September 24, 2023

Jaskaran Kooner
Investing in housing is the quintessential American way to build wealth. All you have to do is take out a 30-year mortgage or two and make the payments, and with patience and luck, you’ll eventually be a millionaire. Of course, that is unless you buy into a huge housing bubble like the one in the 2000s.
So are we in a housing bubble, and is it now popping?
The evidence says yes. The affordability math is as brutal as it has ever been in the post-WWII era, while the demographic picture clearly shows that there’s no fundamental reason for prices to be as high as they are (more on this later). The main ETF that tracks the residential real estate industry, the iShares Home Construction ETF (BATS:ITB) is down 30% this year. But in all likelihood, ITB should be down much more when you dig into the underlying economics of the housing market. Mortgages are now over 7%, making it impossible for most buyers to finance a home unless prices fall, likely by a magnitude at or near the housing crash of 2008. An interest rate shock on top of houses changing hands for nonsensical bubble prices has effectively smashed the housing bubble, with rapid month-over-month price declines now taking effect.
In Dallas-Fort Worth, 10 years ago the median home price was roughly $160,000. It hit $405,000 this summer. Moreover, 10 years ago the median 30-year fixed mortgage rate was about 3.4%– now it’s more than double. The narrative is that there’s an enormous housing shortage and everyone should borrow as much money as possible to buy as big of a house as possible–hurry up and don’t miss out!
Back then, if you could cough up a 20% down payment, the principal and interest on the median house would set you back $567 per month– making it a no-brainer to buy a house. Now, under these same assumptions, the principal and interest payment is $2,155 per month. The median income is up about 29% over the past 10 years in Texas, and the typical mortgage payment is up 280%. That’s a terrible deal! Especially when you consider that the property taxes have tripled as well in many cases. Yes, there are plenty of people here old enough to remember paying much higher mortgage rates in the past. The difference is that they were paying it on a low-priced home, not paying many multiples of their salary just to buy a basic starter home at 7% interest. Roughly 75% of buyers have to use financing, so housing is extremely sensitive to higher rates.
But everybody is moving to Texas, right? People are, but not as many as you’d think. Texas is historically fairly cheap because there aren’t a lot of constraints to supply, unlike California (which Texas is always compared to). But housing units per capita are roughly at 2008 levels, while prices are far higher. This is a clear argument that the housing boom was not caused by a “housing shortage,” but rather by the Fed and global central banks artificially suppressing interest rates for years as a sort of economic science experiment that led to ~10% inflation and economic chaos.
Housing Units Per Capita (Economica)
I’m cherry-picking this example a bit because housing was generationally cheap from 2008-2012 and likely undervalued at the starting point. But I have acquaintances tripping over themselves to lever up 7x their and their significant others’ pretax incomes to go all-in on the housing market continuing to go up. Insanity!
That means if you get it wrong, you’re effectively losing years of your salary to paying an inflated purchase price at 7% interest. That’s certainly not a bet I’m willing to make. In 2008, tons of people walked away from their overpriced houses and mailed the keys back to the bank. Unemployment likely won’t go as high as then, limiting the damage from a foreclosure standpoint, but houses are arguably more mispriced now than they were in 2007.
How Overvalued Is Housing? (Moody’s Analytics via Fortune)
I’m focused mostly on the U.S. and Texas because that’s what I’m familiar with, but there are similar housing bubbles in most English-speaking countries in the world, with Canada, Australia, and New Zealand getting a lot of press for enormous bubble booms and crashing prices now.
Population growth has tanked since the pandemic. In 2021, the U.S. population is estimated to have grown by about 0.1%. It’s expected to bounce back to about 0.3% per year for the next few years, but the lack of babies being born indicates that at some point, the population is going to start shrinking.
If we use the high end of the estimate for 2021 and assume 0.3% population growth, that’s a million people added to the population. On average, you have 2.5 people per household, so that would imply that we would need to build 400,000 homes to keep pace with demand. Homes go obsolete too (maybe 300,000 per year), and there’s some natural demand for vacation homes (maybe 100,000 per year at the highest) as the economy generates wealth. That would imply necessary housing starts of about 800,000 per year.
