by Kermit Baker, PhD, Hon. AIA

With long-term interest rates remaining low and employment rebounding, 2004 was another record-shattering year for housing markets. For the fourth consecutive year, home building, remodeling, and home sales all continued to climb. Single-family starts hit their highest level ever, improvement spending easily eclipsed its 2003 record, and new and existing home sales approached 8 million.

House price appreciation was up 10.6 percent nationally—the largest one-year surge posted since 1979. Higher prices, together with interest-rate increases on adjustable mortgages, made it more difficult for many first-time buyers to break into the market. Even so, many households rushed to take advantage of still-attractive interest rates and buy in advance of potentially higher prices. As a result, homeownership posted an all-time high of 69 percent last year, with households of all ages, races, and ethnicities joining in the home-buying boom.

The rising tide of housing wealth gave consumer spending another lift. In combination with historically low mortgage interest rates, house price gains last year sparked near-record cash-out refinances and home equity borrowing. Although refinancing activity dropped by nearly half in real terms to $1.3 trillion, the amount of equity borrowers cashed out held fairly steady at $139 billion while net growth in second mortgage debt almost doubled to $178 billion. As cash-rich households stepped up their spending, housing wealth effects again accounted for a third of the growth of personal consumption last year.

Persistent house price concerns
With house prices rising so rapidly over the last few years, there is a concern that house price bubbles may have formed in many areas. Ratios of house prices to median household incomes are certainly higher than in the past, with more than half of evaluated metros hitting a 25-year high in 2004.

Indeed, over the past five years the number of metros with median house price to household income ratios of 4 or more shot up from 10 to 33. About one-quarter of the nation’s households live in these 33 metro areas, which include most of Southern California, New York City and surrounding metros, and the larger metros of Southern Florida. Outside of these high priced markets, however, most metro areas have relatively small and stable ratios. Fully 77 of 110 of the largest metros have ratios under 4. Thanks to lower interest rates, housing remains affordable in these places. But in the others, first-time buyers are struggling to keep up with escalating housing costs despite prevailing interest rates.

Whether the hottest housing markets are headed for a sharp correction is another question. The current economic recovery may give house prices in these locations the room to cool down rather than crash if higher interest rates slow the sizzling rate of house price appreciation. Moreover, in several metros where prices have risen the fastest, natural or regulatory-driven supply constraints may have led to more permanent increases in house prices.

Still, the recent uptick in investor loans does give pause. Between 1998 and 2003, the share of home purchase loans to others than owner-occupants climbed from 7 percent to 11 percent. While this is likely a signal that speculation has begun to creep into the single-family market, it also reflects strong growth in vacation home demand.

For now, though, house prices are likely to keep going up as long as job and income growth continue to offset the drag from the recent jump in short-term interest rates. House prices would come under greater pressure, however, if the economy stumbles and jobs are lost.

Favorable long-run fundamentals
Thanks to immigration, household growth is likely to accelerate over the next 10 years. With family reunification laws and the extraordinary appeal of the open US economy, the number of new arrivals could easily top the 1990s record of about 10 million. As a result, immigrants are expected to account for about one-third of net household growth in the decade ahead.

At the same time, the children of immigrants who arrived in the 1980s and 1990s are about to become a force of their own in housing markets. These second-generation Americans now account for 21 percent of children between the ages of 1 and 10, and 15 percent of those between the ages of 11 and 20. If history is any guide, members of this generation are likely to out-earn their parents and thus become an even greater source of housing demand in the next two decades.

Immigrants—particularly Hispanics and Asians—have also lifted the growth of minority households. As a result, over the last 10 years, the minority share of first-time home buyers has already expanded from 22 percent to 35 percent, of new-home buyers from 13 percent to 24 percent, and remodeling homeowners from 12 percent to 19 percent.

Although their homeownership rates still lag white rates by about 25 percentage points, minorities are clearly making economic progress. Between 1980 and 2000, over 6.2 million minority households joined the ranks of middle-income earners—a number nearly equal to that of whites. In fact, households of all ages, both white and minority have benefited from the strong income and wealth gains of the past 15 years, which in turn is strengthening housing demand across the board. As each successive generation spends more on housing and remodeling than the one preceding it, residential fixed investment will set new records in the decade ahead.

Decentralization pressures
Demand for new homes is on track to total roughly 20 million units between now and 2015. The vast majority of these homes will be built in lower-density areas where cheaper land is in more ample supply. With each passing decade, metropolitan areas are sprawling more and more into what were once non-metro communities.

People and jobs have been moving away from central business districts (CBDs) for more than a century. Today, the number of the country’s largest metros with more than half of their households living 10 miles from the CBD has more than tripled from 13 in 1970 to 46 in 2000. Those with more than a fifth of households living at least 20 miles out has likewise jumped from 17 to 44. And in seven metros, more than a fifth of households live at least 30 miles out.

As sprawl continues, commute times of an hour or more are increasingly common. Indeed, the number of workers with such long travel times increased by 3.1 million in the 1990s. Lengthening commutes and worsening congestion are keeping demand for newer units in and near city centers robust, adding to the premium households must pay to live closer to employment centers. Without looser restrictions on higher-density construction closer to city centers, though, the lion’s share of new households will live in cheaper, outlying areas.

Meanwhile, worsening congestion, longer commutes, and higher infrastructure costs will no doubt add fuel to the smart growth debate. With sprawl encroaching further into undeveloped areas, calls for allowing higher-density developments near city centers will get louder even as those opposed to new development dig in their heels.

Housing affordability challenges
Despite only modest increases in rents in recent years, growing shares of low- and moderate-wage workers, as well as seniors with fixed incomes, can no longer afford even a modest two-bedroom apartment anywhere in the country. Today, nearly one in three American households spends more than 30 percent of income on housing, and more than one in eight spend upwards of 50 percent.

Even these sobering statistics understate the true magnitude of the affordability crisis because they do not capture the tradeoffs people make to hold down their housing costs. For example, they miss the 2.5 million households that live in crowded or structurally inadequate housing. They also exclude the growing number of households that move to locations where they can afford the housing, but must pay more for transportation.

Among households in the lowest expenditure quartile, those living in affordable housing spend $100 more on transportation than those who are severely housing cost-burdened. With total average monthly outlays of only $1,000, these extra travel costs amount to 10 percent of the entire household budget.

Meanwhile, the stock of affordable rental housing is shrinking rapidly. Additions are occurring only at the upper end of the rent spectrum while heavy losses continue at the lower end. As a result, increasing numbers of lower-income renters are spending half or more of their incomes on housing at the sacrifice of other basic needs.

Expanded access to credit has permitted more low-income households to buy homes in recent years. But many are making the leap with little in savings to cover their mortgage payments in the event of a temporary financial setback. Furthermore, many of these renters have blemished credit records that add to their financing costs.

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