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Will future generations be locked out?

Will future generations find themselves increasingly locked out of the housing market? Or will other factors, brought about by changing demographics, ultimately ease affordability problems?

American demographics are in flux. As a nation, we are getting older, warmer, more racially heterogeneous and more pervasively single. We expect such change to influence just about everything--housing being no exception. Given that's the case, it is important for us to explore just how America's changing demographics have affected the housing market so far, and how they might continue to affect housing in years to come.

Perhaps the best known demographic phenomenon taking place in America today is the aging of the population. Birth rates plummeted by more than one-third between 1960 and the present. At the same time, improving diet, exercise and medical technology have allowed people to live to increasingly older ages. As a result, the median age of the population has risen from 27.9, as recently as 1970, to 32.6 today. (All data are from the U.S. Census).

Besides getting older, the nation is also marrying older and divorcing more. The upshot: the number of households headed by singles has risen sharply from 29.5 percent in 1960 to 43.9 percent today. Not surprisingly, average household size has taken a sharp dip, from 3.3 people in 1960 to 2.6 people today.

Meanwhile, the percentage of non-white Americans has risen from 11.4 percent in 1960 to 16 percent today. Finally, the advent of central air conditioning has brought about the well-documented migration from the Northeast and Midwest to the Sunbelt.

For this article, we will largely focus on the impact of age and household living arrangements on housing affordability. In the end, we will also consider how increasing ethnic heterogeneity and mobility might affect the future.

Demographics and housing affordability

Housing affordability, to use an ungainly yet currently popular phrase, may be broken down into a number of components. For potential owner-occupants, housing affordability is a function of home prices, interest rates, down payment requirements, and, of course, the future buyer's income. Most housing affordability indices contain each of these elements. For example, the National Association of Realtors' index expresses the percentage of a median-priced house that a median-income family of four can afford, given a 20 percent down payment and current interest rates.

For renters, affordability may be expressed simply as the ratio of dollars devoted to rent divided by gross income. When this ratio is greater than 30 percent, analysts generally maintain there is a rental housing affordability problem.

The 1980s were a decade full of housing affordability problems. In the early part of the decade, mortgage rates were at their highest levels since self-amortizing home mortgages became popular in the 1930s. In the later part of the decade, prices skyrocketed in the Northeast and in California, shutting the door to many potential first-time homebuyers in these markets. And the percentage of families paying more than 30 percent of income for rent rose sharply throughout the 1980s.

Can demographics explain all this? Probably not; nevertheless, we can make a plausible case that changing demographics did have something to do with the affordability problems of the last decade.

In the first place, a large "bulge" of post-war baby boomers entered the labor force en masse during the 1970s and 1980s. At about the same time, the percentage of adult women in the work force also jumped. Both of these developments likely contributed to slowing growth in labor productivity. In the first place, as more workers enter the labor force, the marginal productivity of the last worker is lower than that of the workers who entered before him or her. To use an example, if an acre of land is farmed by four people, it likely will not produce twice as much corn as an acre farmed by two people.

In the second place, the work force swelled with large numbers of inexperienced people, who generally are less productive than more experienced workers. This is one reason why workers in their forties generally earn significantly more than people in their twenties.

These demographic phenomena almost certainly contributed in part to wage stagnation in the late 1970s and 1980s. While certainly the 1980s saw other events (increasing international competition, weakened unions and so forth) that had powerful effects on wages, the combination of the boomers coming of age and increasing participation in the work force by everyone almost surely had an impact as well.

The implication of these developments for housing affordability is fairly straightforward: incomes among households headed by 20 to 30 year-olds fell during the late 1970s and 1980s, meaning that potential first-time homebuyers would have an even harder time making monthly payments, not to mention down payments, which we will discuss in more depth later.

One other demographic phenomenon also caused household incomes to stagnate: households got smaller. As the divorce rate rose, and as people remained single until later ages, the "headship" rate--the proportion of household heads to total population--rose. While people choose their own households arrangements, one of the side effects of shrinking households is that household incomes stagnate or shrink, which in turn, means the ratio of home prices to household incomes is higher than it otherwise would be.

Demographics also may have had something to do with the trajectory of interest rates over the last 15 to 20 years. To understand why, we should refer to Nobel-prize winning economist Franco Modigliani's "life cycle hypothesis."

