Behind the Home Building 'Shocker'

Why did housing starts plunge nearly 11 percent in October? Where are they headed from here?

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The fitful nature of the housing sector's healing process was apparent Wednesday when a government report on new-home construction came in much weaker than economists had expected. The Commerce Department reported that October housing starts dropped nearly 11 percent from September and almost 31 percent from a year earlier. "The headline number is a shocker," Patrick Newport, U.S. economist at IHS Global Insight, said in a report. Here are four things you need to know about the development:

1. Single and multifamily drop: While single-family housing starts dropped nearly 7 percent from the previous month, multifamily-housing starts—that's condominium, townhouse, and apartment projects—fell off a cliff, plunging more than 34 percent and hitting an all-time low. Newport says the multifamily sector is being hammered by broader problems that are plaguing the market for commercial real estate. "Property values are down, rental vacancy rates are at an all-time high and rising, too many units were put up during the good years, the securitization market imploded in 2008, banks are not lending, the job market is still in recession, and a tax credit is encouraging renters into becoming first-time homeowners," he said in his report. "Going forward, multifamily starts should start growing later this year—but only because new construction in this sector is at rock-bottom levels. The recovery will also last two to three years."

[See Home Building Figures Come in Weaker Than Expected.]

2. Single-family dive: Remember, this data is from October, when the political outlook for the first-time home buyer tax credit extension was less clear. So it's possible that builders were reluctant to break ground on new projects until the issue was resolved. "Perhaps out of fear of the expiration of the home buyer tax credit, builders pulled back on both starts and permits in October," Mike Larson of Weiss Research said in a report. (President Obama signed legislation to extend and expand the tax credit on November 6.) In addition, "an early onset of wintry conditions in October may have slightly depressed home building in the month," says a report from David Resler, the chief economist of Nomura Securities International. Nevertheless, housing starts remain above the lows they hit in April.

[Check out Expanded First-Time Home Buyer Tax Credit Becomes Law.]

3. Thin inventory: As demand evaporated, builders drastically reduced the number of homes they put on the market. "Builders also have just 251,000 new homes for sale," Larson said. "That's the lowest level since November 1982, which tells me a pickup in construction is inevitable." Keep in mind, however, that new houses have to compete with a massive "shadow inventory" of foreclosed homes, and many of these properties will go for sharp discounts. Despite the Obama administration's sweeping efforts to keep struggling borrowers in their homes, Moody's expects to see about 3 million foreclosure sales in 2010 and 2011, on top of roughly 1.8 million in 2009.

4. Rebound: Still, falling home prices, attractive mortgage rates, and a beefed-up tax credit from Uncle Sam will work to fuel demand and help chew through inventory. "Going forward, we project that single-family housing starts will continue to grow, although levels will remain low by historical standards into 2012," Newport said. "[I]n 2010, job growth, low inventory levels of new homes (currently at their lowest point since 1983), and household formation will result in sustained increases in housing starts."

[See Cheaper Prices--More Than Tax Credit--Motivating Home Buyers.]

Michelle Meyer, an economist at Barclays Capital, said the disappointing Commerce Department report isn't enough to derail her view of the home building sector. "We continue to believe that the recovery in the residential construction market is underway, but as we have been warning, it is likely to be bumpy," Meyer said in a report.