Fundamentally Sound

Kermit Baker, the economist who oversees the Remodeling Futures Steering Committee of Harvard University’s Joint Center for Housing Studies, makes it a policy not to issue a specific annual forecast for the remodeling market, but thankfully, that does not stop him from providing an outline of what to expect over the next 12 months.

Broadly, the remodeling market, which according to some estimates crossed the $290 billion threshold in 2007, was beset by two forces last year that impacted the remodeling markets in pockets around the country. In Michigan, Ohio and many parts of the industrial Midwest, remodeling has slowed down as a function because of an automobile industry downturn.
“It started about a year ago with the automotive-based economies where a significant amount of the economic base serves the auto industry,” says Baker, who is also the chief economist for the American Institute of Architects. “The poster child is Detroit, but it is clearly beyond that area. In these places we are seeing a traditional slowdown in the economy: declines in jobs, declines in incomes, and a commensurate reduction in spending for home improvement projects.”

The second force is a decline in the overall market for new and existing homes. Home sales activity, which has been breaking records for several years in a row, began to fall back from peak levels last year. At the end of 2005 and 2006, existing-home sales were tracking at an annualized pace of 7 million and 6.5 million units, respectively. According to the National Association Realtors, that pace has slowed to an annual rate of 5 million units for the month of November. This, in turn, has hurt house prices, which have leveled off, and even fallen in some markets. The house price reversal, Baker says, has dampened consumer confidence for home-improvement expenditures.

“The second wave just began unfolding in the second half of 2007, maybe even third quarter, and is a result of the weakening in the housing market, particularly in house prices in some of the key, overheated markets,” notes Baker. “Households seeing their house prices decline or flatten did not have the equity to pull out to finance home improvements. But more fundamentally, these households, just got nervous about whether this was the right time to undertake a home improvement project, particularly an upper-end project.”

The slower housing market has not only flattened out home-price appreciation which hurts consumer spending as a reverse “wealth effect” takes hold, it also directly impacts the pool of ready customers for professional home improvement services.

There is a long-established direct link between existing-home sales and remodeling activity. Those buyers and sellers are top buyers of remodeling services. So as existing-home sales numbers level off to a more sustainable, long-term pace of activity, real demand recedes as well. The slowing housing market affects remodeling across a much broader geographic area than the industrial heartland.

“This is affecting big chunks of California and the Southwest, Phoenix, Las Vegas and virtually the entire state of Florida, particularly southern Florida,” Baker explains. “And then you have the Northeast Seaboard from Boston all the way down to Washington D.C.”

NAR data bears out the broader based geographic impact of a slower housing market. According to the NAR, median house prices fell 3.3 percent nationally from $219,000 in November of 2006 to $210,000 in November of 2007. Regionally during the same period, house prices fell 3.2 percent in the Northeast to $258,000, .5 percent in the Midwest $168,000, 2.5 percent in the South to $174,000, and a whopping 6.8 percent in the West to $325,800.

This lower house-price phenomenon “is really the flipside of what drove the market through 2002, 2003, 2004 and even into 2005,” says Baker. “There was a rapid run-up in home prices. Investing in your home seemed like a prudent thing to do.

House prices were going up, so you could ride that wave up by improving the value of their home. Some people rode the wave up by trading up, but others did it with improvements to their current home. Now we are beginning to see the flip side of that with house prices flat or declining. Why make a major investment in your home when you are worried that it may be worth $20, $30 or $40,000 less mid-year.”

The Third Risk

The third and final risk to the remodeling market is the questionable health of the overall economy. A banking credit crunch, sluggish job growth figures, along with a slower housing market and higher energy prices may signal a U.S. economy that is moving into negative territory. The “R” word (recession) is being mentioned by a higher percentage of economists, the Wall Street Journal reports. And if that happens, it would likely impact every area of the country in terms of remodeling activity, not just the pockets that are currently experiencing housing- and automotive-based downturns.

While the jury is still out on whether the country is about to move into a recession, the implications of a recession are clearer, says Baker. A combination of weaker demand for professional home improvement services and a generally lower level of home equity for homeowners to tap would result in a more generalized slowing of the remodeling market. Specifically, a weakened economy would primarily put further downward pressure on house prices.

“There is a sense (among economists) that house prices need to adjust more than they have,” says Baker. “Depending on what index you use, house prices are flat to down about 5 percent now, depending on the index. I think virtually everyone agrees that broadly based, they are going to decline a little bit more. There are estimates of 10 percent peak-to-trough declines and I think credible estimates of 15 percent peak-to-trough declines.”

