Housing Market Monitor
Construction Slump Spreads to Non-Residential Sector
September 3, 2008
By Dean Baker
"Price declines in the bottom tier of the market will trickle up to higher-priced homes."The construction data for July indicate that non-residential construction might also be headed downward. Non-residential construction had boomed when the residential sector first turned downward in 2006. The end of the housing boom freed up labor and material to be used in non-residential construction. Since bottoming out in the third quarter of 2005, real non-residential construction has increased by almost 40 percent.
The increases in some categories of spending over this period have been especially dramatic. For example, nominal spending on lodging has increased by almost 250 percent from its lows in the summer of 2005. Nominal spending on manufacturing structures is up by 135 percent over the same period.
However, this boom appears to be ending. This raises two issues. First, an important source of demand growth for the economy will be lost. Non-residential construction added nearly a half percentage point to GDP growth over the last year. With consumption and residential housing heading downward, this increases the likelihood of a recession.
The other issue is that there was almost certainly some over-exuberant lending in non-residential construction just as there was in the residential sector. If the non-residential sector turns downward, this can mean another category of bank loans going bad, adding to the stress on the financial sector.
The Case-Shiller index last week provided more evidence of a divergence in prices between the high and low ends of the housing market, with the low end being hit much harder, especially in formerly hot markets like San Diego and Los Angeles. This is a predictable outcome of the collapse of subprime lending. On the demand side, buyers in these markets now find it much harder to get loans. The supply of homes has also been increased by the flood of foreclosures and distressed sales.
While it is not surprising that the low end of the market would be hardest hit by the subprime crisis, it is wrong to imagine that the effects will be confined to the lower end of the market. The housing market is inter-connected and there will inevitably be spillover. Homeowners who might otherwise move up to the middle or higher end of the market will find that they have much less equity to buy homes in the higher end of the market, due to the fact that their home has lost so much value. This will inevitably lead to a reduction in the number of buyers for higher-end homes.
This trickle-up process will eventually reach even the higher ends of the housing market. If homeowners who would be moving up from the bottom tier to the middle are unable to do so because of the loss of value of their home, then homeowners who would otherwise be moving up from the middle tier to the top tier will face the same problem.
The availability of much cheaper homes in the bottom tier of the housing market will also reduce the demand for higher-end homes. While many potential purchasers of higher-end homes may view the lower-end homes that are now plunging in price as being undesirable, when the price differentials become large enough, these lower-end homes will become attractive. Purchasers can take advantage of the large savings from buying a lower-end home to build additions or in other ways substantially improve the quality of these houses.
It is important to recognize that the different components of the housing market are connected, even if adjustments may take time. It was possible to recognize the bubble in the housing market earlier in this decade because there was no run-up in rents remotely comparable to the increase in sale prices. If the increase in house prices was driven by fundamentals, then it would have led to substantial upward pressure on both sale and rental prices. Similarly, sharp divergences between different segments of the market will be at least partially reversed. It does not make sense for housing prices in the bottom third of a metropolitan area to plunge, and for the rest of the market to be unaffected.
Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. (www.cepr.net). CEPR's Housing Market Monitor is published weekly and provides an incisive breakdown of the latest indicators and developments in the housing sector.