The concept is a reasonably simple one. Rather than consume some constant fraction of current income every year, households implicitly try to figure out their lifetime income, determine a constant annuity that will produce that lifetime income and consume a fraction of that annuity.

Needless to say, households generally do not consciously perform this exact exercise, but they do, in fact, seem to smooth out their consumption. To be more concrete, consider how early in adulthood, one uses debt to buy automobiles, furniture and sometimes even clothing. This behavior is based upon an expectation that income will rise with age, so that spending too much in early adulthood can be justified.

In middle age, on the other hand, households begin looking at their retirement years, when incomes generally fall substantially: even those with pensions generally will not receive as much in their later years as they did while working. Consequently, middle-aged individuals will save, so they can live at a reasonably high standard of living during their later retirement years. Hence, while income rises, and then falls, consumption remains relatively smooth over the life-cycle.

But while consumption is smooth over the life-cycle, savings are not. In the early part of life, people take out debt, or "dis-save." In the middle years, people save. At the end of life, people dis-save again.

Understanding that, we can now discern the impact of the baby-boom cohort on interest rates. In the late 1970s and on into the 1980s, the baby boom generation was largely in its "dis-saving" period. This demographic phenomenon likely explains part of the dismal savings performance in the United States economy in the 1980s (although once again we should hasten to add that it was certainly not the only reason accounting for a low national savings rate). The lack of savings in the economy, combined with massive fiscal budget deficits, put pressure on capital markets, and thereby pushed up real (inflation-adjusted) interest rates. Higher interest rates, of course, cause affordability problems, both for homeowners and renters.

But while demographics brought serious problems during the 1970s and 1980s, they actually may help lower interest rates during the 1990s. The baby boom generation is now reaching middle age, and we should begin to see improvements in the savings rate. In fact, one of the arguable causes for the economy's lingering doldrums is that households are not accumulating debt as rapidly as they did in the 1980s, and are correspondingly consuming less. The benefit of reduced consumption should be that interest rates, which have already fallen substantially for short-term securities, may also fall for longer-term assets, such as mortgages. As it is right now, long-term, real, interest rates remain quite high by historical standards, at least in part because the fiscal deficit remains high. But demographics should help bring about lower interest rates in the years to come, and as such, promote housing affordability.

On the rental side of the housing market, the high interest-rate environment of the 1980s also created problems. When the cost of capital is high, landlords must be compensated with high rents, or else they will remove their money from the rental property market and put it into more lucrative investments. The high interest rates of the 1980s were one of a number of factors that caused a substantial number of low-rent units to fall out of the housing market. That left an ever-increasing share of higher-cost units available for renters. (Other events, such as increasing regulatory burdens on landlords and the Tax Reform Act of 1986 also contributed to the loss of many low-cost units). Under the circumstances, it should hardly come as a surprise that the percentage of households paying more than 30 percent of their incomes for rent rose considerably during the 1980s.

While the impact of changing demographics on incomes and interest rates might be considered slightly controversial, the impact of demographics on home prices is exceptionally controversial.

If we look at the trajectory of real home prices in the post-World War II era, we find that they generally fell from the end of the war until around 1970, then rose from 1970 until 1980, and then have bounced around a bit since then. (This is documented in a recent piece by economists Joe Peek and James Wilcox called "The Measurement and Determinance of Single-Family House Prices," AREUEA Journal, Fall 1991, Vol 19, No.3.) Harvard economists Gregory Mankiw and David Weil published a paper ("The Baby Boom, The Baby Bust and the Housing Market," Regional Science and Urban Economics, Vol 19, No. 2, 1989) that maintained that a leading cause of this pattern in real home prices was the baby boom. Specifically, they estimated demand equations that show that as people age from their twenties to their forties, their demand for housing rises, but that it falls thereafter. Specifically, they found that the average 40 year-old consumer in 1970 demanded $9,122 of housing, whereas the average 60 year-old demanded $7,893 of housing.

We already know that as the baby boom generation ages, the number of 40 year-olds will diminish and the number of 60 year-olds will rise. Mankiw and Weil combined these facts and concluded that home prices would inevitably fall in the decades to come to the tune of about 47 percent in inflation-adjusted terms between 1987 and 2007.

