Many construction economists strongly believe that retail construction is the "second tier" of construction activity that follows the development of new housing. These new households, after all, will need stores near them so they can buy food, clothing and all of the other essentials and non-essentials that American families need and desire.

Unfortunately, the downward shift in housing starts was swift and acute in 2006. After averaging nearly 1.6 million housing units (at a seasonally adjusted annual rate) in the first three months of the year, single-family starts fell to a much softer 1.2 million units by August. With the housing market falling off, and further declines anticipated in 2007, does that mean retail construction is soon to follow?

The answer is yes; retail construction could take a sizeable hit in 2007. Starts are likely to drop 7 percent to 278 million sq. ft. But this sharp decline is not just the result of the direct effect of lower housing starts on retail construction. Instead, other recent trends in the housing market (trends in home prices and interest rates that have had a profound impact on consumer wealth and spending) may have an even greater impact on retail construction.

Consumers have been spending well above what their incomes would dictate, thanks to the boom in cash-out refinancing. Home prices have risen substantially over the past five years. According to the Office of Federal Housing Enterprise Oversight (OFHEO), national home prices have tripled since 1980, and home prices rose more than 50 percent over the past five years. At the same time home prices were surging, interest rates dropped to their lowest levels in more than 40 years. Combined, this enabled homeowners to pull record levels of equity from their homes to divert for other purposes.

According to Freddie Mac, 88 percent of loans that were refinanced in the second quarter of 2006 resulted in new loans that were at least 5 percent higher than the original—the largest share since 1990. Moreover, total cash-out volume for all of 2006 is expected to surpass the unprecedented levels of 2005. Freddie Mac estimates that equity extraction will climb to nearly $258 billion, a 5 percent increase over 2005. Though a much smaller gain than the 71 percent registered in 2005, it is still healthy given the current interest rate environment.

Because studies have shown that one-quarter to one-third of the money extracted from a home during a refinancing is used for current consumption, a considerable amount of these funds have directly benefited retailers.

However, the chance that this cash-out refinancing trend will continue in 2007 is bleak. Home prices across the country have begun to ease. According to the OFHEO, home prices rose just 0.9 percent in the third quarter of 2006 compared to the previous quarter—the slowest rate of increase since the second quarter of 1998. Meanwhile, home sales continue to stumble as both buyers and sellers refuse to settle—creating a period of "transaction paralysis." According to the National Association of Realtors, existing home sales in August declined 6 percent from year-earlier levels to an annualized rate of 5.86 million units.

Higher interest rates will further erode cash-out refinancings. With home equities squeezed by worsening financing costs and slower price appreciation, consumers are likely to apply the brakes to their freewheeling spending. Because some estimates have pegged cash-out refinancing as contributing more than 30 percent to consumer spending levels, this slowdown in housing is worrisome indeed.