Framing the Housing Sector
How have rising mortgage rates impacted the once red-hot housing market?Download PDF
We recently sat down with Pacific Asset Management Analyst Tommy Zhang to get his insights into the slowing housing sector, including how rapidly rising mortgage rates have been affecting—among other things—affordability, homebuilder strategies and institutional investors.
From your vantage point, what are the most important macro changes over the last year, and what’s happening right now?
I would say it’s been a tale of two markets. If you go back to 2021, the housing market was basically on fire, and that was helped by low interest rates. As a result, you saw home prices jump up over 40% since 2019. But starting around April of this year, we had a rapid cool down when interest rates shot up by 300 basis points in a matter of months.
To give you some context, at the start of 2022, you had the 30-year fixed-rate mortgage around 3%. Today, it’s sitting around 7%. And the way we think about it, every 50-basis-point increase in that 30-year fixed rate increases your monthly mortgage payment by about 6%. When you have a 300 to 400 basis-point move, it has a huge impact on affordability, especially given home prices have also gone up significantly.
This combination of higher rates and higher prices has definitely impacted the market. Affordability has recently hit multi-decade lows, with affordability now actually worse than it was in 2006. According to a recent Black Knight report, if you look at the data as of September 2022, the national payment-to-income ratio stood around 37%, meaning that it takes about 37% of median household income to make the monthly mortgage payment on your average-priced home today, assuming a 20% down payment and prevailing mortgage rates. That is a substantial increase from 2021, when that ratio was in the low 20s.
For comparison, back in 2006, right before the 2008 housing crash, that ratio was at 34%. So anytime affordability is worse than the 2006-2007 levels, it doesn’t make you feel too great.
What’s your view on demand and home price volatility? We’re a long way from 2008, no?
Demand has certainly come down a good amount recently, and that’s a function of higher rates. So, higher rates have made housing less affordable for a large portion of the buyer pool. As a result, there’s a lot of people locked out of the housing market. They’re not able to afford as much home as they would like.
But what’s really interesting to me is that supply still remains relatively low by historical standards. As of the end of August, we had about 1.3 million homes available for sale. That represents about three months of housing supply. Generally, a balanced market is viewed as four to six months’ supply. So even with the slowdown, supply today has remained relatively constrained.
How does today’s cooling housing market differ from the 2008 housing crisis?
I think one of the things that differentiates this down cycle from 2008 is the lack of distressed supply. Back in 2008, you had many buyers who couldn’t afford the loans they were taking out. So, when the market underwent stress, they became forced sellers in that market. As a result, you had millions and millions of homes that were foreclosed upon. At one point, the mortgage delinquency rate peaked at around 10%, and people saw that. They saw all these homes coming to market, they saw all these forced sellers, and that put a lot of panic in the market because you knew if you waited another couple of months, there’d be more homes out there.
For this downcycle, I just don’t see that happening. Underwriting standards have been much tighter. If you look at the delinquency rate today for mortgages, they are at a record low of 2.8%, so, you have a strong borrower. And on top of that, I think homeowners are very incentivized to stay current on their mortgage payments because they’re locked in at attractive low rates. If they were to be foreclosed upon, they might actually end up paying more in rent than their mortgage.
What do you see as the role of institutional buyers in housing?
They have certainly been a growing presence in the new home construction market. Prior to 2020 and 2021, institutional buyers were mostly focused on the existing home market. But what we really saw in the last two years was that they began buying new homes wholesale. For a lot of these builders now, they’re selling 5 to 10% of all their homes to institutional buyers and another 5 to 10% on top to what you would call mom-and-pop investors.
It’s entirely possible for 20% of new homes to be sold to investors instead of traditional retail homeowners. That has definitely altered the market, and I think one of the reasons why home prices went up so quickly in 2021 was because you had this institutional bid that was supporting it. They had a lot of capital to deploy, and they deployed it.
What’s interesting about this down cycle is that a lot of people were expecting institutional bidders to support the housing market as it went down because institutional buyers are cash buyers. They’re not affected by mortgage rates going up to 7%. But what’s been surprising to me is those institutional buyers have actually backed off. I think they realize that they could have a better opportunity to buy homes six to 12 months down the line. They’re choosing to conserve their capital, and they’re being a bit more cautious this time around. So, their presence in the home market I think has exacerbated price swings both up and down. It’s created a bit more volatility, in my mind.
