“Way” back on October 28, while responding to comments on an article documenting a 31% drop in pending home sales, I wrote that eventually, house prices in the US “will correct more (and probably a lot more) than the vast majority of people who’ve weighed in publicly were willing to concede ahead of time.”
I went on to suggest that they (the people who weighed in publicly) won’t frame the situation that way, though. Instead, everyone will move their goal posts gradually in an ongoing mark-my-implicit-prediction-to-market exercise, until the sum total of incremental consensus shifts allows most people to claim they weren’t wrong.
That’s already happening. On Monday, four days after it was originally published, an article in The New York Times made its way to my inbox. “The Housing Market Is Worse Than You Think,” read the title. It was replete with what would’ve seemed like dire projections just six months ago, but now sound entirely feasible.
I’m sure the title was apt for the vast majority of the Times‘s audience, but not for me. I’ve spent the better part of two years insisting US housing is headed for what’ll feel like a crash, and although I might’ve been early, I don’t think I was wrong.
The Times piece kicked off with a quote from Mark Zandi, mainstay of mainstays. “Mortgage rates are sky high, prices are sky high and there’s no inventory,” he said. “This may be the worst time in my living history for the home buyer — it just doesn’t make sense.”
It wasn’t entirely clear what, precisely, didn’t make sense to Zandi. He probably just meant that it doesn’t make sense for Americans to buy a home right now. But for many analysts, the conjuncture Zandi described is itself nonsensical to one degree or another. As much as I despise nebulous old adages, this is the quintessential example of a “something’s gotta give” scenario.
I can’t believe I’m saying this, but the overwhelming consensus among experts seems to be that the US housing market can simply grind to a complete halt without highly deleterious side effects for the broader economy, a contention undermined by the simple figure (below).
Over the past half century, there’s never been a case where residential fixed investment was as much of a drag on real GDP as it was in the third quarter of 2022 without an NBER recession.
Maybe that’s a meaningless statistic. Or maybe I’m unwittingly asking a chicken-egg question. I don’t know. Too many smart people pretend to be experts on everything simultaneously. I assiduously avoid making any such claims for myself, although I would note that when I think I’m especially bereft, I’ll readily put tens of thousands of dollars on the line in order to remedy the situation, as I did earlier this year during a three-month crash course in crypto and Web3. While I’m no expert on the US housing market, I’m not bereft either.
Even if I were bereft (or, in other words, let’s assume you’re bereft, and all you’re interested in consulting are the simplest, broadest measures you can find), I’m highly confident in asserting that the US economy can’t function well in an environment where housing isn’t just kneecapped, but in fact encased in carbonite, like Han Solo.
Below, find the official, US government-approved definition of residential structures investment, on the off chance you don’t know what the word “residential” means, aren’t apprised of what a “structure” is and are confused as to what constitutes an “investment”:
Investment in residential structures consists of new construction of permanent-site single-family and multi-family units, improvements (additions, alterations and major structural replacements) to housing units, expenditures on manufactured homes, brokers’ commissions on the sale of residential property and net purchases of used structures from government agencies. Residential structures also include some types of equipment that are built into residential structures, such as heating and air-conditioning equipment.
We (society) can’t just stop doing all of that (investing in the residential sector) and expect things to be ok. But, in effect, that’s what too many housing market aficionados seem to be suggesting, albeit accidentally.
The narrative goes something like this. Mortgage rates are very high, and so are prices, which means buyers are drying up. Sellers, meanwhile, know their leverage is slipping due to a lack of qualified buyers, and besides, if they (sellers) intend to take out a new mortgage for any portion of a new home upon selling their existing residence, they’ll almost surely be trading a very low rate for a very high one. Nobody wants to do that, so there are no sellers, and that leaves less inventory, which supports prices despite waning demand. Meanwhile, the affordability crisis is driving up demand for rentals, and thereby rents, which means renting is unaffordable too. Builder sentiment is abysmal for all manner of reasons, not least of which is that suddenly, nobody can afford to buy, which means having to offer incentives and rate buy-downs, further crimping margins already squeezed by higher input costs. The worse builder sentiment is, the less gets built, which could eventually squeeze supply even further, thereby supporting prices and prolonging the stalemate. Finally, the cost of debt on commercial property is rising so rapidly that for some developments, the financing could exceed earnings from rent which, in turn, could mean fewer rental options, and thereby higher rents.
