The House Price Hockey Stick

Macro economics is concerned with "the big picture", and micro with the small. Real estate is an exception which bridges between the two and real estate companies have to live with it.

Residential is a different scenario than the commercial mini-bubble in the making (last month's topic*). There is likely to be a collision of scarce supply and increasing demand that leads to a full-blown hockey stick of inflationary prices.

So, let us look at demand in the upswing of the next business cycle. Employment will be increasing, even if unemployment is falling only slowly. Wages drive housing demand, so that will be on the rise. To the extent that unemployed workers lost their homes during the Great Recession, there may even be some excess demand as they regain employment and re-enter the market.

On the supply side, you'd think that there would be a fairly smooth response of residential supply to increasing demand as employment climbs out of the present slump, but "entitlements" will cause its usual lag. Here's the "the entitlement process". Developing land is much more than simply going to the relevant jurisdiction and paying permit fees. Going from raw land, even if zoning is favorable, to "entitled land" for which permits CAN be pulled takes time. Often it takes a lot of time. If you think developing CRE is hard, residential is no easier. Yes, selling houses isn't as big a deal as renting floors in a Class A downtown office building or finding key tenants for a mall, but getting the NIMBYs to let you build houses at all is time consuming and costly. Yes, some entitled land will have been preserved from the last cycle, but there will be an inflationary lag in the supply of land.

The business cycle obviously impinges on real estate on the demand side, while "entitlement" impinges on supply. Business cycles are the macro fluctuation of the economy around the long term growth trend line. They often have about the same timing as the land development approval process. So we can see land becoming available for housing development just about the time the cycle is turning recessionary. Lennar took advantage of its superior knowledge to get the finance types at CalPERS to buy high and sell low on the recessionary side of the last cycle.

Another supply constraint is that homebuilders have reduced capacity. Not only will it be difficult to re-assemble labor forces, but the equipment will also have to be obtained. The whole process of gearing up is probably worth at least a year, more probably two.

Then, last but far from least, is the question of overall Consumer Price Index (CPI) inflation. Last time the CPI got over 5%, people started to flee money. One of their options was to buy houses. House price inflation, pardon me "appreciation", exceeded CPI inflation in the '70s. Housing was in fact an inflation shelter and more for most of those who owned in that period. Lesson learned? In this case, probably.

So expect, on the five year horizon, that all the "shadow inventory"** will be absorbed. Employment, wages and inflation will all be rising, while supply will not... I expect a house price hockey stick.

*http://www.charlesbwarren.com/minibubble.html

**http://www.charlesbwarren.com/shadow.html

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Charles B. Warren, MRICS ASA-urban real property Pleasant Hill 925.609.7241 www.charlesbwarren.com