February 5, 2013

Cautious optimism seemed to be the dominant mood for the industry in 2012. Will that give way to something better this year? K+BB once again catches up with Kermit Baker, senior research fellow at Harvard University’s Joint Center for Housing Studies, to get his take on what to expect.

What is your outlook for the remodeling market in 2013?
Our most recent Leading Indicator of Remodeling Activity (released by the Remodeling Futures Program) was very positive—surprisingly positive. Since many of the elements we used to compute it were broader housing market indicators, such as existing home sales, housing starts, financing costs, clearly what pushed our leading indicator up is a broader recovery in the housing market. In the past, that has meant great things for remodeling, and hopefully, it won’t be any different this time. There is a lot of momentum behind the new residential construction market (off of a very low base), which saw 25 percent growth this year, and 25 percent is the consensus for next year. However, our leading indicator didn’t factor in a fiscal cliff, a blowup in the Euro debt problems or the Middle East. If they should sink the U.S. economy, the residential markets will follow. There’s still a risk that things are not going to be quite as rosy as our indicator is telling us.

What’s spurring the growth in new construction?
A better question might be: Why did it take so long? We’ve had unprecedented low levels of home building, but we’re finally starting to see growth in the number of households formed, which is the basic building block for housing demand. A lot of it is bounce-back from the housing bust and the distressed property situation. But the consensus on 25 percent growth for next year would take us to about a million housing starts for 2013. I think most analysts would agree once things get back to normal, the U.S. economy and our population can support 1.5 to 1.7 million housing starts. That’s what we averaged over the last several decades.

What factors do you see affecting growth in remodeling?
We’re on the upside of the distressed housing problem, which, for years, was reducing home improvement activity. If you couldn’t pay your mortgage, you weren’t improving your home or even maintaining it. If the home went into foreclosure, and most of them did, it would undergo a process that averaged two years in most states, resulting in a fairly large stock of homes that has been dramatically under-invested in recent years. As those come back on the market, banks are fixing them up to ready them for sale. Similarly buyers and investors are sinking a lot of money into improving them. We estimate about $10,000 is spent on average for every distressed home once it comes back on the market. In 2011, home improvement activity on distressed properties amounted to about $10 billion—a pretty significant chunk of overall market activity. As these markets turn the corner and more distressed properties work their way back to the market, what was a big minus for the home improvement industry will become a pretty significant plus. That’s going to provide a little pop for the industry for the next few years.

How many distressed properties are still working their way back to the market?
They’ve been coming off at the rate of about a million a year. We have about 3 million homes that are currently 90 days past due on their mortgage, which makes them targets for foreclosure.

Are some regions doing better than others?
For the last two or three years, the Northeast and Midwest have not been as hard hit by the housing downturn. They didn’t have as many distressed homes because they didn’t have as much construction. The markets that got overbuilt were most severely impacted. We’ll be issuing a report at the International Builders Show that looks at some of the strongest markets for home improvement spending. There are some names on that list we haven’t seen before: Phoenix, for example, is in the top five for spending per owner on home improvement activity in 2011 and is the prototype of the new market—very new housing stock and not a lot of home improvement spending on it. But it’s a market with a ton of distressed properties that has started to bounce back. By contrast, Las Vegas and the Florida markets aren’t quite as far in the recovery process. Atlanta didn’t see the downturn early and is now having trouble coming out of it. So we’ll have several on our top markets list that are not the traditional hot spots for home improvement spending.

What types of home improvement projects will people be doing?
For the distressed projects, they’re more exterior work. What has been weak for the last four or five years has been discretionary projects, particularly the upper-end kitchen and bathroom additions, which will slowly come back. The contractors we’ve talked to are saying the average size has kicked back significantly in the last several years. They just don’t see many $150,000 to $200,000 kitchens; the budgets tend to be more $50,000 to $70,000. And it’s not: “Come in, gut it and start from scratch.” The remodels are more product-based: replacing countertops, resurfacing cabinets or installing new appliances.

The financing issue is also difficult. Financing costs are very low, but banks have become more stringent about whom they will loan to. Typically, roughly 30 to 40 percent of the project activity on a dollar basis is financed, but now it’s probably under 20 percent. Increasingly, projects are done on a cash basis because households can’t get financing or don’t want to take on new debt and put their home at risk. Consequently, they’re less willing to increase the project budget by 15 to 20 percent to add a few extra goodies; if you’re financing, that might be an additional $100 to $200 a month, which is an easier sell. Contractors have to be much more sensitive to and work with the project budget they’re given.

Are you seeing any trends relating to the baby boomers?
Yes, we are, and our report covers them quite a bit. The baby boomers didn’t do nearly as badly as younger households because most have owned their home for a while. When prices dropped, that burned off some of the appreciation built up over the last 15 to 20 years but not all of it, leaving them with some equity in their home. Baby boomers are willing to continue to invest in their homes, and as best we can tell, their share of the market has been growing pretty significantly in the last five years.

