Smaller Living Spaces and Higher Density Are Here to Stay

We've all seen the explosion of apartment construction, with many of these often mixed-use structures primarily containing "micro apartments." We have also seen a growing trend to build smaller single family homes in recent years. On the surface, it seems clear that some of the trend for small living can be attributed to the sustainability movement (smaller spaces require less energy to operate and have smaller carbon footprints, in part due to requiring less materials). But the question that I asked myself was "is this trend going to be around for the long term?" After thinking about it a bit, and taking a look at the housing market as a whole, I came away thinking that, in fact, this will be a long-term trend. Not only because of the strength of the sustainability movement, or the growing demand for urban/walkable living, but because there will be considerable economic incentives to living small.

So, exactly what economic incentives are or will be at work to stimulate the trend for small living?

To answer this question, we have to take a close look at mortgage rates. We have been experiencing historically low interest rates for several years. These low rates result in expanding the pool of potential home buyers by essentially lowering the cost of home ownership. Basically, low mortgage rates tend to increase the demand for homes. But what does any of this have to do with the trend of living small? To answer that, you have to consider what could change in the economy that would influence the current pattern of home buying. Current mortgage rates are low, but they won't be low indefinitely, especially if you consider that these rates have been kept low through artificial means. In fact, historical prime interest rate levels of roughly 7-8% (approximated from evaluating US. prime interest rates since 1947 as sourced by the US Federal Reserve and the Wall Street Journal) have been artificially reduced since November of 2008 through monetary policy (Quantitative Easing, or QE1, 2, and 3). QE is the term used to describe the Fed's massive bond purchasing efforts to keep interest rates low (to stimulate economic expansion). Roughly, QE works like this: the Fed increases the demand for bonds by purchasing large quantities of bonds every month. These massive purchases decrease the supply of bonds, and as a result, given a constant demand, the price of bonds increases. As bond prices rise, bond yields drop, meaning that these bonds are priced with lower interest rates. Since mortgage lending agencies collect mortgages and package them into bonds that are sold to investors, cutting interest on bonds leads to lower mortgage rates. Generally speaking, lower bond yields translate to lower interest rates.

As the Fed pulls back the bond purchasing (QE), the supply of bonds expands, bond prices fall, bond yields rise and mortgage rates rise. As mortgage rates rise, the cost of home ownership will rise substantially. As an example: If a person borrowed $300,000 in 2012 at, say, 4%, he or she could be paying $1,400 in principal and interest monthly. Without QE in place, a 30-year fixed mortgage could be 7.0%. That would pencil to roughly a $2,400 monthly payment on the same size loan (a 71% hike).

QE will end someday, and when it does, and interest rates will rise. When that happens, the loan amounts that people can afford to carry (assuming stable housing prices, and continued slow wage growth) will drop dramatically.

And the trend to live small?

In an economy without QE, future home investors will be looking to offset their decreased buying power. Many will drop out of the home buying pool and back into the rental market, which will stimulate rental demand and rental prices. As rental prices rise, the demand to rent small will rise. For those who stay in the home buying pool, they are likely to try to offset decreased purchasing power by buying small...or smaller. In the end, the economic incentives that are likely to stimulate the trend for small living are higher mortgage rates. Considering this, along with the sustainable movement and the demand for urban living, it is my opinion that living small or smaller is a trend that is here for the long term.