There Will Be Demand for Housing

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Investor Bill Ackman was on CNBC yesterday discussing investments and the economy. He seems particularly bullish on the latter. "I think there's a decent chance that we massively outperform expectations," he told host Andrew Ross Sorkin.

The rationale is simple. Between collapsing prices and record-low interest rates, housing is now more affordable than ever. Factor in rising rental rates, and demand for new homes should rise dramatically. "Once unemployment stabilizes -- which, I think we're heading in the right direction -- all of the sudden people feel comfortable buying a home," Ackman said. That builds momentum that can drive the entire economy higher.

But hold on, warned former senator and co-host Judd Gregg:

How do you factor in the demographics? I mean, we're going from 35 million retired people to 70 million retired people ... the baby boom generation, the generation that basically drove the home market in the '70s, '80s, '90s, and 2000s ... they don't want to buy a home. They'd actually probably like to get rid of the home they're in ... It would seem we don't have the energy to buy homes that we did in the '80s and '90s.

Ackman's reply was, to paraphrase: Yes, but the baby boomers had kids. And they like buying homes, too.

I'd like to expand on that a little.

The baby boom generation was indeed large compared with their parents' cohort. But given the number of kids they had, the U.S. now has a fairly young population:

Age Cohort

Number of Americans (2010)

Percentage of Total Population

<2083.2 million27%
20-45102.7 million34%
45-7091.8 million30%
>7026.6 million9%

Source: Census Bureau.

That's important when forecasting housing demand. Over the long run, housing demand rests on one key number: new household formation.

Since 1947, an average of 1.2 million new households have formed every year. New home construction has averaged slightly more -- 1.5 million a year -- for two reasons: Some old and dilapidated homes are torn down every year, and we had massive housing overbuild over during the 2000s.

The bad news: New household formation fell off a cliff when the recession hit. In 2009, just 398,000 new households were formed, the lowest in decades. High unemployment among the young pushed a wave of people to move back in with their parents, and financial strains among older workers caused families to double-up in a single home. According to the Census Bureau, the number of individuals and families doubling up jumped from 61.7 million in 2007 to 69.2 million in 2011, and the number of those age 25-34 living with their parents rose from 4.7 million before the recession to 5.9 million in 2011. That drop in household formation is partly why new home construction plunged (it's now at an all-time low), and why it's been so hard to soak up excess housing inventory left over by the bubble.

Here's how a recent Goldman Sachs research report put it:

Holding headship rates within each age group constant at their 2007 level, growth in the size of the population and changes in its age structure would have warranted annual household formation of 1.3 to 1.4 million per year over the last few years. The reason that actual household formation was only about half that amount per year was a decline in headship rates within age groups -- and in particular, a sharp drop in the headship rate for persons aged 18 to 34.

But the dip won't last. Young folks living in their parents' basement and suppressing the urge to start a family can only handle it for so long. Once jobs bounce back -- and they are -- household formation will come back, too.

In fact, it already is. The Census' latest numbers show household formation hit 1.1 million in 2011, or close to the long-term average. That figure will almost certainly be higher this year and next as pent-up demand from those forced to delay starting a household during the recession get a chance to strike out on their own.

But the big question remains: What will long-term household formation be like going forward? Because that's what drives housing demand.

The good news is that our fairly young population and continuing immigration means it won't be half bad. Here's what Harvard's Joint Center for Housing Studies predicted (link opens PDF) in 2010:

[H]ousehold growth will average about 1.48 million annually in 2010-20. Even if immigration falls to half the Census Bureau's currently projected rate, household growth will still average about 1.25 million annually. This low-end estimate puts household growth in the next 10 years on par with the pace in 1995-2005, and should support average annual housing completions and manufactured home placements of well over 1.7 million units. The higher-end estimate would likely support production exceeding 1.9 million units per year on average over the coming decade.

Goldman sees between 1.1 million and 1.2 million new households formed every year for the next five years, and that assumes a conservative jobs growth of 150,000 a month for the next two years -- below what we've already achieved over the last year.

Bottom line: Despite retiring baby boomers, there will be demand for housing going forward. In fact, it will likely be in line, if not higher, than demand seen over the last several decades.

That's one reason I think homebuilding stocks offer opportunity for enterprising investors, albeit with heavy risk. I've given the green light to MDC Holdings (NYS: MDC) , KB Home (NYS: KBH) , and Meritage Homes (NYS: MTH) , among others, in my CAPS account. I expect all to outperform in the coming years.

Disagree? Let loose below.

At the time this article was published Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Motley Fool newsletter services have recommended buying shares of MDC Holdings and Meritage Homes. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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