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By Dirk van Dijk, CFA

The party in Housing Starts and Building Permits is over, and the industry is now dealing with the hangover. With the homebuyer tax credit now over (people have until the end of June to close, but contracts had to be signed by the end of April), housing starts have plummeted.

In May, total housing starts fell by 10.0% to a seasonally adjusted annual rate of 593,000. That is up just 7.8% from the extremely depressed levels of a year ago. The level of starts was well below consensus expectations of a 655,000 annual rate.

Even those dismal numbers understate the damage. For starters, April’s numbers were revised down to an annual rate of 659,000 from an originally reported 672,000. Thus, from where we thought we were, the drop is more like 11.8%.

Further, the number was cushioned by a big increase in the very volatile apartment and condo segment. The number of starts in buildings of five or more units soared 38.3% to an annual rate of 112,000, although that is still 17.0% below the year-ago level.

When most people think of housing starts they think of single-family houses. Those declined 17.2% on the month but are up 15.3% from a year ago. The graph below (from CalculatedRisk) shows the history of housing starts, both total and single family.

The damage was concentrated regionally in the South, which is by far the largest, and thus most important of the four census regions when it comes to housing data. Housing starts in Dixie plunged by 21.3% to an annual rate of 228,000, although that is up 4.7% from a year ago. In other words the region was responsible for 38.4% of all starts, down from 55.5% in April.

The April percentage was about normal; the May percentage was the lowest seen in a very long time. The Northeast, which is the smallest of the four regions, was the next weakest with a 6.3% decline, but up 25.0% from a year ago. The other two regions actually saw an increase in housing starts, with the Midwest seeing a 4.9% increase on the month and up 35.4% year over year, while the West saw a 10.8% jump on the month, but it is still down 9.6% year over year.

Housing Starts, Historically

As the graph shows, normally housing starts begin to fall before a recession starts, but then rebound strongly just before the end of the recession. Residential investment is thus normally one of the most important locomotives in pulling the US economy out of a slump (and declines in housing starts one of the key reasons we go into recessions). That locomotive has been derailed so far in this recovery, and that is one of the most important reasons why this recovery has been so anemic.

The 2001 downturn was an exception to the rule about housing, largely being responsible for causing (or at least being the transmission mechanism for) recessions. The housing bubble in the middle of the decade caused an enormous number of houses to be built, and a huge percentage of them were McMansions built in the ex-urbs, far from employment centers.

When the bubble popped, home prices plunged, and millions of people were left with houses that were worth less than what they owed on their mortgages. For a large number of those people, the most economically rational thing for them to do now is simply stop paying their mortgage and wait for the sheriff to knock on the door and kick them out. In most areas of the country, people can now live rent- and mortgage-free that way for over a year. However, eventually they will be kicked out, the banks will take over and want to sell the house.

This is the "shadow inventory" of housing, and it is huge -- most likely totaling over 5 million houses. With so many excess houses on the market, it is not really economically rational to be building more of them, from a big picture point of view.

However, residential investment is normally what pulls us out of slumps. Each new house built creates an enormous amount of economic activity (used home sales, even though they are far more numerous, do not have anything close to the economic impact of new homes). Building a house employs lots of carpenters, plumbers and electricians. Those are relatively good-paying jobs for people who do not have a lot of formal education. They are also jobs that are very tough to outsource to China or India (although given the number of undocumented workers in the industry, some might say we “outsource” much of the work to Mexico).

Beyond that, building a house will generate a demand for wallboard from USG (USG), lumber from Weyerhaeuser (WY) and plumbing fixtures from Fortune Brands (FQ). Those primary jobs then support other jobs as those workers then have enough money to go shop at Wal-Mart (WMT) or go out to eat at Pizza Hut, which is part of Yum! Brands (YUM).

Total housing starts, and especially single family starts are below the worst levels seen in previous recessions. The only other slump that comes close was the 1982-83 recession, and in that case the Fed was trying to wring inflation out of the system, and to do so they jacked up mortgage interest rates to almost 20%.

Now mortgage rates are at historic lows. The population of the country has also been growing at about 1% per year since the 1960’s and 1970’s. More people should mean more demand for places to live. The problem is that the rate of household formation is extremely low.

Household Formation

"Household formation" is economist speak for getting junior out of Mom’s basement and into a place of his own. It is also about getting people who have lost their homes and are now doubling up with friends or families into their own places. In both cases, the key to doing so is for those people to have a steady job so they can either pay rent or pay a mortgage.

But coming out of a recession, housing-related industries are normally one of the biggest engines of job creation. The construction industry was one of the hardest hit during the recession. It has lost 1.944 million jobs since the start of the recession, or more than one in four of all jobs lost in the downturn, even though at the start of the recession it accounted for just 5.46% of all jobs in the country. If those jobs are not coming back, then it is going to be tough to get household formation going, and without household formation, we will not absorb the existing oversupply of houses. Chicken meet egg; egg, chicken.

Disclosure: No positions

Source: Housing Starts' Hangover