Well, last year we actually built 1.6 million houses in the US. In 2020 we did about 1.4 million. In 2022 we’re on pace for 1.5-1.6 million. You can see that we’re building about twice as many houses than we need demographically speaking, which does not make sense.
Again, the narrative is that people left cities to flood into the suburbs, driving up prices. But how does that explain why prices soared in cities as well? If the main narrative about work-from-home were driving this, then one would expect prices in northern cities to fall while sunbelt suburbs rose in price.
What really happened was quite simple.
There’s a famous painting around the time of the Tulip Bubble of monkeys dressed as aristocrats, trading tulips at the exchange.
A Satire of Tulip Mania (Jan Brueghel The Younger, ca. 1640)
That’s really all there is to home price gains of 30%, 40%, 50%, or more. A couple of ill-advised government policies that were meant to help but ended up backfiring, and the collective psychology of millions of people believing this time is different and that YOLO is the way.
The long-term question for the housing market and for investors in a product like ITB– with population growth slowing to zero, who is going to buy all of these millions of houses being built? If you’ve got a good rate on a house you like, you have nothing to worry about, but prices are set by marginal buyers and sellers, where there is a lot of craziness. But for companies that built their business models around super-low government-subsidized mortgage rates, raging inflation could be a quick checkmate.
I initially underestimated the full extent of the issues in the housing market. I bought stocks like Home Depot (HD) and Compass (COMP) and have lost money, but c’est la vie. Maybe these housing-adjacent stocks are okay in the long run (especially Home Depot because they’re one of the top vendors for hurricane cleanup). But with everything going on in the real estate market, homebuilders look like hand grenades here, and they’re by and large the top holdings of ITB.
ITB Top Holdings (Etrade)
As you can see here, many homebuilders like D.R. Horton (DHI), Lennar (LEN), Toll Brothers (TOL), and PulteGroup (PHM) are trading with PE ratios under 5.0. These stocks ring alarm bells of being value traps. I believe the low PE ratios are going to turn into price-to-loss ratios because profits are going to turn into losses. The speculative appetite for homes dries up when people are paying free market interest rates for homes, and the demographic picture is bad. Again, I’m not sure who will buy all of these homes!
How fast are prices falling? In some hot West Coast markets that had seen pandemic price booms without population growth, as much as 3% per month (over 30% annualized). Here’s some data from May 2022 to August 2022 (i.e. when mortgages were at 5.5% instead of 7%– before the interest rate shock really took hold). These price declines are rapid and significant, and they’re spreading from west to east.
Home Price Correction US (Fortune)
We’re already seeing some drops of 10% peak-to-trough in hot markets like California, Colorado, and in Austin, Texas. Florida has held up so far but I’d imagine that once the correction gets rolling Florida will end up as one of the worst performers overall due to the magnitude of crazy gains.
Notably, this has all happened without any rise in unemployment. A rise in unemployment from 3.5% or so to 6% or so (the historical average), would cause millions of homes across the country to come onto the market, likely taking prices back to pre-pandemic levels or lower. 2008 saw an unprecedented foreclosure crisis, 2022-2023 isn’t likely to see as many of those due to high levels of home equity, but is likely to see plenty of inventory piling up nonetheless, and plenty of fire sales.
I think we’re in the second or third inning of the housing correction. Now that it’s approaching full speed, the correction will likely last for about 18-24 more months and could see cumulative home price declines in excess of 30% nationally, erasing the pandemic surge and then some. Hot markets in the US and other countries like Canada, Australia, and New Zealand could see home price declines near 50%. This has profound implications for anyone looking to buy or sell a house (the correct move is to stay put), and for investors in housing stocks. The rollercoaster is underway, and one of the biggest bubbles ever is ending with a bang.
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Disclosure: I/we have a beneficial long position in the shares of COMP either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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