here’s no doubting it. Although last month's decrease was welcome, inflation is more than likely here to stay. Non-sticky inflation will continue moderating with the travel season over and gas prices declining in the short term. The used car market is also cooling down thanks to high interest rates and no free stimulus checks to finance down payments.

Broadly speaking, goods disinflation is needed to push back on accelerated services inflation. But the sticky component is hard to unstick on the supply side, and even if oil and food are resolved, rent and housing will be unchanged. But with Bloomberg reporting today that 1 in 6 households are so far behind on their energy payments that power is being shut off, you might be wondering. Is the housing market ok?

Although housing prices are declining, homeowners whose property values increased by 36% over the last two years are not concerned with a 5% decline, and the aggregate housing price index will not change very much. And despite higher prices across the country, demand for housing persists and there is still a shortage of nearly 1.7MM homes. Homebuilders, who understood the boom wouldn’t last, have kept strong balance sheets and continue hiring to meet labor demand for unfinished construction.

Housing has the most influence on inflation for good reason. It’s the average American's biggest expenditure, the largest component of net worth, and a major economic industry. When interest rates rise, preferences shift quickly, and new households are formed in multifamily residential apartments instead of single family housing.

top remote-work cities slash prices
source: bloomberg

Still, nobody forecasted double digit rental growth. But a decoupling of households shifted demographics dramatically. Tenants moved from having 2-3 roommates to living by themselves. Institutional operator Avalon Bay shared their tenants went from 1.8 people per apartment to 1.6 people per apartment in a 1 year period, a significant shift in the context of hundreds of thousands of units.

While we’re here, we should talk about institutional buying too. Yes, Blackrock and others are buying single family homes. But the sensational stories are missing something. Portfolios like these started growing in 2012 after the financial crisis in areas of distress or with high concentrations of subprime borrowers.

Many institutions stepped back into the buy-to-rent market thanks to that decoupling. But all this action is concentrated in areas known as “buy boxes”, where investors look for homes around the median price that have a strong rent/price ratio.

Zillow’s failed iBuying venture is a great example of how this strategy often ends. Although this only accounts for roughly 6% of nationwide buying activity it appears significant because the press loves the story. The same thing already happened 40 years ago to create the institutional apartment market.

new apartment constructions per year (thousands)
source: statista

And for 20 years, that market rented 300,000 units per year. But in 2021 it exceeded 700,000 while new rental supply was still 330,000 units per year. That unpredictable surge created the tightest rental market ever.

Regardless of the 13% increase in the national average rent, every public operator that disclosed rent-to-income ratios showed no change. People relocated, took their large incomes to an area with lower incomes and rented a nicer apartment there.

Austin, Texas is the poster child for this phenomenon. Monthly housing costs appreciated 40% YoY, but the debt-to-income ratio of the average tenant actually decreased. Now Austin has the lowest debt-to-income ratio in the country.

Single family households were very healthy too.
Although mortgage delinquencies have slightly increased in Fannie and Freddie mortgage pools, foreclosure rates are still at an all time low. The truth is, these borrowers are much healthier than those before 2008. A closer examination of FHA mortgage data reveals the average down payment approached 7.5%, while average credit scores are in the low 700’s. Many of these borrowers also have substantial equity built up and are able to make their payments on time. At one point, 10% of all US homeowners (9 million people) were in the FHA’s COVID forbearance program. Now, only ½ million are still in forbearance.

fha mortgage delinquency, foreclosure, and bankruptcy rates (percent)
source: federal housing administration

But what about future demand? Five years ago analysts projected a need for 1.36MM new homes each year for 10 years. Now that number is close to 1.55MM a year for the next 10 years to bring supply toward demand, including the supply shortage noted earlier. In fact, we’re already nearing 1.8MM housing starts for the year despite materials and labor shortfalls.

These projections are based on noticeable demographic shifts in the US population. Economists foresee a continuous decline in housing starts and demand because household formations will decline among zoomers, a shrinking generation. Furthermore, baby boomers, who are now mostly in their late 60s and early 70s, will start selling their second or third homes which will free up the supply of existing homes for the first time.

Finally, a massive shift in the balance of new college graduates and people passing away will slow household formation even more. During the boomer generation, 4 million college graduates emerged every year as 2 million people passed away. Now, 4.3 million people graduate college each year, as 4 million pass away. Growth is stagnating.  

change in new housing units authorized by state
source: us census bureau

Regardless of what happens five years from now, the supply crunch is still underway and materials suppliers are the biggest headwind to housing starts. Although housing starts are nearing that 1.8MM figure for the year, materials suppliers will not invest in higher output capacity unless there is a clear trend of 2MM starts per year for several  years ahead. As we know from demographic data, that isn’t the case.

Many materials manufacturers do not believe the most bullish cases, instead assuming, like us, that housing starts will eventually return to normal. Sure, a persistent supply side crunch here will keep pushing goods inflation up, but this relationship resolves on its own as housing starts revert to “normal”.

Instead, our focus should be on materials suppliers who are not at 100% capacity, and who have innovative products in the pipeline for future home remodels. Our expectation is that although the number of new homes may decrease, the number of old homes being remodeled will increase. This tends to occur when financing rates are high, but will be especially common as the boomer supply hits the market.

Aug 24, 2022

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