Are housing prices about to drop? A value investor’s take by Katsenelson as of 3 Nov 2022

 

專家預測： 美國商辦自高點回落35%

Economists had expected a house-price bloodbath. In March 2022, when the Federal Reserve first started raising interest rates to combat resurgent inflation, the average value of a house in a rich country was 41% higher than five years earlier. Prices had bounced back from the financial crisis of 2007-09, then rocketed during the covid-19 pandemic (see chart). 目前2023房價比2017年還要高41%, 2017年當時房價已經恢復08金融風暴前水準

 

Global house prices have certainly come off the boil. They are 3% below their recent peak, or 8-10% lower once adjusted for inflation. This is in line with the average correction since the late 19th century. Yet this slump should have been different because it followed a boom when prices rose at their fastest rate of all time. The upshot is that real house prices remain miles above the level of 2019. Many millennials and Gen-Zers, who had dreamt that a crash would allow them to buy their first house, are no doubt disappointed. 許多千禧世代和Z世代, 都希望目前房價回檔一些, 好買進他們人生中第一棟房子 ( 暗示全美購屋需求未來一直都存在)

By contrast with previous housing slumps, there is no hint that lower house prices have created financial contagion. Banks do not seem worried about a surge in bad mortgages. They have fewer risky loans and have not binged on dodgy subprime securities. In New Zealand mortgage arrears have risen, but remain below their pre-pandemic norm. In America delinquencies on single-family mortgages recently hit a post-financial-crisis low. In Canada the share of mortgages in arrears is close to an all-time low.

 

Nor do property woes appear to be throttling the wider economy. Weaker housing investment is dragging on economic growth, but the effect is small. In previous housing busts the number of builders declined sharply long before the rest of the labour market weakened. Yet today there is still red-hot demand for them. In South Korea construction employment has dropped slightly from its pandemic highs but now seems to be growing again. In America it is rising by 2.5% a year, in line with the long-run average. In New Zealand construction vacancies remain well above historical levels.

 

 

Three factors explain the rich world’s surprising housing resilience: migration, household finances, and people’s preferences. Take migration first, which is breaking records across the rich world. In Australia net migration is running at twice pre-pandemic levels, while in Canada it is double the previous high. Demand from the new arrivals is supporting the market. Research suggests that every 100,000 net migrants to Australia raise house prices by 1%. In London, the first port of call for many new arrivals to Britain, rents for new lets rose by 16% last year.

 

Strong household finances, the second factor, also play a role. Richer folk drove the housing boom, with post-crisis mortgage regulations shutting out less creditworthy buyers. In America in 2007 the median mortgagor had a credit score of around 700 (halfway decent), but in 2021 it was close to 800 (pretty good). Wealthier households can more easily absorb higher mortgage payments. But many borrowers will also have locked in past low interest rates. From 2011 to 2021 the share of mortgages across the eu on variable rates fell from close to 40% to less than 15%. Even as rates have risen, the average ratio of debt-service payments to income across the rich world remains lower than its pre-pandemic norm. As a result fewer households have had to downsize, or sell up, than during previous slumps.

 

The pandemic itself has played a role. In 2020-21 many households drastically cut back on consumption, leading to the accumulation of large “excess savings” worth many trillions of dollars. This stash of savings has also cushioned families from higher interest rates. Analysis by Goldman Sachs suggests a positive correlation across countries between the stock of excess savings and resilience in house prices. Canadians accumulated vast savings during the pandemic; home prices there have recently stabilised. Swedes amassed smaller war chests, and their housing market is a lot weaker.

 

The third factor relates to people’s preferences. Research published by the Bank of England suggests that shifts in people’s wants—such as the desire for a home office, or a house rather than a flat—explained half of the growth in British house prices during the pandemic. In many countries, including Australia, the average household size has shrunk, suggesting that people are less willing to house-share. And at a time of higher inflation, many people may want to invest in physical assets, such as property, infrastructure and farmland, that better hold their value in real terms. All this could mean that housing demand will remain higher than it was before the pandemic, limiting the potential fall in prices.

The Housing Market is Worse Than You Think

 

In this letter I’d like to explore the impact interest rates will have on the economy and especially the housing market.

 

Currently, the 30-year mortgage rate is pushing 7.6%, up from less than 3% a year ago, while the median house price in the US is up 37% from $320k in 2019 to $440k today. You cannot have both interest rates and housing prices making new highs. Something's got to give.

 

Let’s start with new home buyers, as they’ll be impacted the most.

 

If you are a first-time home buyer, you don’t have home equity to roll into a new purchase. If you bought a house in 2019 for $320k (assuming you put down 20% of the purchase price as down payment), your annual mortgage payment at 4% would have been $15k.

 

Two years later, in 2021, you would have paid $420k for the same four walls and white picket fence (dogs, spouse and 2.5 kids sold separately). However, despite a 37% house price increase, thanks to Uncle Fed, you would have been able to finance this purchase at 3%, and your annual mortgage payment would have gone up to $17k – a manageable $2k annual increase.

 

As I have mentioned, today the median house price is at $440,000, but the interest rate has skyrocketed to 7.6%. Thus, if you are a first-time home buyer, the same American dream would cost you $30k a year – that is a $13k increase from just a year ago.