Some industry experts are seeing a move into cities. Are you seeing this as well?
I work with the American Institute of Architects (AIA) on quarterly surveys on design trends, and what architects are telling us is the number one locational preference is infill housing in urban areas. So that’s true, but you have to put that in the context of the years from 2004 to early 2006, when at the peak of the boom, 2.2 million homes were being built on an annual basis. Big plots of land were needed to generate that level of production, so you were moving farther and farther out from urban areas for 200- to 400-unit parcels. Now, three to five-unit parcels are in demand, and you don’t go 50 miles outside a metro area for those because you also have to build all the infrastructure. Instead, you look for small, more convenient build-out lots, which tend to be more infill locations.

Secondly, the people looking for housing are often younger folks who want to rent. They don’t want to rent in the exurbs in a big single-family subdivision. They want something smaller, more convenient and more affordable. So the pressures have changed. We’re seeing, at least temporarily, a redirection of the location of activity, but this has more to do with the specific circumstances of the housing market and who at this point in time is really looking for housing. The national homeownership rate over this time has declined 4 to 5 percentage points, too, so a lot of people, including those forming households, are moving from owning to renting. And rentals tend to be in more urban locations, where there’s close access to public transportation or other conveniences.

As the market recovers, people will begin to seek more homeownership opportunities. When people get married and have children—a very familiar pattern—they’ll start looking at more suburban locations but probably not the big exurban developments because I don’t think we’re going to see that level of construction again for a long time. These “onesy, twosy” lots that are very convenient now will get built out and you’ll have to look for other opportunities. And it’ll be more inner locations rather than exurbs. So I don’t know if this is a huge back-to-the-city movement, where people suddenly decide they want to live downtown. It has more to do with the particular circumstances we’re in now.

Is there still interest in green design?
Green design has been a growing share of the market, partly because we’re seeing more replacement projects: roofing, siding, windows, doors. The projects are more geared toward maintaining the structural integrity of the home and were the ones getting tax credits during the stimulus program. They also tend to be more energy-efficiency-focused. If you ask contractors what share of their projects has energy efficiency as a goal, it has gone up. Is it because more households are fundamentally green in their outlook? It may well be. But it may also have a lot to do with what they think energy costs are going to be.
As an aside, we’ve had a kind of revolution in terms of new energy opportunities in the United States. With all the fracking that’s going on, natural gas prices have been driven down and now they’re beginning to frack a little more oil, too. A report by a European group came out on Veterans Day projecting that, based on all the new extraction technology we currently have, the United States will become the largest oil producer by 2020, surpassing Saudia Arabia. Environmental concerns can limit that production, too, but with the new technologies, there are more opportunities for traditional carbon-based energy resources.

But what is this going to mean for the sustainability movement? If energy becomes cheap again, are people just going to lose interest in trying to achieve more energy efficiency? It’s going to be an interesting dichotomy because energy independence has been one of the national goals for quite a while. And suddenly overnight, it looks like it might be materializing. We have to ask ourselves, “Is this really what we wanted?”

Has anything surprised you?
As I said, I was quite surprised our leading indicator was pointing to such strong growth as we move into 2013. But as I thought about it, that’s sort of the level of growth we’re seeing in the housing market, so it makes sense we’re seeing it on the home improvement side, too.

We’re going to spend a lot of time in this report talking about reinvesting in distressed properties, which has not been a topic we’ve ever covered before. We’re also going to discuss green issues and how much improvement we’ve seen in retrofitting the distressed housing stock. According to a Department of Energy survey, homes built in the 1950s, ’60s and ’70s use about 25 percent more energy per square foot than homes built over the last decade—not a big surprise but a pretty big number. The corollary to that is when we look at older versions of the same survey, the homes built in the 1950s to ’70s use 30 to 35 percent less energy now than they did 20 to 30 years ago. So you’re talking about a fixed stock of homes that has been improved through retrofits and energy upgrades.

The magnitude of that effect is greater than the differential between old homes and new homes, which just goes to show there’s more potential in improving older homes than there is in building new homes to higher standards, especially as we have 130 million homes in our housing stock.

What specific factors are you monitoring going forward?
We’re monitoring demographics quite a bit. We’re looking closely at how the baby boomers as a group continue to hold up the market and conversely, at how severely Gen X and Gen Y households have been impacted. Their spending is at fairly depressed levels relative to 5 to 10 years ago. When do they get back on the home improvement track again? Are they going to be as focused on their homes as prior generations? Are they looking to reinvest as much in their homes as prior generations? That’s a question that still needs to be addressed.