ByAdam M. Zaretsky
National real estate markets have been booming for many years now. In fact, 1999 was the strongest year ever both for sales of existing homes and for new housing construction—almost 5.2 million existing single-family homes were sold, and more than 1.3 million new homes were built. Moreover, this stellar performance followed closely on the heels of what was a record year in 1998. By the third quarter of 2000, sales of existing homes and construction of new homes were both slightly behind their 1999 records, but still on pace to surpass the 1998 numbers.
The Eighth Federal Reserve District's seven states also enjoyed a record year of residential construction and existing home sales in 1999.1 More than 150,000 new single-family homes were built, and more than 840,000 existing homes were sold. As at the national level, both of these numbers followed on the heels of a record-setting 1998. By the third quarter of 2000, sales of existing homes in the seven District states appeared on track to set a new record, while new construction was off somewhat from a year earlier.
National and District nonresidential real estate markets have mirrored residential markets pretty closely.2 A record amount of space—more than 1.8 billion square feet—was built nationwide in 1999. That's up from the slightly more than 1.2 billion square feet built in 1996—a 50 percent increase in three years. In the District, more than 263 million square feet of nonresidential space were built in 1999—up 23 percent from the 213 million square feet built in 1996. Since the beginning of 2000, however, the fevered pace of sales and building in both residential and nonresidential markets has waned.
Healthy local economies, as well as a prosperous national economy, have been the driving forces behind the gains in real estate markets over the past several years. Despite all the claims about increased globalization and its effect on the domestic economy, local influences continue to dominate movements in real estate markets. This is so because housing and other buildings are immovable goods—a house cannot be moved from an area with a weaker economy to an area with a stronger economy. That said, District local economies continue to experience low levels of unemployment, notable job growth and better-than-average personal income growth.3
Much of the slowing in real estate markets has occurred because of the recent upward movements in interest rates. The average rate charged on a conventional 30-year fixed-rate mortgage recently bottomed out in October 1998 at around 6.7 percent. By August 1999, this rate had increased to slightly more than 7.9 percent—a jump of 1.2 percentage points in less than a year. The rate peaked in May 2000 at slightly more than 8.5 percent—another 0.6 percentage-point jump. In approximately a year and a half, then, the rate on a 30-year fixed mortgage rose 1.8 percentage points. Consequently, buying a home became a more expensive and, therefore, a more difficult achievement for some households.
A simple example helps illustrate the difference. By the third quarter of 2000, the average interest rate charged on a conventional 30-year fixed mortgage had dropped to around 8 percent. At this rate, the monthly mortgage payment for principal and interest on a $100,000 loan would be $734. To qualify for this loan, a household would typically need an annual income of about $31,500.4 The same loan at an interest rate of 6.75 percent (near the 1998 low) would have cost only $649 a month and required an annual household income of just $27,900—about 13 percent less. It's not surprising, then, that housing markets have slowed somewhat over the past year.
The District still contains some of the most affordable housing markets in the nation. According to the National Association of Home Builders (NAHB), housing affordability was down in the second quarter of 2000 when compared with a year earlier, which is not surprising given the rise in interest rates. Still, affordability is much better in smaller metropolitan areas and cities—especially in the Midwest—than in the larger coastal cities.
The NAHB computes its quarterly Housing Opportunity Index (HOI) by measuring the share of homes sold in a specific market that a household earning the median income in that market could afford to buy (see footnote on table below). The index uses a national, weighted average of mortgage rates from adjustable- and fixed-rate loans and accounts for differences in house prices by market area.
|HOI*||Median Price||Median Income|
As the table shows, housing is cheaper and more affordable in the District's major metropolitan areas than in the rest of the nation, with the St. Louis area being the most affordable.5 As the table also shows, this affordability has declined over the past year in all three District metro areas—a trend mimicked by the nation. In each of the District metro areas, income between the second quarters of 1999 and 2000 grew faster than the national average, while housing prices grew more slowly. Thus, the drop in housing affordability has not been as dramatic in the District as in the rest of the country. By the same token, real estate values haven't appreciated as quickly here as in other regions.
New residential construction in District metro areas hit an all-time high in 1999. By the third quarter of 2000, however, new construction in all but two District metro areas—Owensboro, Ken., and Texarkana, Ark.—was down from a year earlier. The declines in other areas not only reflect higher interest rates, which have slowed housing markets in general, but could also be an artifact of the data: Making comparisons with the strongest housing year on record almost guarantees that "slowing" will appear if even a bit of the market's steam has been lost.
Although nonresidential construction in the four major District metro areas has ridden the wave of the recent real estate boom, it too has felt the bite of higher interest rates, making such projects more expensive to finance and, therefore, less profitable and attractive. Through the third quarter of 2000, slightly more than 31 million square feet had been built in Little Rock, Louisville, Memphis and St. Louis combined. Over the same three quarters in 1999, that figure hovered around 42 million square feet. Total square footage built in 2000, therefore, has so far been off by more than 25 percent. This decline has hit all District metro areas, but has been sharpest in Louisville, where square footage is down by more than 40 percent. Memphis, on the other hand, has experienced the smallest year-over-year decline—only 7 percent. In all instances, the total amount of square footage being built today is much greater than it was three or four years ago.
Real estate markets were (and generally are) some of the first markets to experience the effects of rising interest rates. With the District and national economies remaining healthy, however, part of the recent slowing can likely be attributed to growth rates returning to more-sustainable, long-run trends. Does this imply a continued slowing in housing markets? Potentially. While the boom that real estate markets experienced in 1998 and 1999 probably won't be repeated in the near future, all indications are that sales and new construction in 2000—although not likely to break the records set in 1999—appear on track to run a close second.
Zaretsky, Adam M. "The District Economy: Still the Front Runner or Just Part of the Pack?" The Regional Economist, Federal Reserve Bank of St. Louis (October 2000a), pp. 12-13.
__________. "Was That a Soft Landing, or Have We Not Touched Down Yet?" The Regional Economist, Federal Reserve Bank of St. Louis (October 2000b), p. 19.