Why I think Home Prices Will Not Suffer a Major Correction
I’ve had several conversations recently with investors and homeowners who know my background and the topic always turns to “how much do you think houses are going to depreciate?” Clearly, a great deal of anxiety is present in the market today as the Fed appears hellbent on crushing inflation through continued hawkish interest rate hikes and the historical mental model for housing consumption has been “rates go up, prices go down”. People are generally shocked when I tell them that I don’t really see considerable pressure on home prices outside of those who may be forced to sell a marginal asset in the very near-term.
Before we jump in, I want to clarify that I have a somewhat poor track record at short term predictions but a really solid track record in both intermediate and longer term. This does not constitute advice on what to do with your portfolio or what your Mom should do with her house.
So why do I think pricing will remain relatively resilient? Four main factors.
Every year the US needs roughly 1–1.2 million new housing units to meet demand (800–900k for new household formation and 200–300k for replacement). From January 2008 through 2014, new home construction plummeted below replacement rate with a nadir in April 2009 of annualized housing starts below 500k. After rebounding in 2014, new housing starts have hovered around the replacement rate and never made up for the 6 years of significant underdevelopment. During this same time period, institutions and investors began snapping up real estate at the entry-level and in desirable short-term rental locations (see next section). Furthering supply constraint is an aging population who is living longer, healthier lives and wishing to do so in their homes. 65+ households are the fastest growing segment with the 85+ sub segment growing at an even faster rate. The combination of these factors means there is a supply constraint for an asset that everyone needs and wants. This does not make for a precipitous pricing adjustment.
This is especially true at the entry-level of homes. The cost of building a home (from materials to labor to governmental impact fees) makes it nearly impossible for homebuilders to build a smaller footprint home and turn a profit. In the 1970s and 1980s, between 1/2 and 1/3 of new homes were under 1,400 square feet. That dwindled to 1/5in the 1990s and 2000s and today is less than 1/10th. If the vast majority of new homes built in the last 30+ years are larger in square footage, it seems natural that overall pricing would climb substantially. This furthers the idea that “pricing” as measured by median will not decline substantially.
It has never been easier to monetize residential real estate. Property management services and software allow landlords to find, screen and manage tenants in ways that were not possible just 10 years ago. Marketplaces make it simple to drive demand for short term rentals which yield higher rents. As a result, institutional and private investor capital has flooded the market to purchase homes over the last 5 years. In my home town of Charlotte, investors made up 33% of all homes purchased in Q1 of 2022 and similar markets such as Jacksonville, FL and Birmingham, AL experienced the same. Investors underwrite a property on its ability to cash flow whereas an owner-occupant is looking at the expense they can afford. This makes the market clearing price equal to the present value of cash flows assumed and not just “what is desirable and who can afford it.”. And if you are an investor, what incentive would you have to sell off a high yielding, cash flow producing asset into a down market in which there is little to no replacement investment for that cash? Further, if affordability is a challenge and people are forced to rent, is that not a good thing for your business? All this adds up to limited inventory hitting the market which further supports pricing.
Stricter Underwriting Standards
I began my “housing” career in 2005 as an investment banker focused on homebuilders, building products, distribution and contractors. The factors that drove the insanity of that market are not what is here today. During the housing crash of 2009–2011, a significant amount of the risk and pricing issues were related to lax underwriting standards and poor risk management in the capital markets. Mortgages were being written with no income, employment or credit verification and multiple mortgages were given to people without the financial means or assets to support them. The mania of “homes never go down” ran rampant, people leveraged themselves to the fullest to own as many homes as they could in an effort to resell them, most of the mortgages were short-term, interest-only ARMs that were used as short-term financing until you flipped the home for the next one, and all the risk was sold off through CMBS. After the crash, lending standards got strict. Gone were the days of no verification. Banks enforced down payment standards, high credit scores and strict underwriting. This means that all things considered, people in their homes today can actually AFFORD to be in those homes and they will be expected to perform on their mortgages. Again, lending to high credit individuals at historically low rates does not support a pricing adjustment or a flood of inventory.
Lack of Replacement
If you are a homeowner today and have purchased prior to the rise of interest rates, you are the beneficiary of historically low cost of capital and reasonable housing prices. If you sell your home today, you will need a way to replace your purchasing power. Selling a home typically costs 6% + repairs and closing costs. Even if you extract every dollar of equity gained during the last few years, the transaction costs will eat into your ability to roll that into another property. Layer on the likelihood that your interest rate would double, there is no way for you to sell your home and get the same quality of house today. So you are staying put unless someone pays your full asking price (or more to cover the increase in financing costs). This again reduces the supply or the willingness to take a lower price.
Something’s gotta give right? To me, innovation is the way to increase attainability of housing. The era of affordability may be over but entrepreneurs are busy building new models today that will make attaining a home (even if it is not under the historical mental model of ownership) possible. I will dive into this and the changing paradigm of what it means to “own” a home in future blog posts.