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.