“A house is made of bricks and beams. A home is made of hopes and dreams.” – Unknown
My wife and I moved back home to the SF Bay Area in August of 2013, which was just two months before our daughter was born. After having pursued both educational and career opportunities in Miami, New York, and finally Tokyo, we felt the time was right to settle down. Life was exciting back in those days, but a change of pace became more appealing. In particular, we looked forward to a fresh start near family, friends, and nature.
Growing up in the western half of San Francisco, fog regularly enveloped our neighborhood from the middle of Spring throughout the Summer. Most people who know me, know that I hate fog and prefer warm, blue skies. My father, who helped nurture my love for the outdoors also felt the same way.
I have fond memories of waking up early on weekend mornings during my youth and joining my father for day hikes on top of sunny Mt. Tamalpais, in Marin County. It was nice to leave foggy San Francisco for the warm sun of the mountain side. We had many good times together just walking and talking. Thinking back to those days makes me very happy.
This experience growing-up was one of the reasons we decided to move to Marin. However, we found out fairly quickly, Marin with its abundance of nature falls short on housing options. Marin County has only about 260,000 residents, yet 85% of the land is protected from development through open space purchases, federal parkland, watershed lands and strict agricultural zoning. This of course is what makes Marin both special and unwelcoming at the same time.
Luckily, we did locate a townhouse to rent just weeks before my wife gave birth, then moved on to a single family home rental, before ultimately making a purchase. It was not easy, but in the end, things worked out.
Real estate professionals tend to remind buyers, sellers, and investors alike that real estate is a local rather than a national market. That may be true, but as the author below, Charles Lieberman explains, we have a residential housing shortage nationally that isn’t going away anytime soon.
From an investing standpoint, the demographics surrounding population growth and housing supply play a significant role in our portfolios. This is one reason we have been overweight both home builders and single family home rental REIT’s for a while. Add in the potential for stable to lower interest rates, and my feeling is this sector could continue to be a winner for years to come.
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What’s Raising Housing Prices? It’s Not Just Higher Rates.
By Charles Lieberman
Barron’s
February 9, 2024
Many people believe that homeowners’ reluctance to move and give up their low-cost mortgages is behind the recent rise in housing prices. Get more people to place their homes on the market and home inflation will moderate or reverse.
This analysis isn’t quite correct because it fails to recognize that a severe housing shortage is the problem, not low supplies of existing homes. Only a sizable increase in new construction can relieve the shortage and boost housing activity. It will take some years to bring housing back into balance.
The seeds for today’s housing shortage were planted during the credit crisis of 2007-08, when an excess of housing supply triggered a collapse in housing prices. New construction added more than two million units at an annual rate when household formation required roughly 1.5 to 1.7 million units. New housing supply outran demographically led growth in demand for several years by a significant margin. The result was a housing glut.
Why were so many units constructed? Too many people bought houses to make a quick buck by flipping them at what seemed to be ever-rising prices. Builders were happy to build to accommodate demand, since they made more money with each home they built. But home flipping failed when the speculators ran out of buyers, which led to a collapse in home prices.
Owning a home for the purpose of flipping is rather expensive. Speculators must cover property taxes, utilities, yard maintenance, and loan costs while the home is vacant and producing no income whatsoever. Flippers need to sell. And when they lack buyers, their only solution is to cut the price, even if it means taking a loss. That may solve the carrying-cost problem of that specific speculator, but it exacerbates the carrying-cost problem of every other flipper. Like the game of Old Maid, the Queen of Spades was simply passed to another unhappy home flipper, who was, in turn, also forced into deeper price cuts. That caused a downward cascade in home prices in 2007-08 that ensnared mortgage lenders, banks, and certainly anyone who owned a home but lost a job or couldn’t meet their mortgage payments.
The Federal Reserve did what it could by cutting interest rates to reduce mortgage costs, but it couldn’t make households materialize out of thin air. The only way to absorb the excess inventory was for housing construction to collapse and allow normal population growth to absorb the overhanging inventory. The collapse in housing values rippled through the economy with widely spread adverse effects. Housing construction contracted by more than 75% from a peak of about 2.25 million at an annual rate in early 2006 to 500,000 units by the beginning of 2009. New construction activity reached 1.5 million units only in 2020, an extraordinary long period of underbuilding.
Having been burned so badly during the credit crisis, mortgage lenders became far more demanding, behavior that was reinforced by regulators. There were also fewer builders, since many had gone bankrupt. The pandemic initially obscured the brewing housing shortage. But it soon exploded into view as people sought to get out of cities into the suburbs or decided they needed more space, driving up housing prices.
Since sellers don’t move to Mars, every seller becomes a buyer or a tenant elsewhere. They might want a larger unit, to downsize, or to become a renter, but they are taking one unit out of the market for each unit they place onto the market. Every seller actually represents zero net demand for housing units. Net demand comes from a growing population (net of deaths), divorces (net of marriages), and demand for second or vacation homes.
Estimates of the current housing shortage range from 1.5 million to several million units. Those upper estimates aren’t plausible. But even the low estimates represent a severe shortage that will take years to eliminate. New construction is currently running about 1.4 million units at an annual rate, close to growth in underlying demographic demand, but still far short of what’s needed to reduce the shortfall. That’s why housing construction stopped falling in 2023, despite the ongoing rise in interest rates over the year.
If people can’t afford to buy, they must rent. That rising demand for rentals in a tight housing market drives up rents, of course, which incentivizes builders to construct more apartments. Eventually, the housing shortage will be alleviated by new construction, both single family and multifamily units, but there must be a period of construction that exceeds the rate of household formation, a condition that hasn’t yet been met. But conditions are very ripe. The recent sharp decline in mortgage rates is likely to unleash a surge in demand for new construction, regardless of whether more existing owners are willing to sell and move. Large gains in employment and rising wage rates provide households with the wherewithal to enter the housing market.
So, housing construction is likely to enjoy several years of robust activity, whether more existing units are put on the market or not. This will benefit home builders and suppliers for years to come.
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Markets have been chopping around the past few weeks. On the one hand, we have a Fed which has signaled an end to interest rate hikes, on the other the economic statistics are coming in better than expected providing a hurdle to near term future easing.
I find the cross currents confusing, yet I tend to believe the large amount of government emergency and non-emergency fiscal spending could have extended and/or offset some of the monetary tightening over the past year or so, which means the lags between interest rate policy and economic reality may have been put off further into the future.
Portfolios are modestly underweight equity and equity-like instruments, while overweight money markets, medium and long term Treasuries. On the equity side, I like large capitalization technology, housing related stocks, consumer staples, utilities and the health care sector.
Sincerely,
Justin Kobe, CFA
Founder, Portfolio Manager & Adviser
Pacificus Capital Management
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Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Cambridge and Pacificus Capital Management are not affiliated. Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as investment, tax, or legal advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. These are the opinions of Justin Kobe and not necessarily those of Cambridge Investment Research, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing in the bond market is subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counter-party capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Diversification and asset allocation strategies do not assure profit or protect against loss.
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