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Is This Another Big Short?

Is This Another Big Short?

May 07, 2021

The housing market is on fire. U.S. home prices soared 12% in February (the most in 15 years) and 11.2% in January1. New single-family home sales exploded 20.7% in March and are up 66.8% from a year ago2. That puts sales up 31.9% from the pre-COVID high and are now at the highest level since 2006.

Numbers like these invariably bring back memories of the last housing boom. That one ended in one of the worst recessions in history, and investors appear worried it could happen again. But before addressing these concerns, let’s first discuss the drivers of prices today and then compare them to what caused the last bubble to burst.

Secular Demand

There are three primary drivers of housing demand today. The first is record low mortgage rates thanks to the monetary policy by the Federal Reserve. It’s unlikely that the Fed will reverse course anytime soon, so as long as the impending tidal wave of government debt doesn’t disrupt the bond market too much, mortgage rates should remain at historic lows for a while.

The second driver is changes in buyer preferences. Buyers are leaving cities for suburbs because they want more space (work from home, etc.). Since most people rent in big cities, these defectors are viewed as first-time buyers. Millennials are also entering the housing market for the first time. This cohort is now the largest living generation and accounted for over 50% of mortgage originations in 20203

The third driver of demand is investors. Since traditional asset classes like cash and fixed income offer paltry yields in a zero-interest rate world, large institutions are buying homes nationwide and then renting them out for income. In some instances, homebuilders are even selling entire subdivisions to institutional buyers4.

This phenomenon may sound crazy but it’s actually a page from the post financial crisis playbook. Back then, Blackstone and other private equity firms bought so much commercial and residential real estate that they became some of the largest landlords in the world5. They also made so much money that it seems to have inspired many others to follow suit this time around. If so, it’s likely that individuals will continue to compete with institutions for some time unless the regulators step in.

Add it all up and these drivers look far more secular than cyclical. If so, expect demand to remain strong.

Lack of Inventory

No matter how you look at the data, there simply are not enough houses for sale. It’s been a problem for over a decade, and there are three reasons why it’s unlikely to get remedied anytime soon.

The first is labor and construction. The homebuilding industry lost approximately 1.5 million jobs (~20%) during the financial crisis and still hasn’t fully recovered6. Limited lot supplies, costly permitting, and restrictive zoning laws all compound the challenge of securing land to build.

The second is the cost of supplies. Lumber prices are up over 230% in a year7. Copper has more than doubled over the same time period and hasn’t been this expensive since 20117. There are countless other examples of inflationary forces causing homebuilders to either pass on building in some markets or raise listing prices in others.

The third driver is supply chain disruptions. Even if builders can pass along higher input costs to buyers, that doesn’t mean they can get access to materials to build homes. The lockdowns have effectively shut down large supply chains because people aren’t allowed to work. Therefore, sourcing lumber, appliances, and pretty much everything else that goes into building homes remains challenging.

These trends have created a staggering supply crunch. According to First Trust, only 40,000 completed new homes are for sale right now, versus 77,000 a year ago and an average of 87,000 in the past twenty years. It’s not just a lack of new houses either. Only 870,000 existing homes were on the market in February. To put this in perspective, the lowest inventory for any February on record from 1982 through 2016 was 1.55 million3.

The Bottom Line

The Case-Shiller 20-City Composite Home Price Index measures the value of residential real estate in 20 major U.S. metropolitan areas. It’s one of the more closely followed indices for housing prices, and the chart below shows that it’s currently 31% above the last peak (red line) that occurred 15 years ago.

Headlines referencing trends like these appear worrisome, but they aren’t telling the full story. To start, the chart above along with most other measures of housing prices fail to adjust for inflation. That’s a pretty big deal because inflation takes a $200,000 house in January 2000 and makes it $295,000 today (48% more)8. The chart below adjusts the chart above for inflation, and in doing so, shows that prices are currently 5% below the last peak.

Furthermore, to say that housing is “expensive” and/or “overpriced” are relative assertions. The only alternative to owning is renting, and over the past 40 years, home values have typically been 16.4 times annual rent3. At the peak of the bubble in 2005, they were 21.4 times annual rent (33% above average). Today, home prices are 17.8 times annual rent, or only 11% above the average. This may even be artificially inflated, as moratoriums on evictions and rent control regulations enacted over the last year have anchored rents in some markets. If this were to reverse, the ratio would fall even closer to the average (all else fixed).

Lastly, the fundamentals driving housing prices today appear to be materially stronger than what fueled the last bubble. Back then, speculative buyers were massively over-levered due to multiple home purchases and during a period of rising interest rates. Lenders were also approving loans with nothing more than a credit check.

Today, the American consumer is arguably in the best financial shape in modern history. Incomes are at all-time highs, cash in the bank has never been higher, and the chart below shows that mortgage affordability (debt payment as a percent of income) is at a generational low. This means that a $500,000 mortgage today has the same monthly payment that a $300,000 mortgage would have with 2007’s interest rates, and what a $210,000 mortgage had with mid-1990’s interest rates9.

Lenders have also tightened standards. Anyone who has survived the mortgage process since the financial crisis can attest to the difficulty of getting approved for a mortgage (it takes a lot more than a good credit score). Strict regulations and limits on lending should help prevent a repeat of the last crisis.

The bottom line is that housing prices are rising, but that does not imply an imminent crash. Today, prices are being fueled mostly by stronger fundamentals and secular trends rather than debt-fueled speculation, and it’s hard to see this reversing course anytime soon. Since rising home values tend to make consumers more confident and spend more money, this housing boom could be yet another economic tailwind going forward.








7 Bloomberg. As of 4/28/2021





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