the bank. Millions of skilled construction workers left their trade behind to seek other employment, creating a skills deficit that has yet to be supplanted. Many builders today attest that the pandemic merely accentuated an already acute shortage of skilled labor.

Complicating the general underbuilding of dwellings is the mix of new construction. New supply of entry-level homes is particularly constrained. The share of new single-family units under 1,400 square feet comprises only about 10% of all homes compared with about a third of all homes in the 1970s, leaving many first-time buyers shut out of the market.

Local zoning laws in many communities favor individual homes and severely limit permitting of multi-family units, even where local market demand prefers them over stand-alone houses. Meanwhile, the regulatory burden on contractors has increased exponentially over the past generation and according to the National Association of Homebuilders accounts for 25% of the cost of the average home. This makes construction of entry-level housing essentially unprofitable.

The magnitude of the construction shortfall can be seen in the accompanying chart which shows the ratio of new housing starts to the level of population going back to the early 1970s. The graph shows the general downtrend in homes started per 1,000 population and highlights how construction has yet to fully recover from the 2006 crash.

A report from the National Association of Realtors in 2021 notes that on average, new dwelling units per year since 2001 have averaged around 1.25 million compared with 1.5 million from 1968 through 2000, creating an estimated deficit of 5.5 to 6.8 million homes. The report states that "the scale of underbuilding and the existing demand-supply gap is enormous... and will require a major national commitment to build more housing of all types."

The current cooling of demand may provide some relief to allow stressed supply chains to normalize and to train more skilled workers. But the broader issue is complex, involving governments at every level to rethink lending, zoning, and regulatory policy to allow the market to respond appropriately.

Christopher A. Hopkins, CFA

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