This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To be sure not to miss anything of Tom’s picks, subscribe to his mailing list here.
Even doctors worry about housing costs…
“Hey Tom, I’m thinking of moving to Long Island City,” an old New York friend told me this weekend. “New York’s Upper East Side isn’t worth it anymore…”
I was stunned.
A doctor…a two-income family…no kids…and still worried about housing prices?
Yet exorbitant housing prices have affected everyone from the average worker to career professionals. The average rent in the United States exceeded $2,000 for the first time in May, according to red fin (NASDAQ:RDFN). A tenant must now land in the top 16% to 21% of U.S. incomes to meet the typical “28% of gross income” housing guideline.
And then it dawned on me that my friend was right.
On New York’s Upper East Side, a neighborhood where rents have risen 51% over the past year, the average home now costs $1.5 million, according to Realtor.com. Assuming a buyer could find $300,000 for a down payment and qualify for a seven-figure mortgage, they would still need an annual salary of $387,777 to meet the same income guidelines — almost twice as much as the average general practitioner.
As house prices continue to climb, investors and homeowners alike are wondering what the housing market will do this year.
Today, I’m taking a quick detour from our regular stock picking reports to bring you the latest data on whether we should expect a property market crash in 2022.
Will the housing market collapse in 2022?
In March, I noted how the resurgence of oil drilling in the United States would benefit midstream companies like Summit Channel Partners (NYSE:SMLP). These monotonous pipelines are paid based on the volume of oil they transport, not its price at each end of the tube, so you can forecast their earnings months in advance.
The housing market works in a similar way. Volume and availability numbers are relatively easy numbers to predict. Much like having children, increased housing starts today lead to more available inventory in about nine months. According to the US Census Bureau, builders only complete 0.5% of housing starts once construction begins.
But much like a toddler’s sleep schedule, the price of housing is an entirely different tantrum. Since 1890, average house prices have changed 5% year over year almost half the time. For a new homeowner with an 80% loan-to-value ratio, this represents a 25% change in home equity.
Soaring commodity prices added to the mix. The cost of wood—which can add $20,000 or more to a home—has dropped 50% in the past 3 months. This month, economists at Realtor.com more than doubled their estimate of house price appreciation from 2.9% to 6.6%.
Housing prices look weak for the next decade…
Nevertheless, there are signs of market overheating.
In February, the Case Shiller inflation-adjusted house price index reached 213, 58% above the 50-year average. And the housing affordability index compiled by the US Federal Reserve has fallen 30% in the past year alone.
The tension is also beginning to be felt at the corporate level.
In April, the leaders of DH Horton (NYSE:DHI), the largest US homebuilder, has cut its forecast for 2022. They now expect to close 89,000 units this year. Slowing demand due to high house prices made managers cautious about overinvesting in housing starts.
There are good reasons to expect a slowdown.
Since 1890, changes in the interest rate have explained nearly a quarter of house price movements over a decade, according to data compiled by Yale University economics professor Robert Shiller. “They’re going to come back down,” Dr. Shiller said in a 2021 interview about house prices. “Not overnight, but enough to cause pain.”
Indeed, higher interest rates increase the cost of mortgage loans and decrease the demand for housing. For every 1% increase in interest rates over this period, house prices fell by 18%. And with the Congressional Budget Office (CBO) now expecting 3-month cash to hit 2.3% by 2032, investors should prepare for the price deceleration.
…But don’t expect a 2008-style crash
But American renters shouldn’t hold their breath for a 2008-style housing crash.
First, there’s the obvious culprit:
A lack of mortgage debt.
American homeowners now own more home equity than they have since the mid-1980s. And mortgage lending standards have tightened significantly since the 2008 financial crisis. Fintechs like Rocket companies (NYSE:RKT) now account for the bulk of new mortgage lending, reducing the burden on the traditional banking sector.
Household equity in real estate
Then there is the Federal Reserve. The current economic slowdown is due to the tightening of interest rates, a cause far less worrying than consumer deleveraging. Consumers are spending just 9 cents per dollar of income on debt service, nearly 30% less than before the 2008 housing crisis.
Household debt service as % of family disposable income
Importantly, the cost of building new homes has risen along with house prices. Once investors factor in the rising costs of skilled labor and raw materials, house prices reflect those of 1950, a period that heralded nearly three decades of stable housing prices.
“Skilled labor shortages are one of the biggest challenges facing the U.S. economy, with 650,000 jobs open in the construction industry alone,” said Stanley Black & Decker CEO, Jim Loree, in April. This problem existed long before the pandemic but has certainly been exacerbated by it.
Rather than suffer a sharp decline, house prices are more likely to slowly deflate.
Where does that leave investors?
It is tempting to draw parallels between today’s housing market The big courta book by Michael Lewis about the real events of the 2008 financial crisis. In the film adaptation, comedian Steve Carell plays Mark Baum, a character based on fund manager Steve Eisman who shorted the bonds backed by receivables (CDO).
There are some similarities. Homebuilders like DH Horton are now earning 4 times their operating profit compared to five years ago. They saw a similar spike in the five years before the housing peak in 2006.
And the practice of issuing subprime mortgages continues today under the new name “non-preferred mortgages”. In 2021, a study by credit reporting firm TransUnion recorded a 17.6% increase in non-preferred mortgages and a 75% increase in non-preferred credit card loans.
But today’s housing market might be closer to another Steve Carell movie:
The 40-year-old Virgin.
In the film, Mr. Carell plays Andy Stitzer, a forty-year-old action figure collector, sporting a personal life that mirrors the film’s title.
Throughout the two-hour film, the main character bounces between “will-he-don’t-want” drama of finding a date and falling in love. The harder he tries, the worse things get.
Homebuyers today face similarly unwinnable challenges. Unaffordable house prices drive people to rent, increase the value of rental properties, etc.
Meanwhile, investors face an equally unattractive market. DH Horton’s stock has already fallen 45% this year, making it a cheap bet on the wrong side of the momentum. Analysts expect the company’s operating profits to drop double digits in 2023. And while it may be tempting to buy these homebuilders down, a slowing market makes these players operating leverage unattractive until the mood picks up.
But tired of bad news? Join me on Thursday when I reveal some of my favorite stocks thriving during the housing crisis.
PS Do you want to know more about cryptocurrencies? Penny shares? Choice ? Drop me a note at [email protected] or connect with me on LinkedIn and let me know what you’d like to see.