Somehow, all of that is supposed to be tenable, where tenable means industry watchers seem resigned to the patently absurd idea that such a conjuncture can persist in perpetuity. That contention is rarely expressed as such. Rather, it’s conveyed via the pervasive “Oh, well. Nothing we can do” overtones that pervade housing market coverage in the back half of 2022.
What I’m telling you is that this isn’t going to play out like everyone seems to believe it will. Something has to adjust such that the burgeoning stalemate eases, because a prolonged stalemate wherein nobody is buying, nobody is selling and nobody is building isn’t a viable state of affairs.
While it’s true that nobody can force anyone else to sell their home, supply isn’t going to simply disappear altogether. But demand might. Some people have to sell for a variety of reasons. And builders can’t just stop building altogether, anymore than McDonald’s can stop frying french fries. If you’re a publicly-traded homebuilder, you have to build homes. It’s not optional. What else are you going to do? Pivot to Bitcoin mining?
At the same time, real estate technology firms are imperiled. Shares of Redfin are down ~90% in 2022, for example. Opendoor, a Chamath Palihapitiya SPAC, last week took a $573 million write down on its inventory while posting a $211 million adjusted loss. If you’re wondering whether that counts as large for the company, the answer is “yes” (figure below).
In a letter to shareholders, the company explained the write down in straightforward terms. “Adjusted Net Income or Loss reflects the earnings from realized gains and losses on the homes sold in a particular period,” Opendoor said. “The inventory valuation adjustment reflects the expected losses on the homes in inventory as of the end of Q3, without taking into account the offset of any gains expected to be realized… akin to looking at equity portfolio performance based only on unrealized losses, exclusive of any unrealized gains.”
That’s all fine and good, but according to Bloomberg, Opendoor is selling a “growing number of homes for less than it paid.” In fact, it looks as though homes sold at a loss are now outstripping those sold at a gain. Earlier this month, the company said it would lay off 18% of its staff. “This is a crucible moment,” Eric Wu, Co-Founder & CEO told investors last week. “Companies without the conviction, perseverance and capital will not be able to weather the storm.”
In September of 2020, Palihapitiya tweeted, of Opendoor, “This is my next big 10x idea.” The shares are down 95% from the highs seen in February of 2021.
This conjuncture has all the hallmarks of a looming collapse. Based on my own extensive discussions with mortgage brokers, mortgage bankers and agents across multiple US states (I’ve documented those discussions in these pages in dozens of articles and comments) industry participants are all in some stage of denial, albeit not the same sort of denial witnessed around the subprime bubble.
Market observers and sundry commentators are all similarly reluctant to countenance the idea that prices are poised for a historic correction, despite the fact that the run-up was unprecedented (as the Times pointed out, the rise in existing home prices logged from December 2019 to June 2022 was “the biggest jump ever recorded in such a short window of time”). Put differently, a 40% collapse would only take prices back to pre-pandemic levels.
Moreover, financing costs went from record lows to the highest in 22 years virtually overnight. Tech companies insistent on the notion that they’ve introduced game-changing innovations are involved, and generally speaking, they still believe their own elevator pitches. Finally, the Fed is still leaning against the market, and may eventually decide to actively sell securities linked to it. Fighting the Fed is a historically bad idea.
As noted above, something’s gotta give here, and while there are a number of candidates, the most obvious is prices. If prices for the inventory that’s out there (however scarce it might be) adjust sharply lower, the rest will begin to take care of itself.
On Monday, Fannie Mae said its Home Purchase Sentiment Index fell 4.1 points in October to 56.7. It was the eighth straight monthly decline and the lowest reading since the gauge’s inception more than a decade ago.
“Consumers are increasingly pessimistic about both homebuying and home-selling conditions,” Doug Duncan, Fannie Mae Senior Vice President and Chief Economist, remarked. “Amid persistently high home prices and unfavorable mortgage rates, the ‘bad time to buy’ component increased to a new survey high this month, while the ‘good time to sell’ component continued its downward trend.”
Interesting about Opendoor – I had never heard of them until we started shopping for a starter home for one of our kids about a year ago. In a market where everything was selling in a weekend at prices over asking, their listings were hanging on the market. None were staged (unless you count CGI on line) and each had some flaw that they had not adjusted the price for – repairs needed, reeked of smoke, cat pee, etc. The last three quarters’ financials bring to mind the old adage, “If you eat like an elephant, you can’t expect to sh–t like a bird.”
