Home is where the H̶e̶a̶r̶t̶ Money Is
Supply and Demand Levers Destroying the American Dream Pt.1
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Ah the American dream!
Work honestly in a capitalist framework so that you can buy a house with a white picket fence in a nice neighbourhood.
Send your kids off to baseball practice via a neighbourhood-sourced minivan carpool.
Get out there, and give the other rival dads and moms a wave as you drag or ride your lawn-mower across the lawn on the weekend.
This dream is dead.
Over the last decade, the median price of a home is up nearly 70%. The median income, however, is up less than 30% over the same time period.
When you hear millennials complaining (which is what we do best) about not being able to afford a house, boomers will say, “Haha! Shouldn’t have bought that avocado toast with a Starbucks coffee and maybe you could afford that house!”
There is a real housing crisis going on right now, and believe it or not, it’s not fancy small indulgences to blame…
This is part of a low interest rate environment where a secured asset can be lent against at historically low rates.
When making the house purchasing decision, new home buyers will look at the monthly amount more than the purchase price.
The decision is not: “Can I afford this well located $1.4M three-bedroom house, or should I buy the one for only $1.2M that has two bedrooms.” instead it is, “Can I afford that extra $300/month on the mortgage?”
Most people say yes, they can afford the extra payment, which is altering the competitive square when putting in a house offer.
Houses will have 10+ competitive bids through an opaque realtor network that allows bully offers, further adding fuel to the FOMO fire.
The supply and demand sides of the equation have both changed and few government authorities are doing anything to step in.
Soon - Sally and Jim will have to compete against the likes of Blackrock when putting in a bid on a house. What a broken system.
This week in part one of this two-part series, we’ll cover the supply and demand levers of the housing market:
Demand Side 👉 Why low rates = much higher demand
Supply Side 👉 Boomers staying put, NIMBYism
How GRIT’s Playing it 👉 Opportunity Cost
Let’s get started!
1. Demand Side 👉 Interest Rates, COVID, Millennials
When people talk about “interest rates” they are generally referring to the US 10yr yield. If we look at how this has moved over time, we are at historically low rates.
Banks use this rate as a reference point for where they set their lending terms around a mortgage.
Typically, large mortgage institutions will set the rate at Prime + x, depending on the lending environment, the individual’s credit history, and other factors.
Since each mortgage payment consists of principal (paying down the loan) and interest (paying the bank to lend the money), lower interest rates mean that over the life of the loan of a mortgage, the lender will pay less total interest.
For example, in Scenario A, if you bought a $500K condo in Toronto using a 30yr Mortgage at 3% per year with a 20% down payment, you are borrowing $400k and paying $207k in interest over the 30 year period.
In scenario B, using the same assumptions above, but moving the interest rate to 15%, you would be paying $1.4M in interest over the life of the loan.
As you can see, there is great incentive in Scenario A vs. Scenario B for total net money out of your pocket and into the banks.
But as I mentioned in the introduction, new buyers are thinking in terms of monthly payments.
The monthly payment amount under Scenario A is $1,686.42 vs. Scenario B at $5,057.78.
Most people would look at their paycheque under Scenario A and say, “Ok, no problem! As long as I have the down payment, I can pay that on a per month basis.” Under Scenario B there are very few who would look at that monthly amount and be able to make ends meet after all expenses.
I’m not saying interest rates will get back up to 15%, but let’s see how that monthly payment schedule scales using the above assumptions:
There becomes a tipping point where the monthly inflow of someone’s salary just doesn’t make sense to cover the mortgage expense let alone other expenses.
With historically low rates, the monthly outlay for a mortgage payment is small = more people realize its rationale to make those monthly payments.
This is the metric that highlights the raw affordability that hits your bank statement each month.
There are also other very important factors such as rent vs. buy and total return on the property in a booming housing market, which I’ll get to below.
As we know, people wanted more space and they were OK with moving away from the office. We saw the direct results through an increase in lumber prices which I highlighted in my inflation piece that you can find here.
There is a gun slinging standoff right now between employers and employees where the latter are quitting if they are not allowed to work from home. This created a social and cultural acceptance across organizations for the ability to work from home.
With WFH, it doesn’t matter where you are so why not live in a cool spot by a lake or in the mountains?
This caused a massive migration around how we think of the physical space that we occupy. Instead of buying that $2M two-bedroom apartment in New York, you can buy a sprawling mansion in Texas for half the price: $1M.
The locals already in Texas will think you’re an idiot for spending that much on that house because they paid $500k for it six months ago. But you don’t give a shit because it’s half of what you would have paid in NYC anyways for way more space.
There may be some migration back into cities as the vaccine proliferates, but the social and culture paradigm has shifted, the damage is done.
Proximity to the office matters less and less.
As of late, millennials (born 1981 - 1996) surpassed boomers as the most populous age group, and are now starting families.
Although they (we) put it off for careers for a long time, demand has skyrocketed to move out from that condo downtown close to work into a more suburban area with single family homes close to parks and beaches.
2. Supply Side 👉 Shortage, Lack of New Builds, Boomers staying put, NIMBYism
“Currently, there are fewer than three months supply of homes on the market, the lowest on record since the turn of the century,” Matthew Speakman, economist at Zillow (January 2021)
“Months of supply” is a common term used in the real estate market and is the time it would take for all the current inventory to sell if it all sold at the current rate without new inventory coming on the market.
