Estimating Residential Construction Cycles

The recent boom and bust in home prices and residential construction and their impact on the global financial crisis has highlighted the need for up-to-date economic indicators that can help analyze the residential construction sector. While various measures of residential construction are available, what is needed is a comprehensive measure of the direction of this important sector because various indicators can at any point in time move in different directions. Historically, the residential construction sector has played an important role in the U.S. business cycle as exemplified by the use of residential building permits in the Conference Board U.S. Leading Index.

While the timing of the residential construction cycle may not always match the overall business cycle, its size and volatility make it an important sector in the overall economy’s growth. This is true at the regional level as well.

A coincident index seeks to measure the underlying comovement among various broad measures of an economy or sector that is consistent with the business cycle. The index can be used to define precise peaks and troughs in the cycle and thus the timing and length of expansions and recessions. Indices are constructed from variables that represent broad measures of the economy or sectors of interest but come from different sources or measure different types of activity such as labor, capital, consumption or production. For example, while real gross domestic product (RGDP) is a broad measure of economic activity, the Conference Board estimates a U.S. coincident index that includes measures such as employment, income, production and sales. The underlying comovement of these variables is likely to better represent the business cycle than simply the movements in RGDP.

Research on business cycle indices has expanded through the years to regional economies. Such widespread acceptance of indices is explained by their recognized ability to measure the overall direction and timing of broad movements in the overall economy or in specific sectors. This is especially critical in the absence of a timely measure of state and local gross state product (GSP) and the lack of high-quality historical time series. Regional coincident indicators have done a good job of providing a timely and accurate overall picture of the current state of a local economy.

To date, there is no reliable summary indicator to measure the residential construction cycle at a regional level. Here, a methodology is applied to calculate a single underlying unobserved variable that represents the coincident index. The approach allows the data to define the component weights that best define the underlying comovement in the component variables.

There is no single indicator that best estimates the timing and length of the broad upswings and downturns in Texas residential construction. Even real residential construction contract values by themselves do not capture the underlying state of the sector, as contracts can be canceled, and the timing of construction activity can vary between contract signing and building activity.

Texas Residential Construction Coincident Index

The estimation period for this coincident index is January 1990 to May 2015. The period of economic contraction as defined by the coincident index is shaded (Figure 1). The coincident index moves smoothly upward during expansion and downward during contraction, thus minimizing the number of false signals of business cycle turning points. The index provides a smooth and clear signal of the state of residential construction from the three input variables: real contract values, real wages paid and the number of jobs (Figure 2).

Research economists at the Real Estate Center at Texas A&M University identified the turning points of Texas residential business construction independent of this index. These turning points serve as a benchmark to evaluate the performance of the residential construction coincident index (Table 1). Center researchers applied the same methodology as the National Bureau of Economic Research business cycle dating committee for the U.S. economy. This consists of identifying economic activity based on a range of indicators while at the same time defining contractions and expansions based on their knowledge of the Texas residential market. They identified three troughs and two peaks in the Texas residential construction business cycle between January 1970 and May 2015. The Texas residential construction coincident index matched the designated turning points for the peak achieved between September 2006 and January 2007 and the trough between April and June 2011 (Table 2). No other peaks and troughs were identified by the coincident index besides the aforementioned from October 1990 to May 2015. The coincident index performs well, replicating the features of the Texas residential construction business cycle for the sample period.

The Texas coincident index estimated by the Dallas Federal Reserve matched the designated turning points for the state’s economy and is widely used as the major reference for the regional business cycle (Table 2). However, the Texas residential construction index did not conform with the timing of the turning points in the overall Texas economy. For example, residential construction did not register a downturn in 2001, but it did register a slowdown two years later (Figure 3).

This reflects the differences between the aggregate economy’s business cycle and residential construction. In particular, it shows how residential investment can lead the business cycle, whereas a fall in residential investment can be a foreteller of a recession, as was observed during 2007. The differences also indicate that the 2001 technology downturn did not affect residential construction in Texas. The residential construction recovery has been slower than the Texas economy’s recovery. This is because of the constraints on construction after the crisis, such as securing financing for tract developments for single-family homes.

The same methodology was applied to estimate a residential construction coincident index for the United States to compare the national residential construction cycle with Texas’ (Figure 4). Observations reveal a difference in timing and magnitude, as in 2000 and 2001, when the U.S. coincident index reflects a mild recession compared with the Texas index, which represents more of a slowdown. Also, between 2006 and 2010, residential construction in Texas recorded a downturn later than the nation, while recovering earlier than the nation (Figure 5). This confirms past findings regarding the heterogeneity of business cycles in both timing and magnitude at different levels of disaggregation, where differences are present not only from national to regional but from aggregate to industry or sector.

The Texas residential construction index indicates broad directional changes in residential construction in a timely manner. Its estimates of economic turning points are sharp and agree with dates determined by experts at the Real Estate Center. It defines one brief slowdown in residential construction from 2001 to 2002 and a steep, long recession from 2007 to 2011. It shows that the residential construction cycle differs in timing from the Texas business cycle and the U.S. residential construction cycle.

Although the index performed well since 1990, this is a relatively short period by which to judge the coincident business cycle indicator. Currently, with data through May 2015, the index is signaling a healthy expansion accompanied by a slowdown in Texas residential construction activity with a low probability that the sector is entering a downturn. The usefulness of this indicator to signal directional changes in Texas residential construction will be monitored in real time in the future.

Cañas and Phillips are with the Dallas Federal Reserve and Dr. Torres ([email protected]) is a research economist with the Real Estate Center at Texas A&M University.