I have to say, I love thinking of the housing market as encased in carbonite, I guess that would make Mr Powell a skinny Jabba the Hutt
https://twitter.com/heisenbergrpt/status/1597437386585444352
While price drop seems to be the most obvious scenario, are there any plausible alternatives? E.g. would it be possible for the owners/sellers to sit out and weather the storm until the rates “normalize” again? Or can a couple of years of inflation make current prices “affordable” again?
… and no one can even mention the “P” word.
The rent/housing costs are too damn high.
Wall Street investors clamored for and received a fed put years ago. Will Main Street (home owners) get one? If something’s gotta give, and it breaks, how far can it go before the public noise overwhelms an already weakened fed? … a Main Street put, oh the irony.
Wall Street (and real estate developers) get to play by a different set of rules.
The real price of residential will fall. The question is how and how fast? Also part of the something has to give is that mortgage spreads and rates are also destined to fall. Before you get a big nominal price correction you need inventories to rise. They will but it will take time.
It’ll be interesting to see if those fortunate enough to either own a home or have one financed with a low interest rate, will learn to be satisfied with what they have, and not be compelled to buy “bigger, newer, better”
if and when this calamity is resolved.
on the off chance you don’t know what the word “residential” means, aren’t apprised of what a “structure” is and are confused as to what constitutes an “investment”
love it
I thought the whole idea of the Fed attempting to engineer a “soft landing” would be that they pivot just prior to a crash ( of almost any type) and therefore, avoiding a crash.
Seems easy enough!
What H’s post suggests is a stand-off between buyers and sellers, where the bid-ask spread is so very wide that no-one will transact unless they are forced to.
The reasons a person could be “forced to buy” are very few – actually I can’t think of one, aside from contrived things like a 1031 exchange period expiring. After all, you can always rent.
The reasons a person could be “forced to sell” are much more numerous – lose job, get divorced, crushing medical bills, business folded, move to assisted living, etc. Sure, loan standards were solid and homeonwers are sitting on big gains and the attendant healthy equity, but that doesn’t mean they can’t be forced to sell, just that their houses are less likely to be sold to the bank aka foreclosed.
When the forced sellers come to market, there will be cash buyers and investor buyers, regardless of mortgage rates, and those cash buyers will drive a hard bargain indeed.
So it is likely that the stand-off will be broken by forced sales. Each unwilling seller who is forced to hit the bid is another low comparable price, and since houses are valued off comps, house values sink.
I think we should expect significant house price declines by mid 2023, massive job loss at real estate brokers, mortgage lenders, escrow companies, and associated industries, and that many of today’s “proptech” companies will go away, including the excreable iBuyers. We should also expect the spending that is fueled by home sales and home equity to decline sharply. And we should expect even more of America’s last great middle-class asset to fall into the hands of the investor class. That is the real tragedy, and I have not heard a peep about it in Washington DC (or my local state house) from either party.
I’m trying to analyze a non-public multifamily REIT given the scenarios outlined in the article and the comments. It seems to me there are a lot of cross currents, and that on the whole multifamily is likely to outperform due to the increased number of renters in a stagflationary environment. That said, the specific non-public REIT I’m analyzing has recently experienced excellent outperformance, being up 40% in the last year. Quite an anomaly given the last 12 months.
Complicating it all is that the elderly individual who already has shares and a large capital gain in the REIT who I’m analyzing it on behalf of at the request of their DPOA has just moved into assisted living because they have simultaneously lost their spouse and also have experienced a sudden decline in their own health and aren’t able to understand investments anymore.
To fund their needs for the next years they need to sell something as they are cash poor at the moment. They have shares in this non-public REIT, and shares in one of the most well known public companies in the world which also have large capital gains associated with them, and those are the only options for funding their living needs in the coming years. Because they have only two assets, each of which could experience a large drawdown, I think they should sell enough now and in early 2023 to fund five years of living expenses. As far as my advice goes, it’s just a question of the mix, and I think the macro favors keeping more of the non-public REIT, but at the same time, I feel the public company is much more of a known quantity. Any thoughts are appreciated.
Good luck with trying to get public REIT values for a private REIT. In my experience, any of your buyers will likely demand a significant discount.
That kind of poor secondary market liquidity should be off-putting. How much of a haircut did buyers demand?
Depends on how extensive the pool of potential buyers- but if the potential pool of buyers is really only the existing pool of owners- could be 25-50%.
