Wednesday, July 6, 2016

Housing: Part 165 - The homebuilding recovery may lag the price recovery

Here is a hopeful Bloomberg article on renters buying their homes from institutional landlords (HT: John Wake).  It makes sense.  In many cases, where the only thing holding back tenants from owning was credit access, it's a no-brainer.  A tenant described in the article will actually lower her monthly payments by shifting from rent to mortgage payments on the same home.  This appears to be the case on millions of properties around the country.

But, this brings up an issue I have been thinking about lately.  Previously, I had considered a convergence trade that would profit from a recovering housing market - a short position on long term treasuries and a long position on homebuilders.  Yields on home ownership are far higher compared to treasuries than they have been in the past.  Interest rates are not the constraining factor in homeownership right now.  So, as households move back into ownership, rising home prices should trigger homebuilding which should cause interest rates to rise.  Since housing yields and treasury rates have diverged, both rates and prices could rise quite a bit in order to converge.

But, I wonder if the homebuilding part of that sequence would be more of a lagging factor than I had thought it would be, in which case the demand for capital would not rise as sharply and there would be less upward pressure on interest rates.

Because of the tax benefits of ownership and the principal-agent problems associated with rentals, non-owning households tend to have less demand for housing than owner-occupiers.  So, when a lack of credit access shut millions of households out of the owner-occupier market, this triggered a negative feedback loop that decreased demand for housing expenditures.  So, there isn't necessarily a latent demand for housing that requires an immediate supply response.  There is potential latent demand for housing that would slowly re-emerge as households attain ownership again.

It could be that the value of ownership will cause market values to rise as that shift occurs, but that the shift in both price and homeownership rate will need to recover somewhat before there is a significant response in homebuilding.  If that is the case, there could be more of a sequence of events as such: (1) rising ownership, (2) rising prices, (3) rising rents, (4) rising new home sales, (5) rising interest rates.

Given the political times we are living in, this will be interpreted as a bubble (rising ownership, rents, and prices) and there will be pressure for self-flagellation before we even get to rising new home sales, let alone rising interest rates.  And, the result would be continued stagnation with limited access to credit, rising rents, and interest rates hitting zero.

Institutional investors will be blamed for raising rents on tenants and for selling homes to tenants at supposedly inflated prices.  There will be broad demand for the Fed to raise rates in order to stave off asset inflation, even though (1) this will actually keep long term interest rates low and (2) interest rates don't have much influence on current real estate values now anyway.  As in 2007, the only way rising rates can kill the housing market is by rising far enough to undermine the real productive economy.  And, the supposed new housing bubble will again be blamed for pushing us into recession.  It could be that housing will not recover far enough to trigger a collapse large enough to create massive defaults.  I would hope.

I hope that I am wrong on this.  In any event, it seems to me that the best way to capture safe alpha is to own rental properties outright.  I think they can be owned with a decent level of leverage with little risk.  Even if a worst case scenario eventually leads to capital losses, as long as they remain unrealized, a landlord would make quite healthy returns on rents, especially in the entry-level part of the market.


  1. I think that based on the current widely accepted idea that we are in a period of "secular stagnation" that the Fed will be content on undershooting their 2% inflation goal and failing to realize that although we are at near 0% short term interest rates - monetary policy is not necessarily easy right now. With this in mind, it looks like long term interest rates will continue their decline or stay at current low levels due to lowered long term inflation expectations & the reduced probability of a sustainable rise in short term interest rates. What would this scenario mean for housing prices and rents going forward though? More of the same spread between owners and renters at lower price points where credit is more constrained? What do you think would happen to home prices and rents in the event of a premature tightening period from the Fed?

    1. Rents will go up. I have seen some reports of a recent pullback at the top end of the San Francisco market. If that continues, it could be a sign that Fed tightening has already been enough to start to pull things down. Since the low end of the market already has very high liquidity premiums embedded in home prices, I doubt that it will go down much. That's why I think low end leveraged rental housing is a good place to be right now, if you have the capability to do it. (Standard disclaimers apply.) I don't think home prices, even at the top end will fall that much. Closed Access home prices are more like growth stocks, though, in that much of their value is based on far future expected rents, since there is an embedded growth rate in Closed Access rents, so Closed Access homes will rise and fall more with general economic expectations more than they did before the problem became so acute.

      That's my guess.

    2. Unfortunately, even that effect (volatility of home prices in Closed Access cities), will also been interpreted as more proof that high home prices are a "bubble". But, the decline in prices will be the product of reduced expectations of real economic growth which lower the demand for Closed Access housing among aspirational workers. So, the result will lead, depressingly, to more calls for self imposed stagnation.

      I hope it doesn't happen, but it seems like a good bet.

    3. Makes sense. I've been looking into low end leveraged rental housing for a while now I just need to figure out how the taxes work. Thanks for the response Kevin!

    4. Yeah. Those sorts of details really complicate this sort of thing at the micro level.

      Let me know what you find on the tax consequences. I'm interested in what you might end up thinking about it.

  2. "Given the political times we are living in, this will be interpreted as a bubble (rising ownership, rents, and prices) and there will be pressure for self-flagellation before we even get to rising new home sales, let alone rising interest rates. And, the result would be continued stagnation with limited access to credit, rising rents, and interest rates hitting zero." --KE

    That did it. I am giving up on macroeconomics and monetary policy.

    I hereby officially take up gardening as my hobby and interest.