New home construction lags previous economic cycles and appears to be shifting away from single-family housing to multifamily rental units. Is this due to a lack of financing for new construction specific to this cycle or to underlying demographics, labor market dynamics, land use and availability, or to behaviors and preferences, especially among millennials that impact demand? To get a perspective on these questions, we spoke with Donald H. Layton, chief executive officer of Freddie Mac.
Q: Why hasn’t housing sector construction responded to the historically low interest rates of the last eight or so years?
A: There is no one simple answer to this question but rather a mix of cyclical and structural factors and changes affecting both demand and supply that are reshaping the housing sector. Comparing the performance of the housing sector to long-term trends provides a useful framework for talking about these dynamics.
Prior to the 2007–08 financial crisis, the long-run average for single and multifamily housing starts was roughly 1.5 million new units per year — 1.1 million units for single-family and 400,000 for multifamily. Multifamily starts have only recently returned to their long-run average, but single-family construction still lags — eight years after the financial crisis — running at only 800,000 units per year. Thus, something pretty fundamental seems to be going on.
Q: To what do you attribute this shift in mix between single-family and multifamily production? Income and credit worthiness? Or, are such things as age, lifestyle changes, and buyer preferences impacting the housing sector?
A: It’s more than one thing. For example, the average person is forming a household at a later age than past generations. Also, the shift in preferences of the millennial generation toward a more urban lifestyle is also striking and will result in a greater mix of rentals on average.
Q: Do you regard these trends as permanent? As millennials start having families, are they likely to want a more suburban lifestyle?
A: Even if the average person forms a household later, there is a new equilibrium going forward on average which will produce a different mix of single- and multifamily housing than in the past. Some of the lifestyle changes do seem to be permanent, rather than just cyclical, favoring more multifamily and possibly multi-use structures in urban areas than in the past.
Q: Perhaps buyers are responding to historically low interest rates, but builders are not. Is it the supply-side that is driving the level and mix of construction or demand factors?
A: I think both supply and demand factors are at work. On the supply side, there are some very noteworthy things going on.
First, 40 percent of skilled workers in the housing sector are reported to have left in the wake of the financial crisis and have not yet come back. This is obviously somewhat cyclical, but builders still complain about labor shortages, so some may be structural as well, possibly relating to immigration issues.
Second, banks have become more conservative and are reluctant to finance construction. Regulators have publicly weighed in that they should be cautious, given the history of excessive construction lending in past cycles. Thus, you have a much more cautious construction industry that is reluctant to start new projects without well-established market demand.
Also, cash-strapped city and local governments are reported anecdotally to be charging higher fees for things like permits. We need to also take into account reported supply-side restrictions on land use. It’s now apparently taking a much longer time to develop land and acquire permits to build. It was obviously a lot easier to open up the next block of acreage in the exurbs prior to the financial crisis than it is to begin construction in urban settings these days.
Finally, and I think very important, are the growing gaps in price and often supply between cities that are considered desirable places to live compared to other cities around the country, reflecting job growth and lifestyle differences.
Q: Even taking lifestyle preferences into account, aren’t employment and income a factor?
Prices are definitely higher in areas with employment and income growth but remain depressed in other cities. You will find the biggest shortfall in supply in some of the most desirable areas.
Examples of the most desirable cities include San Francisco, Austin, Boulder, Seattle, New York, and many others — technology-related employment seemingly playing a big role. Some older industrial areas just don’t seem to be attracting people with job growth in the same way.
Q: And we see these pressures in prices, right?
A: Absolutely. Nationwide, on average, house prices have roughly just recovered to their pre-crisis peak. But this hides a tale of two cities — the “winning cities” are way above the national average, and others cities have not gotten close to recovering. 1
Q: Given the mixed signals in the supply and demand dynamics of housing, how does this affect financing? Are there any new types of financing arrangements that could get the housing sector growing again?
A: For single-family housing, mortgage financing is readily available for people who can indeed carry the mortgage. But the new Consumer Financial Protection Board “ability to pay” rules require lenders to make a reasonable effort to be sure that borrowers can repay their mortgage, so we’re certainly not seeing the laxness that contributed to the bubble. And rates have been at record lows until just recently, which definitely improves affordability.
However, the sources of mortgage financing have shifted. Large lenders are very cautious given the number of lawsuits and liabilities they were subjected to after the housing crisis. On the other hand, smaller lenders are not as cautious. For example, FHA and VA mortgages — which are securitized through Ginnie Mae — that were designed to provide credit to more risky borrowers are now at record volumes.
Q: What factors are driving the Ginnie Mae system? Are they economic or regulatory, or both?
A: FHA and VA — which are the actual lenders in the Ginnie Mae system (Ginnie just does the securitizing) — are under direct control of the presidential administration. After the peak of the crisis passed, the decision was made for FHA (the much larger of the two) to take a more aggressive role in lending.
For many riskier borrowers, FHA pricing is simply cheaper than what the GSEs or other sources can offer, and so their market share has been growing. I note, of course, that FHA and VA loans are not available to finance large and expensive homes because there is a limit to the size of the mortgage they will insure just as there is for the GSEs (known as the conforming loan limit).
