Here is a graph of Home Prices relative to Rents and Mortgage Rates. I have discussed in my previous posts how most of the rise in prices could be justified by the low long term interest rate environment. Average New Home prices and the Case-Shiller 10 City Index have markedly different behavior in the 2000's. Please comment with any insights that you have about this or links to discussions. I'm not sure that I completely understand the causes for these differences. In either case, I am not that interested here in arguing for a specific value. Only in pointing out that home prices have a lot of room to move up rationally. Long term interest rates could rise nearly 2 points without moving above the low rate environment that was in place in the 2000s.
Here is a graph comparing relative mortgage payments to rent. (A caveat: over very long time periods, differences in the underlying adjustments of these data series may cause some divergence.) Mortgage payments are extremely low compared to past relative levels. Keep in mind that while lower inflation premiums should lead to lower mortgage payments, lower real interest rates should actually increase mortgage payments, relative to rent. Even if mortgage rates increased back to 6%, with no change in home prices, mortgage payments would still be lower than rent, indexed to 1987.
Current Home Price Trends
|Rent shows YOY change, Home Prices show MOM change|
This is where QE3 was so important. Its effects on bank credit, inflation, and real economic growth may have been muted, but, since the 4th quarter of 2012, household real estate market values have increased by about $3 trillion, and this was likely goosed by the added liquidity. This greatly reduced household real estate leverage. Without this boost, household credit markets would be dead in the water. But, QE3 basically carried us back to a place where household real estate markets might be able to achieve sustainable growth without further infusions of cash.
Now that housing has recovered from the demand/deleveraging crisis, we should see a sort of self-healing circle as mortgage and equity grow together, which will allow traditional home owners to bid prices up to their reasonable levels. To the extent that home prices have slowed their re-ascent, I think this is a temporary lull as mortgage growth kicks into gear. It would be quite normal for mortgages and total real estate market values to enter a period where both are growing by about 1% per month. Some of this will play out as new home production and some will play out as price appreciation.
|I need to clean up my data a little bit on the homebuilder revenues,|
but this is pretty close to the consolidated outcome of the public firms.
I had originally tried to conceptualize the home builders in our current volatile context as a sort of stable building operation sitting on top of a big pile of real estate assets, so that, in this context, they would effectively be land speculators, even if they don't tend to operate or view themselves as such. But, I could not find any systematic way that large fluctuations in land values were moving into their bottom lines. The fluctuations in the real estate market came to the home builders' bottom lines through higher volumes and some margin expansion. As much sense as it makes to me to look at a firm, like Hovnanian for instance, as an incredibly leveraged option on land appreciation, for some reason that I don't understand, it seems like the bottom line really is a product of operations, and profits seem to come from revenues in a pretty straightforward way.
So, as a basic framework for looking at a position in the industry, I would start with an expectation that by 2016-2017, total homebuilder revenues will be 75% - 100% higher than they currently are (which correlates to total household real estate 30%-40% higher than the current level). Keep in mind, while I think a 30%-40% rise home price-to-rent ratios from where we are is not outside the realm of reasonable expectations, the total increase in household real estate is a combination of rising rents, rising price-to-rent, and new home production. So, this forecast could play out even if we just see an increase in the teens for Price-to-Rent ratios. I would say that, given current trends, something like a 4% increase in the housing stock, a 10% increase in rent, and a 15% increase in Price-to-Rent, over a 3 year period is actually a fairly conservative forecast. And, that would get us into a 30-40% range for total real estate values.
I think this is more optimistic than the typical forecast for homebuilder revenues. I am basically forecasting a positive outcome fairly far out on the probability distribution represented by current market prices. This forecast can be very specifically targeted by taking a highly leveraged position. Looking at a firm like Hovnanian, which has very high financial leverage that in many cases is funding claims on land that are, themselves, options, and where I can take a position in out-of-the-money call options on the firm's equity - I can take a position that is leveraged to the third power, and each layer of leverage is really high leverage with insurance on the downside. I love these sorts of positions, where I can isolate my speculative idea and expose myself to tremendous upside with very little downside.
I will follow up with a second post tomorrow.