The Next Domino To Fall
Update on the Housing Market and VERY Soft Readings
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A disproportionate amount of individual wealth in North America is tied up in real estate assets.
This makes it one of the most important consumer-side issues of our time.
When Covid hit, everyone found themselves sitting on cash not spent on restaurants, vacations, concerts, and live events.
They instead ran to Home Depot to build out that extended deck or renovate the home office. If we’re going to be locked in a jail cell - might as well be a nice one.
This also started the movement of everyone wanting bigger spaces to live in since the utilization of large shared spaces was drastically decreasing.
No one tell this to a16z though, as they incredibly wrote their biggest-sized check ever to one of the biggest scam artists ever, but I digress…
With interest rates on the rise, affordability has been rapidly decreasing, pushing many potential home-buyers into the rental markets, and further spiking rents.
All of this flows into the spike in CPI figures that we are seeing since rent makes up a large portion of the reading.
I wrote this piece back in April warning of the impending downturn, and I hate to say “I told you so” but… I told you so.
There are also a lot of VERY ugly charts out there, which we’ll walk through now.
This week, in <5 minutes, we’ll cover an update on the housing market:
Housing’s Role in CPI Reading 👉 Lagging Indicator, Sticky, Big Portion
State of The Market 👉 Rates, Affordability, Home Values
Past Housing Market Moves 👉 What Can We Learn From History
Where Do We Go From Here? 👉 Rate Path-dependent, Recession, Weakening Consumer
Let’s get started!
1. Housing’s Role in CPI Reading 👉 Lagging Indicator, Sticky, Big Portion
Housing represents about a third of the value of the market basket of goods and services that the Bureau of Labor Statistics (BLS) uses to track inflation in the Consumer Price Index.
For tenant rent, the BLS counts cash rent paid to the landlord for shelter and any utilities included in the lease, plus any government subsidies paid to the landlord on the tenant’s behalf.
If a housing unit is occupied by the owners, the BLS computes what it would cost the owner to rent a similar place, known as Owners’ Equivalent Rent (OER). The cost of utilities paid by homeowners is measured separately in the CPI.
What is NOT included in CPI directly is the change in the value of the house. This is done through somewhat of a proxy manner by using the OER, which incorporates an element of the average rents paid for comparable rental housing units within the same area.
The problem with this is that finding rental housing that is comparable to an owner-occupied unit is quite a difficult exercise to do. Especially because more and more homeowners are staying put in their houses, and there is very little rental inventory available. Also add on the fact that many home-seekers are being priced out of a purchase, which further limits supply, pushing prices up.
Well-known indexes of market rents—like the one published by Zillow—capture rents of units currently advertised on the open market, and don’t capture rents for units occupied by continuing renters like the CPI does.
Rents change when leases expire, which typically happens annually. This creates a lag between changes in indexes like Zillow’s and those in the BLS’s rent measure.
This also means that if we do finally get cuts in mid-late 2023, the same thing happens the other way - a lag before we see this figure start to come down, making these changes much more sticky in nature, which bodes poorly for CPI coming back down.
Now that we understand the role of housing on CPI, let’s look at the more real-time indicators to try to determine where this could possibly go.
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2. State of The Market 👉 Rates, Affordability, Home Values
There are several forces that impact both the renting and buying market, with the primary contributor right now being interest rates.
When a mortgage lender goes to assess to lend money to you to purchase a home, they consider a ratio called the debt service coverage ratio (DSCR). How much are you bringing in divided by how much you need to pay out to repay the debt. The higher the ratio the better.
A higher interest rate environment is making the monthly carrying cost of that debt piece balloon. Let’s assume a $500k variable rate mortgage amortizing over 25 yrs with different interest rates.
The “old rate” in Canada was around 1.45%, making the monthly payment $1,987. The “new rate” by sometime next year will likely be in the neighbourhood of 4.95%, making the monthly payment $2,894.
Let’s say you used to bring in a net of $5k/month after taxes. Assuming no other inflows/outflows, the DSCR on just this debt piece alone went from 2.5 to 1.7. If you are a bank, you will reject far more mortgage applications based on the lendee’s failure to meet debt service coverage ratio requirements.
What this does is push many more shelter-seekers to the rental market since they no longer qualify for mortgages.
The net result is a higher demand for rental units = higher rents, while there is also less demand for buying units, lowering housing prices.
Here is a historical chart of US housing affordability of carrying a house (blue line) as well as mortgage payment as a percentage of income (red line):
Not a pretty chart…
We’re also seeing this clearly shown when it comes to a massive dropoff in listings that experienced a bidding war.
As well as more and more home sellers needing to DROP prices in order to close a sale:
Stretching this chart back even further…
We’ve also got existing home sales dropping off a cliff:
It’s not rocket surgery. Lowering demand from interest rate hikes that eat into affordability are collapsing both volumes of home sales (people staying put because they can’t get an attractive price), and home values (simple supply/demand economics.)
3. Past Housing Market Moves 👉 What Can We Learn From History
The good news is this is not a systematic failure and a complete loss of confidence in the lending environment that led to contagion in 2008.
The 2008 housing crisis was an entirely different beast altogether in that it packaged debt into seemingly more attractive tranches that ultimately ended up being a house of cards, not dissimilar to the Terra/Luna collapse.
The way that I see it, this is a correction from an irrational base, just like we had in certain high-flying tech stocks. A prolonged period of a low interest rate environment led to rampant investment and speculation in the real estate market.
Cheap debt with relatively stable wage growth increased the buying power of every consumer across the board. On top of this, foreign buyers flooded major city centers to use this as a store of exorbitant amounts of cash.
We are now getting a violent wake-up call.
We’re not going back to those 18% interest rates any time soon, but around 80% of active realtors today haven’t seen anywhere close to this type of affordability collapse.
The believers will say that “supply is limited” and “Months of Inventory” still remains healthy. This is completely the wrong way to look at the market.
We are in a period where the demand component is eroding to such a degree that people aren’t even listing their houses because it doesn’t make sense, which makes the “Months of inventory” number nearly useless.
So where to from here?
4. Where Do We Go From Here? 👉 Rate Path-dependent, Recession, Weakening Consumer
I do believe we will get a long and slow burn when it comes to unwinding rather than a bubble bursting. Although housing prices are dismal on a YTD basis, they are still strong when you zoom out to the 10-, 7-, and 5-year time frames.
This time around, there is no structural failure, but rather a demand and supply function naturally adjusting to a higher rate environment.
Those centered around major cities with steady net immigration will be able to weather the storm, but we are not out of the woods yet when it comes to the home value price fall.
You’ve heard the saying that “high prices are the cure for high prices”. Meaning demand will eventually weaken after consumers experience sticker shock from high prices, causing the market to correct to a lower equilibrium.
This has happened and will continue to happen until prices come back down to the point where affordability gets back to realistic levels.
This won’t happen until either housing prices come down even more or interest rates come down, and my bet is the former will happen before the latter.
Until next time. Always Yours. Incessantly Chasing ROI,
-Genevieve Roch-Decter, CFA
What else we Grittin’ On?
HOMEBUILDERS. US homebuilder confidence fell for the 8th straight month. Now at 2007 levels.
BUSTS. SPAC merger deals are breaking up at an alarming rate. More than 40 have been canceled this year.
OIL PROFITS. Saudia Aramco posted record profits last quarter. More than Shell, Chevron, and Exxon combined.
UK CPI. Inflation hit double digits in the UK for the first time in 40 years. Core CPI in the UK is now higher than in the US.
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