Sunday, March 16, 2014

Another observation on home prices, rents, and homebuilders


I recently discussed the housing market.  In one post, I used this graph:

In another post I used the next graph:
Rent Inflation - core CPI (left scale), Price/Rent (right scale)

I think these graphs are helpful in showing the two influences on the housing market that I have been pondering.

Until the late 1990's, there was a fairly consistent set of cyclical behaviors in the housing market.  Cyclical factors would depress home prices, rent inflation, and housing starts.  At the same time, inventories would rise (note, the blue line in the first graph inverts the inventory of houses, in months).

Real and nominal long term interest rates were high enough throughout this period to remain a secondary factor, so a basic supply & demand framework was a coherent way through which to view these changes through time.  I will point out, though, that the one period of low real long term rates, which peaked in the late 1970's, coincides with the pre-2000 high point in real home price appreciation, and this happened during a period where a large number of new homes were being built, home inventory wasn't particularly low, and nominal mortgage payments were astronomical.

But, both graphs display the change in behavior starting in the late 1990's.  Inventories were cut to very low levels, where they remained for years.  Home price rose along with these low inventory numbers, as we might expect.  But there was no supply response, and after a brief rise, rent inflation dropped back to neutral levels.  This seems like more evidence that the home price increases during that time were a product of the changing value of homes as a security, not of supply and demand for housing.

Graph of 10-Year Treasury Constant Maturity RateFinally, in 2002-2003, as rent inflation peaked at a very high level, supply increased.  But, long term interest rates did not rebound after the 2001 recession, remaining low in both nominal and real terms.  This was not a product of a loose money policy by the Fed.  This was a product of market and demographic forces that were creating low real long-term rates, and a very long-term policy of tight money, which had been bringing down long term inflation expectations for 25 years.

FRED GraphReal rates rose in 2005 and 2006.  By the end of 2006, home prices, relative to rents, had leveled out, and rent inflation had risen.  Housing starts began to decline along with declining home prices and increasing inventory.  But, rent inflation continued rising into early 2007.  By mid-2007, rent levels were heading south with all the other indicators.  In hindsight, it would have taken a more inflationary policy to counteract these forces in 2007, so that homes didn't contract so much in nominal terms.

Today we are seeing high home price increases and low home inventories, just like in the late 1990's and early 2000's.  But, today, this is accompanied by increasing rent inflation.  I think this is because both the real interest rate factor and supply and demand are pushing up nominal home values today.

The cash infusion of the QE's has allowed homebuyers to fund purchases from outside the banks, pushing nominal home values back toward where they should be, considering real interest rates and the alternatives for fixed income.  Now that QE is tapering, this funding will need to come from the banks again, and recent indications seems to point to increasing bank credit levels.  This should continue to increase home prices, relative to rent levels.

But, at the same time, rent levels are increasing because of the incredibly low level of housing starts.  If starts remain this low, then rents should continue to increase.  This will push the changing level of nominal home prices even higher.

Homebuilders will either respond to this with large increases in supply, or, if they don't, their home prices should increase substantially.  It looks to me like homebuilders face one of two likely scenarios: (1) continued home price increases with higher-than-expected increasing sales volume, or (2) higher-than-expected increases in home prices with moderate increases in sales volume.

Either scenario should benefit homebuilders with land holdings, options on land holdings, large quantities of available lots, and high operating and financial leverage.  It might be time to look at "low quality" firms in this industry.

Here is a recent update from Calculated Risk.  Notice that home prices aren't just rising, they are accelerating.


Institutional Investors, QE, Banks, and Home Prices

Here is a Bloomberg article (HT: calculated risk) about trends among institutional residential housing investors.  According to the article, the purchases from these investors peaked in 2013.  This has been facilitated in part by QE3, I believe.  The cash from QE3 has been funding non-bank financed investments, which have moved as a counter to bank assets.  This could be because these investors were crowding out banks in the market for asset funding, or possibly the increased interest rate levels reduced bank capital during the QEs, and these non-bank sources of funds, flush with QE cash, made up the difference.  In any case,  I am not surprised that the level of activity from these real estate investors has been coincident with QE3.  You could also see this activity as a process of capital capturing excess returns that are available in residential real estate as a result of the broken down mortgage market.

I also note that home prices are accelerating, even as these investors dial down their activity.  This is because, from a supply & demand perspective, banks have finally begun expanding real estate credit again, and from a valuation perspective, the intrinsic value of homes, relative to other similar investments is still low.


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