Markets & Economy

Starter homes: Low supply meets low demand?

What the housing crisis and new attitudes toward homeownership mean for starter homes

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Across the country, the low inventory of homes for sale has dominated housing headlines, limiting stronger sales growth while fueling large price gains and ultimately feeding into the problem of declining affordability.

The National Association of Realtors (NAR) has noted the particularly low number of starter homes for sale as a key factor keeping potential first-time buyers on the sidelines. According to NAR, the percentage of first-time buyers continues to hover at a low level, accounting for just 30 percent of home sales this past month.

It’s logical to point to a low inventory of starter homes as a key stress point that would otherwise enable a higher homeownership rate, which is undoubtedly true. Potential first-time buyers are also grappling with unprecedented student debt, surging home prices, and stricter lending standards, all of which inhibit their path to homeownership.

However, according to a recent Bank of America report, a weaker underlying demand for starter homes may be a deceptive culprit that is also keeping first-time buyers at bay.

The Bank of America Homebuyer Insights Report features survey results from a thousand adults throughout the country who want to buy a home in the future, and some strong preferences emerge from the results:  A whopping 75 percent of potential buyers indicated that they would prefer to skip purchasing a starter home and instead go with a home that meets their future needs, with 69 percent saying they would rather save money to purchase a nicer home in the future than move into a starter home right away.

When potential buyers were asked why they have not yet purchased a home, 56 percent responded that they did not think they were able to afford the type of home they would want, which could partially reflect the deteriorating affordability for homebuyers, but also reveals the desire to buy something more than a traditional starter home.

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Additionally, more than one third of respondents also said they want to retire in their first home, a swift departure from the concept of purchasing a starter home and eventually trading up.

These figures all point to softer demand for starter homes.

In the aftermath of the housing crisis, people no longer universally see houses as the stable investment they once were; they are more aware of the risks of owning a home that does not always increase in value. This includes homeowners that were directly hit by the crisis a decade ago, as well as many millennials who witnessed the damage.

The prospect of being underwater or trapped in a starter home following another downturn is a real concern. As a result, it appears that many prefer the security of only buying a house if they are prepared to live there for many years, alternatively choosing the flexibility of renting in the short term to avoid this risk or staying at home with their parents to save money for a better home, contributing to the elevated number of renter households and young adults living at home.

This perspective and new housing liquidity preference puts a damper on demand for traditional entry-level homes.

This dovetails with a recent Trulia report that suggests demand for starter homes is declining in a number of U.S. metros.

Trulia divides housing stock into three different segments: starter homes, trade-up homes, and premium homes. In the report, it notes that in 20 of the 74 metros where starter home inventory has fallen, prices have also fallen.

This is counterintuitive to the national narrative on low housing inventory, where tight inventory levels are sparking substantial price gains as competition intensifies among buyers, and instead suggests that significantly lower demand for starter homes is cutting prices in certain metros despite falling inventory for the segment.

In the same report, Trulia also provides insight on a national level by evaluating the 100 largest metros in the country. In the second quarter of 2016, the median list price for US starter homes rose 6.4 percent year-over-year after facing the pressure of a 12.3 percent annual decline in inventory. Over the same time, premium homes saw a larger 7.9 percent price increase, but inventory levels were nearly flat.

While the inventory reduction for starter homes is still spurring price gains, this discrepancy suggests comparatively weaker demand for the segment than for premium homes, again aligning with the Bank of America results that point to buyers’ preference toward skipping starter homes.

The outlook for traditional starter homes is clouded. Recent reports suggest that increased costs for building starter homes, resulting in part from rising regulation and associated fees, are squeezing profitability and steering homebuilders away from starter homes.

The size of new homes continues to rise across the country, reflecting both the higher standards sought by homebuyers and where homebuilders’ greater profit margins are found.

The growing disincentive for homebuilders to focus on this starter segment will undoubtedly hurt inventory and further deteriorate affordability prospects for potential homeowners.

While low inventory is still meeting solid housing demand across the country, including starter homes to some extent, underlying demand for starter homes may be softening, and the size of this market may decline as buyers and builders alike show an increasing disaffection to it.

The desire to ultimately own a home may be alive and well, but it seems that a number of first-time buyers may be willing to wait it out for something more than a traditional entry-level home.

Read the full article in the August 2016 Housing News Report.

Peter Muoio is the chief economist at Ten-X.