The housing sector of the U.S. economy has reached an important inflection point. Bolstered by strong industry fundamentals, housing related stocks have nicely outperformed the broad indexes. Indeed, Long Housing is MRP’s longest running theme going back some six years. There are clearly possible headwinds on the horizon; nonetheless, the best may be yet to come. But the boom will not go on forever.
MRP first identified a turnaround in housing in April, 2012. At the time, starts had bounced off their lowest level in decades, but were still 2/3rds lower than their 2005 peak of 2.1 million. Home prices were down almost 40% and some experts were forecasting further declines of 15-20%. Sadly, the combination of the previous surge in mortgage lending and the subsequent plunge in prices had left as many as 10.9 million families owing more on their mortgages than their house was worth. In 2010, up to 24% of homeowners with mortgages were “underwater”.
But since those hard times, the US housing recovery has been stunning. From the low point in 2012, the Case-Shiller national home price index has rebounded 46%. The FHFA has seen a 33% rise; however, its recent record high is even more impressive than the Case-Shiller index’s gains considering the FHFA did not fall as far during the crash. As of December 2017, U.S. monthly starts have more than doubled since April 2009’s all-time low. Existing home sales and new home sales have also seen very strong growth, climbing 40% and 121%, respectively, from their lowest points in the housing market crash. Importantly, the price recovery has lifted millions of homeowners out of underwater status.
Elsewhere, things are not so rosy. Some housing markets around the world are slipping into deep slumps with countries like Sweden, China, and Canada experiencing plunging home prices. Beijing and Shanghai had seen a 30% rise in home prices until the government implemented property controls in late 2016. These measures, combined with continued construction, have now driven prices into negative territory in those same cities. Sweden is also experiencing a surge in home building, pushing construction to its highest level since the 1990s, and the country’s housing market has descended into the worst downturn since the global financial crisis. In North America, where Canadian real estate prices were the fastest rising in the world just a few months ago, that trend has now reversed and they are now the fastest-falling in the world. This should serve as a stark reminder that housing is highly cyclical and the same fate could befall the U.S. sector at some point.
Indeed, although 2017 saw annual increases in U.S. housing data, many of the monthly numbers recently seemed to be slowing. December’s sluggish data had several prognosticators suggesting the recovery may be over. Total housing starts for the month totaled only 1.21 million, keeping trend with largely flat growth throughout 2017. New and existing home sales plummeted by 7.8% and 3.2% month over month, respectively. In January, sales of new and previously-owned homes declined again, and pending home sales dropped 4.7%, hitting the lowest point in nearly four years. In January, sales of new and previously-owned homes declined again. However, housing starts were more resilient, and jumped almost 10% in the first month of 2018 to an annual rate of 1.33 million, the second highest level since 2007. Even more notable, permits to build new homes hit a 10 1/2-year high, rising 7.4% to 1.4 million. It is instructive that while high commodity costs and a shortage of skilled labor has worked to push home prices sky high, this has yet to deter new construction.
Some have worried that the recently-passed GOP tax reform package, the Tax Cut and Jobs Act (TCJA), could hurt housing prices while also worsening affordability. The lower cap on the mortgage interest deduction and the new cap on state and local property tax deductions could cause home prices in expensive markets to fall, although not necessarily making them a lot more affordable. Before the TCJA, one could deduct interest on up to $1 million to buy or improve a first or second residence (so-called home acquisition debt), or $500,000 for those who use married filing separate status. From now until at least 2025, though, the maximum interest deduction allowed by the TCJA for home acquisition debt is $750,000. For those who use married filing separate status, the limit is also lowered to $375,000.
After years of a fixed 30-year mortgage interest rate below 4%, that rate is now 4.5%. The uptrend will likely continue as the Fed tightens monetary policy and markets rates continue higher on the long end. This would all seem to be bad news for the housing market, but in the short run, the Fed’s policy may continue to boost home sales as prospective buyers feel pressure to find a home sooner, rather than when rates climb even higher. According to a recent survey by Redfin, 94% of respondents would not cancel their search for a home altogether because of rising rates. In fact, 21% of them said rates passing 5% would increase their urgency to buy a home. When the train blows its whistle, it seems, the prospective passengers run to get aboard!
