Economic Report

Economic Report

In January 2015, Pacey Economics, Inc. published a rigorous study of the metro Denver housing market showing that classic economic theory – low demand due to stringent lending requirements, higher down payments, higher purchase fees, lower real income, higher unemployment, later marriage rates, higher college debt, and so on – explains slow condo development, not construction defects.

The Executive Summary is below – and click through to Pacey Economics, Inc. Housing Market Analysis to read the report in its entirety.

Executive Summary

Concerns over the lack of condominium construction in the Denver area have led some to allege fault in the existing construction defect laws, and to argue that further limiting a homeowners’ avenue for remedies will reduce costs to builders, who will then choose to construct more condominiums in the Denver area urban centers. However, a careful analysis reveals that the reasons for the lack of condominium construction are the current low demand for such housing and stricter financing qualifications for builders and owners, both of which are primarily consequences of the recent recession and the credit market scandal and upheaval, and not construction defect costs. As will be demonstrated in this report, the lack of demand resulted in low condominium sales prices, making apartment construction more profitable in the Denver urban centers.

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These market conditions are not unique to Denver, but have been a nationwide phenomenon in cities where rapid apartment building and rising rents have become the norm over the past several years.
The following chart shows there was a surplus of condominiums constructed in 2009 (reflected in the increase in the number of unsold units). In response to the slow sale of condominiums during that period is the supply response of reduced construction, reflected locally in the dramatically reduced number of permits (which may or may not result in actual buildings) issued for condominium construction in the Denver area between 2006 and 2013. The chart also shows that condominium building activity in Denver parallels that of the Western region of the U.S. Also, (although not shown on the chart) the behavior of condominium completions for the U.S. is nearly identical to that of the Western region trend (just larger volume). Of note, the shift between the Denver permits and Western completions likely reflects the time it takes, from one to two years, for a building to be completed after a permit is issued.

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It is an economic reality that the 2008 financial crisis and the residual effects from the Great Recession resulted in low demand for many goods and services, including housing products. 

Stringent lending requirements, typically manifested in higher down payments and higher credit scores, plus increased origination fees and mortgage insurance premiums that were put in place following the housing bubble served to correct some of the lending issues BUT also led to increased difficulty in qualifying for home ownership (i.e., reduced demand). The charts below illustrate the negative impact of the lending requirements on changes on housing ownership.

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In addition to the more stringent lending requirements, depressed wages and high unemployment over the past several years, consequences of the 2008 recession, made homeownership of any kind less affordable across all ages, and to first-time homebuyers in particular.

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Further aggravating these factors are the natural demographic changes that are taking place in our society. The Millennials are coming to the age where home buying traditionally begins to take place. However, due to a myriad of factors including increased student debt, decreased marriage rates and postponed childbearing, younger generations are delaying forming households of their own, further dampening the demand for homeownership.

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It is another economic reality that when construction costs rise, supply will decrease. Labor costs, materials costs, and construction insurance premiums (as well as the costs of remedy or the costs of potential lawsuits), all affect the costs of building and ultimately, the profitability to the builder.

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The data illustrated in the previous charts show that costs have increased for builders in recent years, which will negatively impact both the supply of housing products as well as the profits to developers and builders.

Construction insurance premiums and costs of construction defects and/or associated litigation are factors that impact the supply of housing, with increased (decreased) costs having a negative (positive) impact on the supply of housing.

However, we were unable to obtain relevant empirical data to ascertain the trend of insurance premium costs (and associated coverage) or litigation costs.

These data exist but are only available from the developers/builders who claim the current construction defect laws make building condominiums exorbitantly expensive (apparently because litigation or the threat of litigation).

While this data could be voluntarily produced by the industry or gathered through legislative action, neither has occurred to date.

Importantly, a careful analysis (the details of which are provided in the body of this study) of construction defect statutes across the nation shows that Colorado laws are quite similar to (and less onerous to the Colorado developer/builders) than those in many other states. In addition, we observe that:

  • If, in fact, lawsuits or the threat of lawsuits or high insurance rates are the reason for reduced condominium construction, then the proper solution is to preemptively prevent construction defects from occurring.
  • Preventing construction defects can be accomplished with quality control processes that have been developed over the last several decades and utilized by apartment owners and other industries that require quality assurance to their customers. Providing quality control is a normal cost of business.
  • The solution to construction defect issues is not to make it easier to allow poor workmanship or construction defects and then shift the subsequent costs to unsuspecting consumers.