We’ve underbuilt for a decade, and that was in a low rate, lower cost environment. What’s happening now in expectations longer term for construction?
Prior to the housing crash of 2008, we were building north of two million homes a year. When the crash occurred, we dropped all the way down to 500,000 units a year—that’s a 75% decline peak-to-trough in terms of construction activity. We never really recovered back to those two million levels. Even right before COVID hit, we were building about 1.3 million homes a year, and the industry believes that about 1.5 million homes is what you actually need to meet demand on an annual basis. We’ve been undersupplied for quite a while and based on who you listen to, that number could be as much as four million homes in the market right now.
For this year and next, I don’t think you’re going to see as much of a dropdown in volumes, just because there was never an excess that formed in the new construction market. Right now, we’re at a start pace of 1.6 million homes. Forecasts are generally calling for a decline to 1.4 million new homes annually by 2023 and 2024. I think it’s going to be a pretty modest pullback, call it 10 to 15%. This is going to be nothing like 2008, where you saw a 75% drop in volumes.
And for the home builders, that’s a good thing because they’re focused on volumes and margins. If your volumes are staying relatively elevated and you’re still building above what you’re building in 2019, you should be in a good spot. This is not like the Great Financial Crisis, where volumes basically imploded overnight.
What other trends are you watching in the coming quarters with homebuilders in this higher rate environment? Are companies already adjusting their strategies?
That’s a good question. I think we’re starting to see different companies take different approaches when it comes to the slowdown. On one hand, there are certain builders that are prioritizing volumes over margins, and, as a result, they’re getting a bit more aggressive when it comes to pricing, and offering more incentives such as buying down interest rates. Those builders want to be production builders. They want to build as many homes as they can, and they’re willing to accept a lower margin. And when I say lower margin, that is relative to the peaks of 2021. Most of these builders are still generating margins in excess of where they were in 2019.
On the other side of that coin, you have builders that are focused more on margin. So, for them, they don’t want to be as aggressive when it comes to pricing, and they’re willing to sell fewer homes. So, it really comes down to a company-by-company basis as to how they plan to navigate this downturn.
Where do supply chains stand for new home construction?
This was a major constraint in 2021, when there were all sorts of raw material issues and labor issues. Those are really key bottlenecks in the home-construction process. Normally, when you think about buying a new home, you generally put in an order, and it takes about six to nine months for that home to be built.
Because of all these shortages caused by broken supply chains, we saw construction times extend by about two to three months. It took longer to build the home, and there were a lot of quality issues as well. Those issues have somewhat abated in 2022, just given the pace has slowed down a bit. We’re seeing less builders talk about supply chain issues, but they are still prevalent.
Why is there so much interest in the housing sector?
It has a great impact on our personal wealth. In the U.S., we have a home ownership rate of 65%. For a lot of folks, the home they own is their greatest asset, and when there are swings in the housing market, it can create a lot of fear and anxiety.
Personally, for me, we’ve been in the market, looking for a house, over the past two years. It’s been a tough time to buy because we have been outbid so many times. So, it pays to stay updated with how the sector’s doing and keeping a pulse on the market.
What’s the significance of the Super Bowl when it comes to the housing sector?
The spring selling season usually occurs right after the Super Bowl concludes. Generally, March through July is the prime selling time. That’s when there’s a lot of houses that come to market because they show better given there’s better weather, and that’s when the bulk of sales occur.
While there’s quite a bit of uncertainty in housing, where do you see opportunities in your corporate credit analysis across the sector?
Housing has had a rough year, and it’s dragged down adjacent sectors such as building products as everything that’s associated with housing has become tainted in the credit markets. We believe that not all of these bonds are created equal. Right now, I see a lot of value in roofing names because when you break down building product demand, some of it’s discretionary, and some is repair driven and non-discretionary.
For us, roofing makes a good story. If your roof has a leak, if there’s a storm that blows down your roof, you’re probably going to repair it. If your kitchen needs a remodel, you might not be as inclined to do that if there’s a recession. So, we like names within the roofing sector. We see a lot of good value there. It’s been dragged down a bit by the overall housing market, but we think it’s going to be pretty resilient over the next couple years.
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