To the latter estimate of a possible 15 percent decline in house prices, Baker referenced a recently released Federal Reserve Board analysis of house prices and rents, which showed that a reduction of 15 percent in house prices would bring them in balance with rents vs. historical trends. Economic uncertainty along with room for house prices to decline further then leads to the question time frame — how long it could take for any further corrections to hit bottom. To Baker, a quick correction in house prices to levels as deep as 15 percent is preferable, to a longer period of time where prices remain flat.

“In some sense, the best scenario, and perhaps the most unlikely, is if house prices take a sudden hit — that it happens tomorrow and that people move from there because uncertainty is very bad in this environment,” says Baker. “The way that [house price corrections] have typically played out is they adjust very slowly. We could come up with a scenario where house prices are essentially flat for the next two or three years. This would mean that we are not going to see a strong upswing in remodeling. Conversely, once there is a sense that we are close to the bottom of the market — that it is not going to get a lot worse — then people can be more certain of what is going to happen; then people will start resuming spending on home improvements.”

Remodeling: A bright spot with underlying strength

In any discussion exploring downside, short-term market trends, there is the danger that a negative tone will distort the broader-based, middle and long-term outlook. Much of the current discussion about a slower remodeling market should be put in context with the fact that the market for professional remodeling services is just now concluding a period of prolonged and rapid growth. After experiencing several consecutive years of double-digit growth in remodeling, a period characterized by high backlogs of business and increasing margins, a more normal market, like this one, feels sickly by comparison.

Remodeling expenditures on owner-occupied homes over the past 10 years have more than doubled from an annualized rate of $85.3 billion in the fourth quarter of 1997 to an estimated $176.5 billion annualized rate in the third quarter of 2007.

“In some markets there was 15 percent to 20 percent growth per year,” notes Baker. “In that environment falling back to flat feels like a real dramatic shift. It was very much a seller’s market out there. Contractors could cream off the jobs they wanted. There was much less price negotiation. There was much less sticker shock on jobs in that environment. If people could get a contractor to sign on the dotted line, they were happy to go ahead with it.”

Moving to a slower, less overheated remodeling market did feel different to many remodelers in 2007. At Harvard’s Remodeling Futures conference in October, Mark Richardson, Case Design & Remodeling CEO, said his firm experienced growth during the year, but noted that his team had worked much harder to achieve those results. This seems to be the sentiment among the more than 500 remodelers who responded to Qualified Remodeler’s forecast survey conducted in December. Only 13 percent of the respondents are forecasting a declining level of remodeling activity during 2008, while 42.8 percent see an increasing level of remodeling activity during the year and 40.3 percent see a flat level of activity.

A slower, but solid level of remodeling activity for 2008 is also borne out by the expected shift in price points. About 50 percent of the respondents agree with Kermit Baker that consumers will be shifting to mid-range projects in the $10,000 to $50,000 price range, while only 32 percent see upper-end projects, those with price tags of $50,000 or more, as being strong for them in 2008. The overall assessment from remodelers seems to be that conditions are somewhat challenging for the first time in many years, but these conditions won’t prevent them from achieving their goals and growing in this year.

Timetable for Turnaround

Speculation about when the broader housing market will rebound varies greatly depending upon each economist’s view of the health of the broader economy. A historical analysis of past housing downturns, specifically comparing the peak-to-trough declines of new construction activity vs. remodeling activity, tend to bode well for remodeling. Remodeling downturns tend to start later, end earlier and tend not to vacillate as sharply from peak-to-trough. Baker’s view of new construction activity is that it will remain near the bottom into the first or second quarter of 2009. And if past trends hold true that remodeling activity picks up earlier than any new construction rebound, a remodeling uptick can reasonably be expected by third or fourth quarter of this year.

“I think we will bump around or near the bottom until the first quarter or mid-year 2009 before we begin to see a significant uptick in new construction activity,” says Baker. “Remodeling does not need to wait that long because once consumers get the sense we have hit bottom, then they are going to be a little less hesitant to get involved in home improvement projects.

The upturn in remodeling will happen before the upturn in home building. I think we are going to see more positive signals from remodeling later this year, maybe by mid-year. But I would think that by third or fourth quarter at least we should see some positive signals come out of remodeling.”