Emptynester and Derek,
This particular REIT has a redemption policy. There is a funding pool each quarter. So far, they’ve been able to fund every requested redemption, but with the REIT averaging 20% gains for the last 5 years there are very few sellers at the moment. The penalty to redeem without waiting a year from the time the request is made is 10%.
The thing is, this individual is going to need approximately 15% of the REIT redeemed to cover their annual expenses in the coming years, and if things ever turn negative the quarterly funding pool will quickly evaporate. If they have more requests for redemptions than they have funds they prorate the redemptions. Obviously, in a serious crisis you could easily imagine only getting a nickel on the dollar if everybody was rushing for the exits, and this individual only has 2 assets of any size: This investment, and stock in a single publicly traded company also with a large capital gain.
So the issue is twofold. How much to set aside for the coming years, and how to divide the asset sales between the REIT and the public company.
If the redemption doesn’t work, that would be a nightmare scenario here. Because then the 25-50% haircut Emptynester references could be the only option for monetizing the REIT, and it is 2/3rds of the individuals assets.
Thanks to both of you for your thoughts!
Things to consider for MFD REIT
– Class of buildings. Class A best, in my view, since potential homebuyers who are renting during the high rate period are higher-end tenants.
– Local economy and conditions. Local industries, jobs, migration to the metros where the REIT is, local landlord/tenant laws (rent control), also climate (property damage risk).
– Growth in pipeline. The REIT’s lease-ups, pending acquisitions, construction, remodels.
– Local supply. MFD construction is booming, raising risk of over-supply, need to check the areas where REIT operates.
– Cost and source of capital. Loans are getting tougher and more expensive.
– Management. Maybe you can interview them.
– Trends. New lease rent growth, renewal lease rent increase, blended increase, occupancy rate, net operating income growth, cash flow growth.
– Sustainability of distribution.
– Valuation with private discount.
I generally like MFD REITs here, if in good geographic markets. The pace of new MFD construction worries me, as does slower household formation, but collapsing house sales and new house construction are positives. The better (public) REITs are outperforming general apartment rent indicies. Rising interest rates were a big negative this year but should be less so going forward. Stagflation should benefit real assets, and a REIT is quasi such. But of all the public MFD REITs, I only own two – selectivity still matters.
I’ve been dealing with a family crisis since a few hours after I posted my questions a few days ago. Sorry not to write back sooner. Things are stable now.
It’s Class A properties in attractive cities, though I wish the properties were diversified among more cities as the city with the most properties has over 20% of the properties. The top four geographies have over 50% of the properties. The vast majority of the cities in question are growing and permitting is easy and there will be a lot of new supply coming online in the next few years, which I would say is my main concern. I like management and have spoken with one of the top three executives at length.
Thanks for taking the time to provide such a thoughtful list of things to consider. What I know for sure is that even though this appears to be an above average REIT, given the funding needs this individual has and their net worth, I would never recommend they have more 20% of their funds in this investment, and I’d only recommend 20% if any redemptions would be close to 100% fully taxable- which they are in this case. Right now they have 66% of their net worth in this investment. 30% is in one single stock that has a single digit cost basis. So whatever gets sold is going to incur taxes, and quite high taxes if a lot is sold in one year, as they live in a high tax state. They just lost their spouse and so they do have the benefit of married filing jointly this year, which doubles the bracket in the state they live in.
I think my recommendation is going to be to take 5 years of expenses out over tax years 2022, 2023, and 2024, which net of taxes will be about 55% of their portfolio. My instinct is to cut the REIT down by 70% and take only a small amount from the publicly traded company, because I just feel more confident about it as a long term investment. So if I’m able to redeem the REIT shares, they will have 5 years of expenses set aside in short duration treasuries, and will still have a position in the REIT about 30% as large as it is today, and will have about 85% of the publicly traded company shares that they have today.
Likely they (or their heirs) will miss out on gains (especially the heirs for whom a stepped up basis would make the inheritance much larger), but it is removing a worst case scenario from the table where both assets drop and funding for the care of the individual runs out that I am primarily concerned with.
I much appreciate your thoughtful help. Kindest regards,
EC
We live in a resort/lots of retirees area. “Listed” home prices are dropping anywhere from 10 – 35%. Very few sales. The 35% drop home was an estate sale and sold. New problem for other buyers – that is now the most recent and only comp.
That’s another reason for “forced to sell” …
I am inheriting a condo in Taipei and instructions to RE agent are to clean it up and sell it ASAP (FX and China). That comp is going to be a problem for neighbors, but not my problem.