This metric ticked a low back at the beginning of the year and has since recovered as we’ve seen some cooling over the recent months.
At the end of the day, there just isn’t enough supply out there.
Lack of New Builds
Construction has been up against the same problems that it has faced in the past: Higher lumber prices (although they have retreated quite a bit), limited lot supply, supply-chain issues, restrictive zoning laws, costly permits, and a skilled labour deficit.
All these prohibitive costs have made it extremely difficult for developers to make a solid profit on entry-level homes so they’re not being built. We all know what happens when supply lowers… PRICES UP
Boomers Staying Put
The demographics before boomers usually would either downsize into an apartment or move into a long term care facility.
Now, boomers are staying put in their homes with the intention to convert that living space into its own long term care facility, further decreasing the amount of existing units available.
NIMBY stands for “Not in my backyard.”
These guys are the worst. It’s typically old rich white dudes that don’t want “those types of people” living in their neighbourhoods, and since they have nothing better to do with their time, they go to the town hall meetings to try to block new developments.
This has lead to prohibitive zoning laws that are championed by residents who don’t want multifamily zoning in their neighbourhoods. Homeowners vote against multifamily construction, which drives up land costs. This is profitable for existing homeowners, but it makes it tougher for some would-be buyers to afford a home.
Now, let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel!
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3. How GRIT’s Playing it 👉 Opportunity Cost
So how does this affect the average readers of this letter? I purposely geared this more towards a version around personal finance so I want to break down the math in this section and frame how I think about it.
Personal finance is personal for reason, and the rules that I use here don’t apply to everyone. If you’re straight chilling on a yacht right now, congrats! You’ve made it. But this part is not geared towards you.
Rent vs. Buy
Whenever you rent a property, you are paying down the landlords mortgage.
100% of your rent is gone forever. I understand the flexibility that renting affords most people, but even over the short term, renting doesn’t make sense to me if you can afford a downpayment.
I understand that this is a pretty big IF, but saving for this downpayment by investing that money with downside protection along the way makes a lot of sense.
This all comes down to two things. LEVERAGE & OPPORTUNITY COST.
Let's continue this $500k condo example and walk through it.
Note on assumptions:
These examples that I have given are roughly what is the norm in today’s environment. Obviously, the three biggest determinants of this chart here are Annual House Appreciation, Investment Return, and Interest rate (cost of borrowing).
These can fluctuate greatly, but I’m just using long term historical averages for returns and current market interest rates in the case of this example.
For the case of simplicity, I assumed that the rent is equal to the mortgage payment
4.5% selling fee of the house includes the 3% your selling agent will charge +1.5% in legal and other closing fees.
20% down is what most banks will lend at without making you pay pesky mortgage insurance on top.
It is easier to obtain leverage on a secured asset (your house) than it is on your stock portfolio, so we’ll assume a levered house and an unlevered stock portfolio.
First, let’s look at the power of leverage on the underlying investment.
If you were to sell your house and using the above assumptions, you would return 63% by year 5 and 153% by year 10.
If you were to instead invest that $100k downpayment into the stock market, using the above investment return assumption of 7%, the asset chart would look like this:
Even with the powers of compounding at a higher rate, the returns would be 40% by year 5 on initial investment and 97% by year 10, much lower than the investment on the house.
Ok so a levered house, even with lower appreciation, has a better return profile than investing in stocks. Got it.
Since we also are going to assume you need to live somewhere and pay either rent or a mortgage to do so, let’s also breakdown the Opportunity cost through a cash flow statement.
When you breakdown the “Buy” cash flow statement, assuming the sale of the house at the end of the year, you get the following net position:
When you breakdown the “Rent + Invest” cashflow statement you get the following:
The difference between the two cash flow charts arrives at the Opportunity cost of renting instead of buying that property:
As you can see, the opportunity cost WIDENS for every year that you are renting instead of buying.
Purchase the home you live in
My final note on the housing component is how much leverage you should use.
I can bust out more excel spreadsheets but in a generally increasing or even a dead flat housing market, the answer is simple: As much as the bank allows you.
When the cost of capital right now is so low (around 3%), the only calculation you need to know is that the long-term average of investing in an S&P500 index fund is around 7%, which is higher.
If you can take any capital you have above $100k in the previous example, and either buy an investment property or put it back into the market - this is a better total return idea as long as what you are investing it in can return higher than 3%. Simple.
My final note is one of caution.
In today’s crazy housing market, we have seen home prices go up 20-30% on a YoY basis as everyone completely loses their mind. The figures quickly get astronomical when you look at the total return profile for some of these assets.
“Kids these days” have not lived through a substantial housing crash where they, instead of their parents, owned the house. We have only seen prices go up.
Prices rebounded quite nicely after ‘08 as a flood of excess money came back into the system, but living through it is a whole different story.
Just as leverage can juice your returns on the way up, they have an equally amplifying affect on the way down.
Save leverage for a house which you can’t (yet) trade on your smart phone, so you can’t impulsively sell.
Skip the “Apply for Margin” screen when you sign up for Robinhood…
Until next time. Always Yours. Incessantly Chasing ROI,
-Genevieve Roch-Decter, CFA
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