Like all markets, the performance of housing is determined by only two things: supply and demand. In the late 1990s and early 2000s, demand was strong due to natural demographic trends and to a booming economy. Unfortunately, by 2004, the demographic trends driving natural demand had peaked, but the supply of new homes was still being ramped up to meet speculative demand. When it all came crashing down in 2006 and 2007, the market was left with a massive over-supply that we are still working off today, hence the decline in prices.

As HS Dent wrote in Demographics Trends in Real Estate and in the HS Dent Forecast, this supply glut is likely to last for more than a decade, particularly in the large “McMansion” segment so beloved by affluent Baby Boomers in their primes.

The good news is that the housing market is not a uniform block. There are different subsets, such as apartments, starter homes, trade-up homes, etc, and each has its own demand dynamics based on demographic trends.

Demand for starter homes by first-time Echo Boomer buyers is quietly gathering steam. The largest cohort of Echo Boomers will be graduating from high-school this year, meaning that the bulge of students currently crowding the universities will soon be moving on to the next stage of their lives: early career. These Echo Boomers will first create a surge in demand for apartments and then for starter homes as they begin to settle down and start families.

As Shawn Tully reports in his June 6, 2008 article on CNNMoney.com, this trend is already understood by America’s homebuilders:

"During the housing bubble, KB Home priced out first-time homebuyers by building bigger. Its new, more modest model provides a glimpse of what the return of the housing market may look like…

During the bubble, KB Home, like many other big builders, blew up its old-line business [of mass-produced tract homes] by going ritzy and building expensive houses. Now KB is among the first homebuilders to recognize the error of its ways, and it is returning to its roots as a purveyor of low-cost, smaller homes. In some cases KB is even using the same façades from the go-go years and then shrinking the house that lurks behind them to be half as deep - and about half as expensive…"

Of course, KB Homes was not in error by satisfying the demand for the largest, richest generation in history. The Baby Boomers wanted McMansions, and they got them. KB’s only error was believing that this trend would continue.

The McMansion market is dead for the foreseeable future, but this doesn’t mean that all home construction will cease in the coming years. Echoing HS Dent’s own commentary on the situation, Tully writes:

"When the real estate market comes back, it will not be with a sonic boom. It is likely to be subtle, below the public's radar. The revival will probably begin in the areas hit hardest by the bust: in Florida, Las Vegas, and the honeycombed tracts that flank the broad freeways east of Los Angeles known as the Inland Empire….

Why will housing come back? For a reason as solid as floor joists: The entry-level buyer…, the twenty something young professionals who rent until they get married or the first child arrives, and then reach for the American dream of homeownership…. "

When the housing market recovers, it will do so in a smaller, more affordable form, which is good for young Echo Boomers buying their first house. Unfortunately, it will do very little for the millions of existing homeowners who have seen the value of their McMansions fall precipitously.

In many cases this will be a significant detriment for Boomers. Many Boomers have approached retirement with their real estate equity as a portion of their retirement capital. Since their track record with real estate prices has been consistently rising with intermitent disruption, the underlying assumption is that this softening of prices is temporary.

While real estate is always local, the high flying prices of recent years requires a resurgence of buyers who can afford and who need a McMansion. Few regions of our country are expected to see the necessary demographic growth to revive the pricing we experienced in 2006 and 2007. Boomers who planned on converting appreciated home equity to retirement income assets are loathe to face the reality of deferred retirement, lowered expectations and other consequences of insufficient dedicated retirement assets.