One pill makes you larger

So what’s the difference between Alice in Wonderland and the U.S. economy? Alice knew she fell down a rabbit hole as soon as it happened. We’ve been in Wonderland for three years and we’re just now starting to realize it.

In the real world, the pandemic should have beheaded the economy and taken the housing market with it. Everyone expected exactly that when global commerce shut down in April 2020.

In Wonderland, annualized GDP growth since Q4 2020 has averaged 3.3%—a full percentage point above its 2012-19 average. Until mortgage rates kicked buyers off the bus in 2022, existing home sales were tracking at 2005-06 levels.

In the real world, it should have taken massive job losses to reduce inflation by killing demand. In Wonderland, we averaged 312,167 new jobs per month over the past 12 months—nearly 60% above the 2012-19 growth rate. Meanwhile, inflation fell from 9.1% to 3.0%.

The Federal Reserve is gunning for 2%, but since 1985—i.e., not including our double-digit inflation episodes in the 70s and early 80s—the inflation rate has averaged 2.8%. By that metric we’re already back to normal.

The catch is that normal might not sell a lot of houses. Historically, the U.S. has always been an outlier among developed countries. An exceptionally low price-to-income ratio of 3.0 to 3.5 times median household income made the U.S. the most affordable wealthy nation on the planet to buy a home by a wide margin.

Not anymore. Today our price-to-income ratio looks positively European: 5.3x according to Demographia, or 5.6x as calculated by the Harvard Joint Center for Housing Studies.

Price-to-income is a baseline, but the more important number to anyone with a mortgage is the payment-to-income ratio. Unfortunately, the story is the same. 

Historically, Americans spent 20% to 25% of their gross income on a mortgage payment. That ratio fell in the 2010s when interest rates were low, then rose dramatically when prices and mortgage rates spiked in 2021-22. As of May, the national average was 35.7% according to the Black Knight Mortgage Monitor.

We talk about making homes more affordable, but Black Knight says “it would take a 30% drop in home prices to get back to normal affordability.” That doesn’t sound very likely. Even in the Great Recession, the S&P/Case-Shiller National Home Price Index only fell 26%.

Plus, home prices are on the rise again. In May, Black Knight’s Home Price Index rose for the fifth straight month—and the increase was “equivalent to an annualized growth rate of 8.9%.”

Those are national numbers, of course. Especially in the Midwest and the Rust Belt, you can still find affordable metro markets. But if the payment-to-income ratio is in fact lower, it isn’t necessarily because home prices are lower. Sometimes the ratio is low because median household income is higher than normal in that market.

That’s the other route to affordability, but it’s no tea party, either. “If prices stayed the same and (mortgage) rates fell to 5%, it would take 19% income growth to get us back to normal,” says Black Knight.

Everyone says the solution is to flood the market with new homes and let the law of supply and demand drag prices back into the real world. John Burns Research & Consulting says that to bring supply and demand back into equilibrium by the end of the decade, we’d need to build a whopping 17 million units.

That translates into just over 2.4 million new units per year if we start next year—which is to say “that translates into unattainable,” says Chris Beard, Burns’ director of building products research.

The good news, says Beard, is that any housing downturns in the foreseeable future are likely to be shallow and short-lived.

That also raises a question, though: Just how many housing units can we actually build in a year? In December 2020, single-family starts spiked to over 1.3 million (annualized), then hovered in the 1.1 to 1.2 million range until early 2022 when mortgage rates killed the vibe.

During that period, single-family completions averaged 985,000. We built up a backlog of unfinished homes that took until this summer to whittle down—and only happened because starts fell dramatically.

The Cheshire Cat in this scenario is framing labor. We’ve got more HVAC techs, plumbers, electricians, and roofers now than we had in at the peak of the bubble in 2005, even though housing starts are about 75% of their 2005 level.

A few trades are still well below full strength, and framing is the worst of them. As of April, the number of production workers employed by framing subs was 44% of what it was at the peak in 2005.

So far, those numbers aren’t growing, either. The headcount has hovered around 40% to 45% of 2005 levels since 2017. Annual completions have been rising since the Great Recession, but that’s because framing productivity is rising.

Unless something changes, it appears that we don’t have the capacity to build enough homes to bring supply and demand back into balance. If not, we’ve got two options: 1) recruit and train more framers or 2) prefabricate to reduce the need for skilled framers. Neither one could happen quickly and both would raise the cost of building a home.