Q: Does subprime lending still exist?
A: The answer is that it is very small in the commercial sector and for the GSEs. The Consumer Financial Protection Board sets the rules for what is called “QM” (qualifying mortgages) to prevent people who really can’t pay back the mortgage from borrowing. Some would classify FHA loans as the closest we have today to subprime lending in size, although I’m not sure that characterization is accurate.
Q: Is the book of loans under the FHA insurance program risky enough that the taxpayer is exposed to the potential of losses again?
A: Yes, , by definition of how the government guarantees the loans. The FHA does not have “capital” per se, just a 2 percent reserve according to an actuarial study, as opposed to standard GAAP accounting. Therefore, the taxpayer has a significant implicit risk position supporting FHA if one considers how much capital in excess of the 2 percent reserve a private sector firm would be required to keep by the financial regulators.
Q: Are we sowing the seeds of the next housing finance bubble?
A: No, the housing crisis is not likely to repeat again in the foreseeable future. The causes of the crisis were many, but at its heart was a leveraged housing price bubble combined with a highly leveraged financial system. Not only are borrowers and lenders much more cautious now, but all the reforms (for example, as found in Dodd Frank) have reduced leverage overall in the financial system, housing included. So, for example, in cities where home prices are quite elevated, it does not seem to be due to excess leverage; it is instead due to supply not meeting growing demand.
Q: What more can government do to spur the return of the housing sector?
A: Well, first let’s get on the record that the government already does a lot to “spur” — your word — the housing sector. First up would be the tax deduction for mortgage interest. Then there are the GSEs and the home loan bank system, which enjoy government privileges that help enable them to finance mortgages cheaper than would otherwise be the case. Then there are state and local government efforts to help as well. I live in New York City, and both the city and state have agencies designed to help finance housing construction inexpensively.
I note that there are proposals being discussed in Congress to lower the personal tax rate and broaden the tax base. This calls into question the deductibility of mortgage interest and state and local property taxes. This lack of clarity makes buyers more uncertain than before about the economics of owning a home. We just don’t know what the changes will be and how they will impact demand.
In addition, the proposals to reduce tax rates strike at the economics of the Low Income Housing Tax Credit program. So there is uncertainty in that sector as well. Again, it is unclear how it will play out.
Q: Has the government taken over from the private sector?
A: The wording of your question is very “all or nothing.” In fact, the government has been involved in the housing sector for a long time, starting back in 1932 with the creation of the home loan banks. The GSEs have played a large role for a long time, and the thrifts were also important for many decades. In fact, there are only two large sources of financing that don’t involve these institutions in some manner.
First, the PLS, or private label securities, market — securitizations of mortgage loans without a government or government-supported company’s guarantee to the investor — was a small sector that boomed during the housing bubble. It collapsed in 2007–08.
Many people think it should come back in large size again – in fact, there have been many efforts to “restart” it, including by the U.S. Treasury. None have been successful. My personal opinion is that this is because it has fundamental flaws which the crisis revealed, and the ability to fix them seems to be low. I expect it to play a relatively limited role in the future.
Second, banks can hold mortgages on their own books. But they only want so much of the housing finance market because they cannot handle 30-year fixed-rate mortgages, especially ones with free prepayment, sitting on their balance sheets. Remember the thrift crisis — that revealed the fallacy of sitting on such mortgages in large size.
When people talk about reforming the GSEs, you sometimes hear arguments for abolishing government support to the mortgage system. Most professionals I know, however, believe there is no credible private-sector-only alternative to replace the $4 trillion-plus guarantees now on the books of the GSEs at any reasonable cost. Their conclusion is that some sort of government support is therefore necessary for a vibrant housing sector.
I note that, to the ordinary borrower, today’s mortgage financing market — with the GSEs in conservatorship — is actually working pretty well.
Q: What is the role of “investment” capital in shaping the marketplace?
A: Returning to the question of financing for multifamily housing, much of the recovery in multifamily housing has been financed by institutional investors through specialized real estate fund managers. In fact, these funds have been one of the best investment sectors during this cycle. I also note that these investments are not unduly leveraged, so there’s no obvious bubble-about-to-pop developing.
In terms of single-family housing, there are many articles about professional investors buying up single-family houses and renting them out — turning them into a hybrid between traditional multifamily rentals and single-family ownership. It is too early to tell how big or important this will be long-term. So-called Mom and Pop investors have traditionally dominated this space. We shall just have to see how it plays out.
Q: Given the current shortage in desirable urban housing, where do you think the equilibrium in the housing sector will settle?
A: It’s obviously not fully clear just yet. But most long-term trends point to a new equilibrium that is somewhat more multifamily and less single-family than previously, somewhat more urban than previously, somewhat denser than previously (which has positive environmental results, by the way), and with more dispersion between places that have net in-migration and job growth and those that do not.
1 For a look at the relationship between metro area housing prices and 2016 voter patterns see Did the Lagging Housing Recover Impact Election Outcomes?
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