Dissecting the Market

The third-quarter release of a key indicator reveals that remodeling activity was down by 1.4% over the most recent four-quarter period. The mid-October version of the Leading Indicator for Remodeling Activity (LIRA) also predicts that the decrease will continue — to a greater degree, in fact — until at least the second quarter of 2008 (see graph at right).

Kermit Baker, director of the Remodeling Futures Program at the Joint Center for Housing Studies (JCHS) at Harvard University — the organization that compiles the LIRA — points out that “the numbers aren't very different from the second quarter,” when remodeling activity posted a 1% gain over a four-quarter period. However, he concedes that there is significant psychological impact from the slip into negative territory. “It's much easier to stomach weak growth,” he says, than declines. “People get very nervous about that.”

That's particularly true, Baker continues, when “there isn't any evidence that we're at a turning point yet.” He doesn't rule out the possibility, but says that it would be “unusual” for the trend to reverse itself and for the LIRA to move into positive territory by the end of 2008.

Though the latest LIRA is the first to attach a negative number to the remodeling industry, the somewhat bleak outlook isn't breaking news. Remodelers in most areas of the country have been experiencing slowdowns for some time now. That's not to say that remodeling work will dry up to the extent that the new-home market has. “If remodeling is a $300 billion industry,” Baker says, using a round estimation of the money spent annually on home improvement products and services, “that's still a lot of sales if it drops 5%.”

It does mean that the remodeling market is headed for some change, however. Baker, in a seminar he co-led with the National Association of Home Builders' Gopal Ahluwalia at last month's Remodeling Show in Las Vegas, enumerated some of those adjustments.

Third Quarter Leading Indicator for Remodeling Activity

Photo Credit: Joint Center for Housing Studies

One of the more interesting things about the remodeling market during the current decade is its performance relative to the national economy. In 2001, the country was in a recession, and the following two years saw very slow growth overall. Of course, this coincided with a boom period for remodeling — fueled by favorable lending standards. Currently, though concerns that the housing industry may actually pull the nation into recession have heated up in the last several months, the economy is in a period of (admittedly weak) expansion.

This isn't the norm: Baker says that the average annual growth rate for remodeling during a time of economic expansion is 6.7%, compared with 2.3% during a recession. While a departure from the norm can often be bad news — “if it ain't broke, don't fix it” — Baker says it's a positive sign in this particular case. “That we're going through a transition while the economy is in expansion holds out hope [for recovery],” he says. “It would be a lot worse during a recession.”

One characteristic of the easing of remodeling spending — which began in the third quarter of last year — is that in addition to homeowners being less willing to make improvements to their homes, those projects that they end up doing are smaller than the jobs remodelers took just a few years ago. Data from the Cost vs. Value Report (see page 65) shows that higher-priced remodeling projects are recouping less of the cost of the job in 2007. In 2003, the average return on investment after one year across all upscale remodeling projects included in the survey was 82.5% of the cost to build. That dropped to 80.7% in 2004 and 2005, then 75.5% last year, and now to 70% in 2007.

Remodelers are already beginning to see dramatic reductions in their average job sizes. Some of this can probably be chalked up to softening of the housing market — homeowners were more likely to pour hundreds of thousands of dollars into their houses when home values were skyrocketing. An additional factor, Baker says, is that the industry is returning to more “broad-based participation.”

During the boom years, Baker says, “remodelers were cherry-picking their prices. Middle-income households were told to call back in six months,” he continues, or they received bids on their jobs that were too high for them to afford.

Data from the American Housing Survey reported that the number of homeowners reporting home improvement expenditures dropped 11% from 1995 to 2003. As a result, spending by the top 5% of spenders increased 25% during that same time period. In 2005, that group accounted for better than 60% of all remodeling spending. “There were a few households spending a lot, as opposed to many households spending a little,” Baker says, characterizing that situation as “dangerous” for the industry.

As would be expected in a flagging market, remodeling contractors are experiencing declines in their financial performance. JCHS tabulations of Qualified Remodeler magazine's Top 500 list of the firms with the largest annual volumes shows that these companies are growing at a much slower rate than they were a few years ago. Using data from the 400 largest companies that reported volume numbers for consecutive years, JCHS found that the median annual growth rate for these remodelers last year was 4.7%. In 2004, that number was 12.4% — meaning that the growth rate has slowed more than 60% in just two years.

While too much shouldn't be read into that statistic — these firms are still growing, after all — it does hint at implications for smaller companies. If large remodelers aren't growing, smaller ones may see more volatility in their own performance.

Smaller companies may not just be increasingly stagnating; they may be going out of business at a faster rate. Data from the U.S. Census Bureau reveals that 22% of all remodeling companies with payroll expenditures of less than $30,000 — which Baker says roughly corresponds to less than $100,000 in annual volume — ceased operations in 2004, including nearly a quarter of companies that size that opened in 2003. This data is not available for previous years, but Baker says that “those struck me as high numbers.”

Most recent estimates suggest that things will start to turn up in 2009. Though this date keeps getting pushed back, Baker says that there is reason to be optimistic that these predictions are closer to correct. The extension of the downturn was due in large part to the mortgage crisis, which Baker says was unforeseeable. “People saw that some folks were over-extended, but I don't remember anyone saying six months ago that it would drag down the entire residential sector,” he says. Barring another surprise like that one, things should get better in another year or so — and that, at least, is good news.

Source: Joint Center for Housing Studies