In an NAHB survey a few years ago, just 7% of single-family builders said offsite construction was a viable long-term solution to the labor crunch. Three out of four said the answer was to recruit and train more framers.

That’s fine, but the industry has been trying hard to do that for 30 years without much success. Part of the reason is demographics. Millennials were for the most part committed to college degrees and white-collar careers. Zoomers are more skeptical.

But if the question is what it’ll take to entice young workers to become framers, the fact that most other construction trades have fully recovered from the Great Recession while framing hasn’t might be a clue.

As early as the 1950s, single-family builders began pushing to get rid of in-house crews and union labor, and migrate to non-union subcontractors. It was a great move from the builder’s perspective—it improved the balance sheet, reduced liability, and gave them greater negotiating leverage with subs.

Maybe too much leverage. In a 2019 study titled Creating Good Jobs: An Industry-Based Strategy (Thanks, Mai-Tal!), MIT found a huge disparity between working conditions in commercial versus residential subcontracting.

Commercial framing contractors “are typically large, are more capital intensive, and employ workers who are more educated and higher skilled,” says MIT. “Labor unions operate almost exclusively in the nonresidential sector, where they help workers develop skills through long-established and well-regarded apprenticeship programs. Higher skill levels and the presence of unions help drive up wages and improve conditions for workers.”

Not so much on the residential side. “In addition to the low wages and few benefits employers in residential construction offer, the sector is characterized by cash-only payments, wage theft, the exploitation of undocumented workers, unsafe jobsites, and workers’ compensation and tax fraud.”

MIT says “reports of widespread illegal behavior in the industry stretch from coast to coast and from big cities to small-town America.” But that’s not to say everyone does it.

Exploitation appears to be rare in specialty trades where the barriers to entry for subcontractors are relatively high, and especially trades that routinely cross over between commercial and residential projects.

HVAC, plumbing, and electrical check both of those boxes. Residential roofing doesn’t, but roofers work the commercial side, too. Site prep requires a major capital outlay for equipment, which in turn requires a sub who can qualify for financing and skilled operators who won’t tear up the equipment.

It’s probably no coincidence that framing and drywall have severe labor shortages. Barriers to entry—for both subcontractors and their employees—are extremely low. As a result, both trades are highly fragmented. As a result of that, they’re more vulnerable to price pressure, which in turn means working conditions are likely to be worse.

Exploitation also appears to be more common in production and spec housing, where price pressure is more intense. MIT says custom home building and remodeling are relatively problem-free. Part of the reason is that those projects often require greater skills. Tradespeople who are highly-skilled are usually more highly-valued. Plus, high-end projects are less price-sensitive so there’s more money for higher wages.

It’s important to keep in mind that even within the hot spots, most subs are honest and law-abiding if not generous. In many cases, frustrated, too. It’s not easy to make a living going head-to-head with competitors who cheat their own workers so they can lowball bids.

But even if dishonest subs are a small minority, exploitative labor practices undermine everyone’s ability to recruit employees. In framing, cutthroat bidding has eroded wages to the point where a cell phone sales rep at the mall earns nearly as much as the average carpenter. And works at an air-conditioned jobsite.

Reducing costs by squeezing trade labor only works to a certain point. There are other ways to cut construction costs, and some builders are pursing them aggressively.

Beard says production builders are redesigning their homes to minimize costs: less square footage, smaller lots, simpler decorative details, less expensive finish materials (e.g., faux wood flooring), no dining room, and fewer options overall.

They expect those tweaks to shave 7% to 10% off construction costs. Construction costs are roughly 60% of the sale price according to NAHB, so that’s potentially 4% to 6% of the total. Every little bit helps, but that’s not even close to the 30% Black Knight says we need to bring home prices back down to normal.

As you might expect, that’s already having an impact on the entry-level market. “Buyers searching for starter homes in today’s market are on a wild goose chase,” Redfin economist Sheharyar Bokhari told Bloomberg. “The most affordable homes for sale are no longer affordable to people with lower budgets.”

Actually it’s a little more complicated than that. If you look at national numbers, a 37.5% payment-to-income ratio still puts the U.S. at the low end of the scale for wealthy nations. In Canada the ratio is 60.9%—but the homeownership rate is still 66.5%, identical to the U.S. rate.

A higher payment-to-income ratio simply means that not everyone can afford to own a home anywhere they want. If you earn median income and buy in Winnipeg, you’ll pay 31.4%. The same home buyer would pay 82.8% in Toronto or 94.9% in Vancouver, but no one actually pays that much. Instead, homeownership in those markets is limited to affluent buyers.