 

Let me put this in proper context – median annual household income in the US is about $75k, or about $60k after taxes. In other words, half your after-tax income is now going to servicing your mortgage if you bought today at peak home prices and rates.

 

It is easy to see how the combination of high prices and rising interest rates have turned the American dream of owning a home into a nightmare. For affordability to come back to 2020 at current interest rates, housing prices have to decline more than 40% to $250k. If this were to happen, anyone who bought a house since 2012 would be underwater on their initial purchase.

 

It is hard to envision this rapid price decline happening overnight. Just like stock prices, housing prices are set by supply and demand. But houses are not like stocks. People live in their houses, raise their kids there, create memories, and thus get emotionally attached to them. Also, many decades of declining interest rates and rising housing prices have convinced the public that increasing housing prices must be guaranteed by the US Constitution in tandem with the right to the pursuit of happiness.

 

When we decide to sell our house and we receive offers that are below the highest price we saw on Zillow just a few months earlier, we wait for the right, higher offer to come in. This is why the fact that we live in our houses is important - we are emotionally attached to them and want the best offer possible. This is also why housing prices are quick to move up and slow to come down. It takes multiple painful conversations with a realtor to convince us to start lowering the asking price.

 

This is where things get even more complicated. There are two types of sellers: people who must sell their houses (moving to a new city, lost a job, got divorced) and those who would like to sell their houses (bored with their old four walls, need a bigger or smaller house, would like their kids to go to better schools etc.). I am generalizing here.

 

Our house is worth what someone else is willing and able to pay for it.

 

Let’s contrast two transactions:

 

You are at a grocery store – you want to buy tomatoes, but the price of tomatoes has doubled. Your credit card company is not going to say, “Jane, you cannot buy tomatoes. They are too expensive. You cannot afford them.” Unless you are maxing out your credit limit, your credit card company doesn’t care how you spend your (borrowed) money.

 

This is not what happens when you take out a mortgage on your house. After being blamed for the last housing crisis, bankers became born-again bankers: they found underwriting religion. If an average consumer walks into a bank asking for a loan, this born-again banker will look at the cost of the house in relation to the buyer’s income and will politely tell the buyer to look for a cheaper house or start driving Uber on weekends.

 

In the past, a lateral change from one house to another did not really cost you much, other than transaction costs. However, if you refinanced your house at 3% when rates dropped, as many people did, today this lateral move would cost you dearly.

 

How much?

 

The median mortgage on a house today is about $220k, and the median home equity loan is $40k. My goal here is to be vaguely right rather than complicatedly precise, so I assume that an average homeowner owes a total of $260k for their house. If the house was refinanced at 3–4% interest rates in 2021 and 2022, then that average homeowner is paying about $13–15k a year for their house.

 

Unfortunately, the mortgage is attached to a house. Selling a house cancels an existing mortgage, and a new house requires a new mortgage at market rates, which today are 7.6%. Thus, this new mortgage would cost $22k a year, or a $7–9k increase. Just selling your house and moving to a similarly priced house a few blocks away would cost about 10% of your annual income! This explains why the number of transactions in the housing market has hit a multi-decade low.

 

(When my brother Alex, a realtor, asked me if my housing market analysis came with any good news, I told him, yes, your family loves you.)

 

When prices go up, people who want and must sell a house are selling with ease. As prices decline, at first only people who must sell are selling. However, as time goes by, selling becomes less and less discretionary as a desire to sell turns into a need.

 

People who must sell their houses will have to accept lower prices. How much lower? That is impacted not just by a seller’s willingness to accept a lower price (supply) but also by a prospective buyer’s ability to borrow (demand).

 

I hear this argument at times: “In the 1980s interest rates were higher than they are today, and we had a functioning housing market.” There is a substantial difference between then and now. Today the median house price in relation to median income is at the highest level in modern US history, even higher than it was at the height of the housing bubble in 2007. It is almost double the level of the early 1980s.

 

Side note: The situation I described above is not unique to the US. In fact, other countries, including Australia, Canada, and the UK, are experiencing much bigger housing bubbles.

 

Today, consumers’ discretionary income is being attacked by inflation from different directions: The cost of everything is up, from trash collection to food. Gasoline prices have declined, likely due to our tapping into our strategic oil reserve and the slowdown in the economy. Food prices are less likely to decline, though I could be wrong, since they are driven by currently elevated prices of fertilizers (I wrote about that here.)

 

But it doesn’t stop there. Higher interest rates make anything that needs to be financed more expensive – cars, refrigerators, iPhones, big-screen TVs, etc. Over the last decade we got spoiled by zero-percent financing. Unless interest rates go back down, those days are over.

 

It is important to mention that wage increases to date have lagged inflation by a large margin. The federal government has thrown a bone to retirees by promising to raise Social Security payments in 2023.

 

Spending is both a financial and a psychological decision. If you feel wealthy and confident in your future, you are willing to spend your savings and borrow (against future earnings) to buy stuff. The stock market decline and declining housing prices, along with rising unemployment, will undermine consumer confidence and willingness to spend.  Also, falling housing prices will start to undermine the housing ATM (home equity), and rising interest rates will make borrowing against the house more expensive and reduce equity people have in their houses – thus fewer homeowners will undertake home improvement projects or tap out home equity to subsidize their day-to-day living expenses.