The earlier report by Environmental Planning Systems (EPS) found the Colorado construction defect statute(s) are likely to increase the cost of a condominium construction per $15,000 per unit and such a cost increase would deter the construction of condominiums in Denver urban centers. We found NO empirical evidence to support such a claim and we must STRONGLY DISAGREE.

Even if one is willing, for the sake of the argument, to assume a $15,000 per condominium unit cost increase (remember we do not believe this can be supported) due to increased construction insurance premiums because of potential construction defect litigation, the EPS claim cannot be supported for reasons outlined below:

Consider a potential homeowner who is willing and able to purchase a $200,000 condominium unit but, because of the increased costs (from increased insurance premiums due to construction defect litigation), the price is now $215,000 (i.e., the full cost is passed on to the home buyer).

  • This new homeowner will have to amortize the $15,000 into a 30 year mortgage which will amount to approximately $750 more in annual payments for the homeowner. EPS seems to claim this will deter all construction by builders of condominiums.
  • Now consider this new homeowner faces a 10% down payment rather than a 3.0% down payment, requiring $21,500 cash upfront rather than $6,450 or $15,050 more cash needed for a down payment. This is a more dramatic barrier to purchase than the additional $750 per year if the full cost of the builder’s insurance premium is passed on to the new homeowner.
  • Now further consider, as noted above, that there is also an increase in the origination fee which increased approximately 75 basis points in recent years (since 2007/2008) adding $1,600 more in upfront costs and a mortgage insurance premium with an 80 basis point increase over the same time frame adding an additional $1,720 in annual costs to the homeowner. Both are clearly more limiting for a potential homeowner than the amortized annual cost of the fully passed on cost of the claimed cost of construction defect litigation.
  • Finally, consider the earnings of likely first time buyers (26-30 year olds ) today is only 83% of the earnings (real) of their counterparts a decade ago BUT housing prices have increased, obviously making home ownership even more difficult.
Clearly, the increased down payment, origination fees, mortgage insurance premiums, reduced real earnings are all more significant financial deterrents to home ownership than any barrier from construction defect laws.

The good news for the housing market is that economic activity is finally on the upswing in Colorado and across the nation, allowing demand to rekindle and market forces to provide both the demand and supply incentives necessary to induce condominium construction.

  • Also good news, markets are continuing to correct, unemployment rates are reaching more normal levels, the economy is sustaining its recovery, and incomes are starting to rise.
  • Further good news, banks are beginning to loosen their lending requirements and interest rates still remain at low levels allowing the market to feed an increase in the demand for housing products.
  • Also, if the Millennials’ delay in home buying is “pent-up” demand, there will be a natural increase in the demand for housing products once they begin to marry and have children.

Ultimately, when the price is right, which is determined by demand and supply in a market economy, developers/homebuilders will focus on constructing condominiums again. (Moreover, if there really was an unmet demand for condominiums, apartments can be converted to condominiums.)

  • The demand for condominiums appears to be gaining momentum as prices of condominiums are on the rise, which will result in more condominiums being built as a part of the normal market process.
  • In fact, there are a half-dozen or more condominium projects either currently being developed or in the planning and processing stages.

Limiting or restricting a homeowner’s avenue to remedy a construction problem by changing the Colorado construction defect statute will not make the costs of repair go away.

  • Modifying the statutes will only shift the remedy costs to the individual homeowner and/or future homeowner (via increased cost and/or reduced property value), who had no way of knowing of this defect prior to purchase of the housing unit.
  • In addition to shifting costs to the individual homeowner, the property value of the entire complex will be reduced if the other owners have similar issues.
  • There is a further negative ripple effect from an individual homeowner to a complex or neighborhood of homeowners to the overall community as property values fall, lowering property tax values, and ultimately lowering city revenues and services.
The Colorado construction defect statute serves two public policy purposes:
  • It assures homeowners or potential homeowners that there is an avenue to seek remedies for poor quality construction issues; and
  • It signals to developers/builders that they are responsible for the production of their product.

The construction defect statute serves the same purpose as the quality control requirements in every industry, whether it is in the manufacturing of automobiles, aircraft, toys, agriculture, etc. That is, as a consumer has no way to assess the product quality (or safety) of a product, be it a home, a toy, an airline flight, procedures are in place through our regulatory or legal system to insure that the consumer receives the product as advertised. Without quality controls and avenues to remedy a problem, markets will not work efficiently.