The only reason Canada’s national payment-to-income ratio is higher than ours is that Toronto and Vancouver make up a higher percentage of the total market than, say, San Jose and Los Angeles in the U.S.

Which is to say that if $400,000 single-family homes are the new normal, that’s not necessarily a deal-killer.

Builders are already adapting; the rest of the industry will follow. Lenders may not like payment-to-income ratios higher than 30%, but if 30% becomes the exception rather than the rule, that will change. They can’t make money if they don’t lend it.

Single-family homes in Houston. Photo: City Choice Homes

The good news is that housing demand is rock-solid even if supply is iffy. During the 2010s, surveys routinely found that roughly four out of five renters want to be homeowners. In a 2021 Fannie Mae survey, 83% said they want to own a home—including 95% of 35- to 44-year olds and 96% of 18- to 34-year-olds.

But as the industry adjusts its new normal, suppliers are going to face a few decisions.

The first is how to take advantage of the coming boom in remodeling. Entry-level buyers can’t find homes, but the pickings aren’t much better at any other level, either. The inventory of for-sale existing homes is half of what it needs to be for a robust resale market. The primary reason is that nearly half of the 85,000,000 homeowners in the U.S. have mortgages that are at least 180 basis points below the current rate, says Zonda. They’re locked in to their homes, and “this effect accounts for roughly 70% of the decline in existing home sales.”

But while they may not be willing to move, their housing needs will still change. Any LBM dealer who doesn’t have a plan to tap the remodeling market needs one now.

A second issue is whether to chase the single-family production market. More than a few dealers have bailed out of production housing to avoid the margin pressure, but it’s a big piece of the residential pie. According to Professional Builder, the top 240 U.S. builders held over 30% market share in 2022.

Production housing is good business if you can make money at it. But builders are in the driver’s seat and everyone else needs to be prepared for sharp left turns. In the Washington, D.C. metro, for example, the top ten builders in the market build 68% of the single-family homes. In the Virginia suburbs, two out of three of those homes are supplied by the builder’s in-house supply division.

A third issue—and maybe the most important—is labor. You can hardly throw a rock these days without hitting some analyst crying about the shortage of skilled labor in the U.S.

The Heritage Foundation calls it “unprecdented.” McKinsey wonders whether it’ll “derail plans to upgrade U.S. infrastructure.” Advocacy group Strong Towns asks, “is it Gen Z’s fault?” A recent Bloomberg headline teases The Mystery of the “Job Market’s 2.6 Million Missing People.”

Then solves the mystery in the subheading: “New research (says) low-wage workers in high-cost areas aren’t returning to the labor force.”

Of course they aren’t. When they got laid off during the pandemic, they discovered it was possible to survive without a crappy, dead-end job. When the economy came back, they either found a better job or continued as gig workers.

And more than a few discovered that entrepreneurship wasn’t as scary as they thought it would be. New business formation doubled shortly after the COVID lockdowns in 2020 and hasn’t backed off since.

This is terrible news for employers whose profits depend on crappy, dead-end jobs. For construction suppliers it may be a bigger—and more lasting—opportunity than the mother of all housing booms.

Nobody wants to be a framer, but nobody even thinks about a career in the building supply business; it’s not on the radar screen at all. Yet LBM is the perfect career for Zoomers who are reluctant to take on debt for a degree that may not earn them any more money than they could make on the sales counter.

You have to get off the bottom rung, but once you do, construction supply jobs are challenging and encompass a wide range of disciplines—e.g., sales, manufacturing, logistics, design, or construction. Most jobs offer a high degree of autonomy. Some offer flexible hours or even fully remote work. The work serves a valuable social purpose and the pay is higher than many jobs that require a degree. Construction supply is one of a handful of industries where you can earn $200,000 per year with a high school diploma.

The labor shortage is real. According to the Chamber of Commerce, an additional 1.9 million Americans would have jobs if the labor participation rate was the same today as it was in February 2020.

That doesn’t mean they aren’t working, though. The labor participation rate doesn’t count people who are self-employed unless they’re incorporated, and most aren’t. The number of new businesses formed since July 2020 exceeded formations in the three years from 2017-19 by a whopping 5.5 million.

Half of those businesses will fail within five years and that’s no black mark; that’s called paying your dues. It seems likely that a lot of those people would be attracted to a work environment that scratches the entrepreneurial itch and still provides reasonable security.

And construction suppliers could do a lot worse than to compile a team that has direct experience with what it means to think like an owner.

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