As academic articles go, the Mankiw and Weil piece made a big splash. Barron's reported their home price forecast in an article entitled "Crumbling Castles," which in turn helped cause Fannie Mae and Freddie Mac stock prices to fall by something like 20 percent. Fannie Mae and Freddie Mac stock have since recovered and then some, perhaps in part because the academic community, upon closer analysis, found the Mankiw and Weil forecast less than convincing.

For example, Ohio State University housing and finance economist, Patric Hendershott, noted that Mankiw and Weil's downward trending forecast was largely the result of a time-trend term in their mathematical equations, rather than any fall-off in demand. A downward time-trend in prices likely reflects technological improvements in housing construction practices. Hendershott pointed out that this trend was largely established before the 1970s: since then, there has been no evidence of such a trend.

In fact, while Mankiw and Weil found that demand does fall from the ages of 40 to 60, they also found that total demand should continue to increase in the years to come.

Consequently, the phenomenon driving the forecast's frightening fall in home prices may no longer be present in the marketplace.

Nevertheless, the question of how demographics affect home prices remains an interesting question. Specifically, Mankiw and Weil's finding that 60 year-olds consume less housing than 40 year-olds merits further reflection.

One might think it obvious that 60 year-olds would consume less in housing dollars than 40 year-olds: after all, people in their 40s tend to have children in the house, and, therefore, "need" more housing than people 20 years older.

But consider how people tend to live in their houses. They will often buy a first home while in their late twenties or early thirties, start a family, trade up to a larger home and then remain in that home until retirement. (This is, of course, an extreme generalization, but will also serve to make a point.) This pattern means that people will often remain in their large homes for some years after their children move out on their own. Once the children leave home, the per capita housing consumption of those who remain (i.e., the 60 year-old parents) increases. Thus, the dramatic reduction in demand between the ages of 40 and 60 portrayed in the Mankiw and Weil article is something of a puzzle.

The Mankiw and Weil findings make sense, however, when one considers that the year from which their results were generated was 1970. At that time, the lifetime incomes of 40 year-olds was much higher than the lifetime incomes of 60 year-olds. We would always expect those with higher incomes to consume more housing than those with lower incomes. Would we expect the incomes of those who were 40 to fall substantially by the time they became 60? Of course not: the higher incomes of 40 year-olds reflected the fact that successive generations could expect higher and higher levels of general well being, in large part because of the greater availability of education.

Consequently, it would appear incorrect to attach the housing demand of a 60 year-old in 1970 to a 60 year-old in 1990: in fact, we might expect a 40 year-old from 1970 to have an even higher demand as a 60 year-old in 1990, for the reasons already set forth.

Patric Hendershott and I are now working on calculations to determine the effect of age on housing demand, once we control for lifetime incomes. While our results are at this stage preliminary, they suggest that we probably should not live in too much fear that the changing age structure of the population will cause home prices to collapse.

Having said that, however, some demographic phenomena remain worrisome. We have already suggested that demographic changes have contributed to stagnating household income. Given that income does appear to be an important component for housing demand, should household incomes fall for any reason--poor productivity performance, higher divorce rates and the like--the future for home prices could be a bit rocky. Conversely, should the "baby bust" generation--the much smaller generation that follows the baby boom--produce labor shortages and increasing levels of productivity, the outlook for home prices should be smooth.

Finally, the impact of demographics on the ability to raise down payment money is largely residual, but nevertheless important. At least partly for reasons we have discussed already, household incomes among young renters have fallen. At the same time, a substantial number of low-cost rental units have been removed from the supply of housing stock. Taken together, this combination reduces the amount of cash young renters have available to save for down payments, and, therefore, it delays the time when people can become homeowners.


How the average level of home prices in the future might be affected by changing age patterns is very much open to question. We can say with some confidence, however, that American society's ever increasing mobility will mean that the distribution of home prices by region and by housing type will widen. In other words, while home prices nationally may rise on average by, say, 2 percent per year, prices in a city with large in-migration may rise 20 percent, while a city with large out-migration may fall 18 percent. In short, regional events, rather than national events, may become increasingly important in determining home prices.

At the same time, the increasing number of minority households will require us to better enforce fair housing laws. In the absence of such enforcement, discrimination could do more than injustice to minority families--it could destroy housing markets.

Richard Green is an assistant professor of real estate and urban land economics in the graduate school of business at the University of Wisconsin, Madison.
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Title Annotation:housing market
Author:Green, Richard R.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Oct 1, 1992
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