This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
Even Doctors Are Worried About Housing Costs…
“Hey Tom, I’m thinking of moving to Long Island City,” an old New York friend admitted to me this weekend. “New York’s Upper East Side just isn’t worth it anymore…”
I was stunned.
A medical doctor… dual-income family… no kids… and still worried about housing prices?
Yet, exorbitant housing prices have hit everyone, from the average worker to career professionals. The average rent in the U.S. crossed over $2,000 for the first time in May, according to Redfin (NASDAQ:RDFN). A renter 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.
In New York’s Upper East Side — a neighborhood where rents have risen 51% in the past year — the average house now lists for $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 a $387,777 annual salary to meet the same income guidelines — almost twice as much as the average primary care physician makes.
As real estate prices continue their upward march, investors and homeowners alike are asking themselves 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 housing market crash in 2022.
Will the Housing Market Crash in 2022?
In March, I noted how the resurgence of U.S. oil drilling would benefit midstream companies like Summit Midstream Partners (NYSE:SMLP). These hum-drum pipelines are paid by the volume of oil they transport, not its price at either end of the tube, so you can forecast their revenues months in advance.
The housing market operates in a similar fashion. Volume and availability figures are relatively simple figures to predict. Much like having kids, higher housing starts today lead to more available inventory around nine months down the road. According to the U.S. Census Bureau, builders fail to finish just 0.5% of housing starts once construction begins.
But much like a toddler’s sleep schedule, the price of housing is an entirely different temper tantrum. Since 1890, average housing prices have changed by 5% year-over-year nearly half of the time. For a new homeowner with a loan-to-value ratio of 80%, that’s a 25% swing in home equity value.
Gyrating commodity prices have added to the mix. The cost of lumber — which can add $20,000 or more to a house — has fallen 50% over the past 3 months. This month, economists at Realtor.com more than doubled their estimate for home price appreciation from 2.9% to 6.6%.
Housing Prices Look Weak for the Next Decade…
Nevertheless, there are signs of overheating markets.
In February, the Case Shiller Index of inflation-adjusted housing prices hit 213, 58% higher than the 50-year average. And the housing affordability index compiled by the U.S. Federal Reserve has fallen 30% in the past year alone.
The strain is also starting to show at the corporate level.
In April, executives at D.H. Horton (NYSE:DHI), America’s largest homebuilder, trimmed its guidance for 2022. They now expect to close 89,000 units this year. Slackening demand from high housing prices has made managers wary about overinvesting in housing starts.
There’s good reason to expect a slow down.
Since 1890, changes in the interest rate have explained nearly a quarter of home price moves over a decade, according to data compiled by Yale University economics professor Robert Shiller. “They’ll come back down,” Dr. Shiller said in a 2021 interview on housing prices. “Not overnight, but enough to cause some pain.”
That’s because higher interest rates raise the cost of mortgages and decrease the demand for housing. For every 1% increase in interest rates over that period, housing prices have declined 18%. And with the Congressional Budget Office (CBO) now expecting the 3 month treasury to rise to 2.3% by 2032, investors should brace themselves for decelerating prices.
…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 housing debt.
U.S. homeowners own more home equity today than they have since the mid-1980s. And mortgage lending standards have tightened up considerably since the 2008 financial crisis. Fintechs like Rocket Companies (NYSE:RKT) now originate the bulk of new mortgages, reducing the burden on the traditional banking industry.
Household owner equity in real estate
Then there’s the Federal Reserve. Today’s economic slowdown is driven by rate tightening, a far less worrying cause than consumer deleveraging. Consumers spend just 9 cents per dollar of earnings on debt service, almost 30% less than before the housing crisis of 2008.
Household debt service as a % of disposable family income
But most importantly, the cost of building new homes has risen in tandem with home prices. Once investors account for the rise in skilled labor and commodity costs, home prices mirror those of 1950, a period that heralded almost three decades of flat housing prices.
“The skilled labor shortage is one of the biggest challenges facing the U.S. economy, with 650,000 open jobs 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 suffering a steep drop, housing prices are more likely to slowly deflate.
Where Does That Leave Investors?
It’s tempting to draw parallels between today’s housing market to The Big Short, a Michael Lewis book about the real-world events of the 2008 financial crisis. In the movie adaptation, comedian Steve Carell plays Mark Baum, a character based on fund manager Steve Eisman who shorted collateralized debt obligations (CDOs).
There are some similarities. Homebuilders like D.H. Horton now earn 4x their operating income compared to five years ago. They saw a similar spike in the five years leading up to the 2006 housing peak.
And the practice of issuing subprime mortgages continues today under the rebranded moniker of “non-prime mortgages.” In 2021, a study by credit reporting firm TransUnion counted a 17.6% increase in non-prime mortgages and a 75% jump in non-prime credit card lending.
But today’s housing market might be closer to a different Steve Carell movie:
The 40-Year-Old Virgin.
In the film, Mr. Carell plays Andy Stitzer, a forty-year-old man who collects action figures, sporting a personal life that reflects the movie’s title.
Throughout the two-hour movie, the main character bounces between a “will-he-won’t-he” drama of finding a date and falling in love. The harder he tries, the worse things get.
Today, homebuyers are faced with similarly unwinnable challenges. Unaffordable home prices are driving people towards renting, raising the value of rentable real estate, and so on.
Meanwhile, investors are faced with a similarly unattractive market. D.H. Horton’s stock has fallen 45% already this year, making it a cheap bet on the wrong side of momentum. Analysts expect the firm’s operating earnings to drop double-digits in 2023. And though it might be tempting to buy the dip on these homebuilders, a slow-grinding market makes these operationally-leveraged players unattractive until the mood picks back up.
But sick of bad news? Join me on Thursday when I unveil some of my favorite stocks that are thriving during the housing slump.