Still, at this point, it is reasonable to wonder how much higher U.S. home prices can go. Like any tradeable asset in a free market, prices are set by supply and demand. The notion of home prices having an intrinsic value is illusive, at best. However, it is known that about half the cost of home construction is labor, and construction workers’ wages have increased 20% since 2009. The producer price index for Building Materials, Paint, and Hardware Wholesaling, on the other hand, has decreased almost 7% over the same span. So, on a replacement cost basis, current house may be slightly above the trend of the past three decades, but still well below where they were when prices previously peaked in 2007.
But it is demand vs supply that determines prices, and, those forces point to continued appreciation.
MRP has previously noted a huge buildup in pent-up demand for housing that has accumulated over the past decade. Housing starts hit a bottom in March 2009, and have since roared back more than 162%. However, again, the latest reading of 1.33 million housing starts is still below the long-term average of approximately 1.5 million starts that is needed to keep pace with normal replacement demand, population growth, and new household formations. According to MRP’s calculations, since breaking the long-term trend in 2007, there has been a cumulative underbuild of 5 to 6 million units, a net shortfall that can be thought of as pent-up demand. At the current pace, that cumulative gap could rise well over 6 million in the next year.
Millennial household formations have been slow, lending false credence to speculation that they may “never leave their parents’ basements”. But, according to our analysis, the surge in household formation by this generation may, at last, be on the verge of breaking out. The number of households in the U.S. had increased only 4% between the first quarter of 2012 and the fourth quarter of 2017. Over the first few years of that span, millennial job growth was sluggish. But in the past three, there has been a cumulative increase of 7% in the employment rate for those aged 25 – 34 against only 4% in the overall working population, creating a sizeable gap between the 25-34 group and everyone else. The millennials are also the largest age cohort in the labor force.
Similarly, whereas birth rates seemed to have been on the decline among millennials, it now appears to have simply been a postponement. While the annual fertility rate is at an all-time low, the completed fertility rate — the total number of births by women ages 40 to 44 — is higher today than it was in 1994, over 20 years ago. These divergent trends can be explained by two patterns: women are having babies later in life, and they are having more babies.
Since 2012, millennials have actually been the largest annual group of homebuyers. This is especially significant in that, while the average homeowner keeps their home for ten years, the average millennial does so for only six years. 2018 may be high time for that initial wave of 2012 buyers to start moving on, providing a boost to existing home sales. Moreover, 68% of Millennials view their first house as a stepping stone to an even better home in the future. An upgrade could mean shifting from an existing home to a brand-new home, with the equity accumulated from paying down their mortgage and higher home prices making it possible. Data from America’s largest luxury home builder, Toll Brothers Inc., seems to support this hypothesis as, through August of 2017, 23% of its sales for the year were to customers with at least one buyer aged 35 or younger.
Not only did the level of occupied housing units hit an all-time high in the final quarter of 2017, ownership rebounded as well. Homeownership in the United States peaked in 2004, when 69.2% of all U.S. households owned their dwellings. The rate bottomed at 62.9% in the second quarter of 2016, a level not seen since 1965. The rate has now since risen sharply to 64.2%. Home ownership for those under age 35 climbed from 34.7% to 36% in 2017. Optimism remains high as February’s National Association of Home Builders/Wells Fargo builder sentiment index held at 72 for the second consecutive month. That’s only 2 points shy of December’s reading, which was an 18-year high for optimism among the nation’s builders.
There is no question that new headwinds have arisen that some think could threaten the recovery in the overall housing sector. Rising mortgage rates and soaring home prices are making homes less affordable; changes in the tax rules have introduced some new negatives. On the other hand, the tsunami of maturing millennials, with improved employment and income prospects is a powerful longer-term force. We believe it is likely to outweigh the shorter-term negatives. Our best guess is that, in 2018, home prices will continue rise, construction will accelerate towards the 1.5 to 2 million annual rate for starts, and housing-related securities will outperform the market. As such, MRP reaffirms our long U.S. Homebuilders theme.