This is a 3 part series blog post on the housing economy. This is the second of the series of articles. The first article talked about the demand side. Please read that before you read this article.
The supply side is less intuitive compared to the demand side and requires a little bit more digging into to understand. When people think of the housing economy, they often gravitate toward the demand side factors but barring the people who really understand the housing economy, they don’t really think of the supply side. Without understanding the supply side, you can never get the full picture.
What is the supply side for housing?
Fundamentally, the supply side is determined by how many homes are available in the market. So, what drives supply? All the demand factors influence supply because they drive companies and developers to build more housing. But the supply side is a bit different because it is not just driven by new housing construction but also by the number of existing homes coming up for sale. Here is the kicker – Approximately 80% – 90% of the housing supply in the US is driven by existing home sales and around 10% – 20% by new home sales on an average. So while new housing gets a lot of press, its important to fundamentally understand the existing home supply even more. Let’s examine drivers for both.
Factors/drivers for new housing construction:
- Demand side factors (long and short term): These factors are very much like the demand side. Developers will decide to develop new housing by looking mostly the longer-term factors like demographic trends and diversity of the economy, but their short-term plans might be influenced by interest rates and the general state of the economy.
- Local government policies and regulations – this is something that is very local and can vary. So, some local governments (could be state or city government) may have policies that either restrict or promote new housing. Local zoning laws/policies have in a lot of cities prevented multi family development for example in the US. In recent years, we are seeing local governments ease off on that to help the supply situation.
- Return on investment – ultimately, developers will decide whether to build new housing based on the return on their investment. This is essentially whether the current prices of homes as compared to the cost of building homes can help give them a reasonable return. This has been a big story lately in the US during and after the pandemic. With inflation being so high, cost of labor and materials have skyrocketed and even though prices have gone up, developers for many projects are unable to justify the returns. For this reason, developers have said it no longer makes sense for them to build ‘affordable housing (housing that are smaller and tend to sell for lower prices which in Feb 2023 terms is housing lower than $200K approx.). They have stated they are unable to make a reasonable rate of return on these smaller houses (without any government subsidies or funding).
For the US, you can track this with the ‘New Housing Starts’ Metric published by the US Census Bureau.
Below is a chart of new housing starts in the US from the St. Louis Fed (FRED):
Factors driving existing home sales:
This is very different from the above and is driven by very different factors. In the US, you can track a metric in each local market that specifically calls out existing home sales. This represents a much larger % of the housing supply in general in the US and so is an important supply source to track. From my perspective, this is fundamentally driven by the price levels of housing in the economy. The factors are very similar to the demand side factors but more influenced by the short-term factors.
- Demand side short term factors:
- State of the economy: If the overall economy is doing great and unemployment tends to be low, people are interested in ‘upgrading’ their homes to larger homes and putting their existing homes for sale. Or people are relocating for better jobs and are moving to other cities and putting their existing home for sale. This is very normal and is part of the typical churn of housing stock.
- Interest Rates: But interest rates also drive this because people who are looking to upgrade housing will see if the current interest rates are fundamentally different from the interest rate, they locked in. For eg. at the time of writing this article in Mar 2023, interest rates are higher than they have been for a long time (>6%) and people who purchased homes prior to the recent interest rate hikes had mortgages at 3.5% or lower for most parts. This is driving a lot of people from re-thinking their need to move and reducing supply of existing homes.
- Level of equity and financial distress – Going hand in hand with the above short term demand factors that drives supply is the amount of equity people have on the properties and how challenged they are in meeting their monthly mortgages (which is tied to the overall economy health). In the US, during the 2008/2009 financial crisis, people had very low equity in their homes and high level of debt coupled with a bad economy. People lost jobs and were unable to make their mortgage payments. They were forced to sell their properties in distress (through foreclosures for most parts). The added nuance was the quality of the borrowers (sub-prime) which made them more vulnerable to the economy. More recently, in 2020-2022, the economy has been strong and people have a lot more equity in their homes. So they can afford to sit out of the market and wait and watch. This is of course slowly changing at the time of this article.
All of this is neatly summarized in the US in the form one measure – called months of supply. In general Months’ of supply refers to the number of months it would take for the current inventory of homes on the market to sell given the current sales pace. In the US, the National Association of Realtors (NAR) publishes this data every month. See this link for the most recent data.
So, if you have on average 6 months of supply, the market is said to be at equilibrium. If you have lesser than that, its considered to be a seller’s market (more demand than supply). If you have more than 6 months, it’s a buyer’s market (more supply than demand). During the 2008/2009 crisis and a couple of years following that, the months of supply in the US exceeded 6 months. In the decade following that until today, the months of supply is far below 6 months.
Below is a chart showing the supply of existing homes through the ‘months of supply’ of existing homes metric (Source: Ycharts.com)
Next week, I will close out this article series offering my analysis on the current US housing market. Thank you for reading and I wish you success in your personal finance journey!
Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.
