Housing Starts Slump in May

After encouraging news that building permits were up, builders broke ground on fewer homes in May.

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It's more mixed messages from the housing market this week.

After building permits—a leading indicator of future construction—surged almost 8 percent in May, the optimistic mood for the recovering housing market was dampened by news that builders broke ground on significantly fewer homes last month.

Overall housing starts plunged almost 5 percent in May to a seasonally adjusted annual rate of 708,000, according to the Commerce Department, disappointing economists who expected an almost 1 percent increase. Housing starts remain well below historical and demographic norms. According to economists, the U.S. economy should be cranking out close to 1.6 million homes a year.

[See a slideshow of the cities with the fastest shrinking inventories.]

One reason builders are starting work on fewer homes is space. Much of the land closest to major city centers has already been developed, according to Mesirow Financial chief economist Diane Swonk, and with gas prices skirting $4 a gallon or higher in some places, longer commutes from the suburbs have become less and less attractive.

Competition from previously owned homes is also putting a damper on demand for new homes, Swonk says. "Most buyers can get more for their money in the existing home market than in the market for newly built homes," she writes.

[Read: Bidding Wars Are Back for Summer.]

But the news wasn't all bad. Slumping apartment building starts—a sector known for its volatility—was responsible for nearly all the pullback in new construction, economists said. Single-family construction on the other hand grew more than 3 percent, the third month in a row that sector has seen increases.

"The continued modest growth in single-family construction and permits…suggests that housing is finally taking its traditional place as a leader rather than following in economic recoveries," said David Crowe, chief economist at the National Association of Builders.

Meg Handley is a business reporter for U.S. News & World Report. You can reach her at mhandley@usnews.com and follow her on Twitter.