3 reasons why the US housing market could be on the verge of collapsing

ADragan

Co-produced by Austin Rogers.

In the past year or so, the fundamentals for nearly every type of housing in the United States have never looked better

  • House prices have risen by 30-40% or more
  • Rental rates have risen 20-45%, depending on the market
  • Vacancy rates for both rental properties and owner-occupied homes have plummeted to nearly all-time low

vacancy

Yardeni research

But nothing lasts forever. Trees don’t grow in the sky.

Indeed, as long-time investors know, excessive movements in markets often reverse violently: generally, the more exaggerated the trend, the more violent the reversal. Rather than simply returning to the average, exaggerated price movements often reverse and move well beyond the average in the other direction.

Despite this disturbing configuration, we do not necessarily anticipate a collapse in house prices similar to the Great Financial Crisis. The future is unknowable and investing on the basis of such dire predictions turns out little more often than it works in your favor.

However, the data doesn’t look good for the housing market. In what follows, we present three reasons why house prices may soon begin to fall. And let’s wrap up with a brief discussion on one of our favorite investment types right now.

1. Rapidly eroding economy for homebuyers

The first and most obvious reason the housing market may be in trouble is the simple fact that the affordability of homes this year is dramatically eroded.

Just consider two factors to come to this conclusion: house prices and mortgage rates. Although there are a few all-cash buyers out there, including institutional investors like Blackstone (BX) along with real estate investment funds (“REITs”) like Invitation Homes (INVH) and American Homes 4 Rent (AMH), most buyers must use financing to make such a large purchase.

For most buyers, the affordability of the home essentially comes down to the total monthly payment rather than the selling price of the home itself. That’s why falling mortgage rates tends to drive house prices up, while rising mortgage rates tend to slow or reverse house price growth.

So far this year, mortgage rates have risen rapidly, even as house prices have continued to rise.

30-year mortgage rate data

Y Graphs

The 30-year mortgage rate hasn’t been that high since late 2008, yet house prices have nearly doubled since then.

The same mortgage rate combined with significantly higher home prices equates to a much higher monthly payment for incremental buyers. This has put a huge portion of would-be homebuyers out of business.

The erosion of affordability for housing can also be seen in the ratio of new home prices to disposable income per capita:

US home accessibility

Y Graphs

The average new home in the United States is being sold at around 10 times the disposable income per capita right now. That ratio is higher than at any time in the past 50 years and could very well be an all-time high. This relationship could rationally be supported only by ultra-low mortgage rates, which we no longer have.

2. Increased inventory of new homes

As a result of the rapid erosion of the affordability of homes for new buyers, fewer homes are being sold. This is a problem for home builders (XHB). Although the start of single-family home construction is now plummeting, builders have begun construction of large numbers of homes between late 2020 and 2021 which are now expected to be delivered to a market with much lower than expected demand.

Housing begins in the United States

Y Graphs

It’s hard to overestimate how violent this whiplash effect is. Ultra-low mortgage rates combined with lots of government-injected stimulus money in 2020 and 2021 resulted in a huge surge in demand, which sent signals to home builders. build, build, build. They responded to those signals, but then mortgage rates went up and the government stimulus ran out.

Now an excess of newly built homes has rapidly risen to its highest level since March 2009.

the surplus of new homes has rapidly risen to its highest level since March 2009.

Federal Reserve

There were 11 months of supply on the market in July 2022 and there is still no sign that this surplus of new homes available is peaking.

The laws of supply and demand would seem to indicate that excess supply will require a fall in prices for the market to free itself and the excess to be reduced.

3. The collapse of the sales volume

Unsurprisingly, based on the previous two points, the volume of sales of existing homes (a much larger market than that of new homes) is also collapsing. Again, it is difficult to overstate the speed at which the trend of increasing volume of existing home sales reversed from 2010 to 2021.

Sales of existing homes in the United States

Y Graphs

By itself, the decline in home sales volume does not necessarily lead to lower house prices. But historically, that correlation exists and is quite strong.

Below, we take a look at the same graph of existing home sales (purple) superimposed on year-over-year changes in home prices (orange):

Sales of existing homes in the United States

Y Graphs

As you can see, there is a pretty strong correlation between home sales volume and home prices. When the volume of home sales increases, house prices are generally rising as well. When the volume of home sales declines, house price growth tends to follow it down, sometimes in negative territory.

Note that the sales volume of existing homes fell (fairly rapidly) to the same level that home prices began to decline in the late 2000s. Does this necessarily mean that home prices will fall? No. But at least it indicates that nominal house price growth is expected to fall to a low figure.

It should also be noted, however, that a substantial drop in house prices is not beyond the realm of possibility.

Why we like REITs

At High Yield Investor, REITs are some of our favorite sectors of the equity market. Although initial yields are lower, the asset type is highly defensive, benefits from higher inflation, and tends to outperform private property for long periods of time.

This is especially true for apartments:

multi-family outperformance

BSR REIT

Armada Hoffler apartment complex

Hoffler Army

While we think apartment occupancy and rental growth are likely to continue to moderate this year as the economy approaches, it is important to note that the loss of home ownership is a gain for multifamily.

See, for example, the more or less inverse relationship between the growth in the formation of owner-occupied households and the formation of rented households over the past two decades:

Family unit formation: owners vs renters

Yardeni research

As more and more would-be home buyers are priced to purchase a home, the benefit steadily accrues to apartment owners.

Even beyond the decline in affordability of home ownership, there are still several favorable winds supporting the demand for rental housing, particularly apartments:

  • Low unemployment
  • Growth in employment and increase in the labor force participation rate
  • Income on the rise
  • Large cohort of Gen Z capable of replacing older Millennials moving into single-family homes.

In other words, we don’t see the same vulnerabilities present for apartment performance as for the housing market.

That said, here are some of our favorite multi-family REITs:

  • AvalonBay Community (AVB): This primarily coastal Class A apartment owner / developer is the blue-chip multi-family REIT focused on East and West Coast markets. Its vast development pipeline, which is largely found in the fast-growing cities of the Sunbelt, offers a huge opportunity for value creation, as it can develop new properties at a much higher return than it can buy existing properties. Despite this, it currently has a 20% discount price to the NAV, which is a historically low valuation for the company.

AvalonBay Communities Apartment Complex

AvalonBay community

  • BSR REIT (OTCK: BSRTF): BSR is a small multi-family Class B REIT listed on the Toronto Stock Exchange and over-the-counter in the United States Over 90% of its condominium community portfolio is concentrated in the “Texas Triangle” of Houston, Dallas / Fort Worth , and Austin. These hot markets are fueling the NOI’s growth rate of the same leading BSR store in the teens. It currently has a whopping 25% off the NAV despite being the fastest growing in its history.

BSR REIT apartment complex

BSR REIT

  • Camden Property Trust (CPT): Houston-based CPT is a company worth $ 18 billion, primarily owner / developer Sunbelt multi-family. Its portfolio is split around 60% of Class B properties and 40% of Class A properties, which should make its rental income more resilient in the midst of high inflation and a potential recession. It is also priced at a large 20% discount on the NAV which is rare for a REIT of this quality.

Camden Property Trust apartment complex

Camden Property Trust

In short, while we are increasingly concerned that the US housing market may suffer major problems in the future, we remain bullish on apartments, especially those located in the Sunbelt.

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