Issue 12 - Real Estate -The Last Domino to Fall

I help Corporations & Financial Institutions increase Brand Awareness & secure CRA Benefits & Volunteering Opportunities. I also comment on Financial Markets.

Click?#jcobservations?to see my posts -?Please share this newsletter with your network

The Last Domino to Fall

Markets tend to move in a particular order & every economic cycle is pretty much the same. First inflation ' rears its ugly head ' in commodity prices, often because a supply/demand imbalance has arisen. These higher prices then begin to show up, at the wholesale level, in producer price inflation. Needless to say, producers & wholesalers don't like to see their margins squeezed from higher input costs so they will pass on these price increases to the retail customer. Thus, inflation now turns up in retail prices.

The consumer is now ' taking the hit ' and he's not very happy. He walks into the office of his boss, or his trade union leader, looking for a wage increase to compensate him for his higher costs.

If the wage increase is granted, the whole cycle repeats itself until a cog appears in the wheel, usually in the form of reduced demand. Reduced demand makes it more difficult for retailers to pass on price increases so they have to take some of the hit in their margins.

So, how does this cycle manifest itself in financial markets? Well, interest rates tend to track inflation pretty closely as they are the primary weapon used by central banks. Higher inflation rates invariably lead to higher interest rates & lower bond prices, ensuring that the bond market is the first domino to fall.

You may be familiar with the expression ' canary in a coal mine '. In the olden days, canaries would be regularly released into the mine shafts. If there was a gas leak, the canary would expire, thus acting as an ' early warning system ' for the miners that the mine was not safe.

In a similar fashion, the bond market often acts as the canary in the coalmine for the stock market. Falling bond prices and higher yields impact stocks in a number of ways. Firstly, higher yields on bonds and bank deposits will attract money flows from stocks. Secondly, higher borrowing costs reduce company profits, making more share downgrades likely.

So, the stock market is usually ' the second domino '. Stock markets, given their liquidity, tend to react very quickly to events, so their response to falling bond prices can be pretty immediate

The final domino is the real estate market. By nature, it's a slower moving market as real estate transactions typically take many months to execute but as sure as night follows day, the real estate market will be impacted, both by stock market trends and even more so by bond market movements. A significant stock market correction causes a material reduction in the ' wealth effect ' and its associated consumer confidence. The impact from the bond market is even more direct as higher interest rates impact heavily on both companies and individuals, thus rendering real estate assets less affordable and creating an immediate drop in demand.

So, where are we right now? Looking at the chart below, it seems that the bond market troughed in Aug 2020 when the 10-Year Treasury Bond yield dipped to 0.5% Current yields around 2% are 4 times higher than they were during that pandemic-induced dip.

The stock market ( S+P 500 ) peaked, 16 months later, in December 2021.

It is my opinion that real estate prices peaked in Q3 or Q4 2021 and that the long bull market is at least pausing but more likely declining from quite elevated levels. Bear in mind that the Case-Shiller U.S National Home Price Index is based on a 3-monthly rolling average with prices, published with a 2-month lag. So the peak level seen on the chart below in Dec 2021 is actually the 3 month average of the August/September/October period.

So how sizeable will the correction be? A lot depends on how much monetary tightening the Federal Reserve decides to execute. If rate hikes are not excessive, we may be able to have a ' soft landing ' with property assets experiencing a drop that's not too severe. However, substantially higher rates will invariably lead to a more significant correction

Reading the tea leaves

' Reading the tea leaves ' is an expression that comes from ancient Greece as experts read the pattern of the tea leaves at the bottom of a cup to interpret the future. In more modern times, this phrase can relate to many different things, including economists seeking to forecast future financial market developments

So let's ' read the tea leaves ' in respect of the real estate market by looking at the elements that could materially impact the near-term direction of real estate markets

Limited supply

One of the biggest drivers of the current real estate boom has been limited supply, at a time when demand has been substantial, thanks to a potent mix of higher stock markets, tax cuts & stimulus payments along with the impact of the WFH ( work from home ) phenomenon. This was further exacerbated by supply chain issues as various building materials & components were delayed by 6-12 months, causing construction projects to get bogged down. Homebuilders have amassed 406,000 single-family houses for sale at all stages of construction. This is the biggest unsold inventory since August 2008, up by 69% year-on-year, representing 6.1 months of supply. It's important to note that 6 months supply is deemed to be the equilibrium level for house prices.

The follow-on impact of this will be a substantial ' supply hump ' of newbuild properties arriving on the market, just at a time when fragility is increasing

Interest rates

Unprecedentedly low interest rates have provided a huge underpinning for the real estate boom. As well as reducing the Fed Funds rates to zero, the Fed has similarly reduced long-term rates via its QE ( Quantitative Easing ) program.

However, rates have now increased by 1%, with expectations that they may reach close to 2.5% before topping out. If the Fed is really serious about reducing inflation back to the 2% target rate, interest rates might need to go substantially higher than 2.5%. In addition, The Fed has indicated that it may soon commence QT ( Quantitative Tightening ). Given that QE saw approximately $8 trillion injected into the market, its reversal would have a massive impact

As mortgage rates increase, people rush to buy a home to lock So initially, rising mortgage rates create a flurry of activity. With each uptick in rates, more homebuyers hit their ' affordability ceiling ' and drop out. This is not visible initially as the drop-outs are outnumbered by the flurry of people desperate to lock in the low mortgage rates.

As mortgage rates rise further, more people throw in the towel, which then translates into a decline in demand.

The average rate for 30-year fixed-rate mortgages rose to 4.06% percent on Feb 18th, the highest since July 2019.

But mortgage rates remain ridiculously low, in face of a 7.5% CPI inflation

Now inflation is the worst in 40 years and spiraling higher. First-time buyers, facing higher mortgage rates & sky-high house prices, have already pulled back as investors & cash buyers piled into the market.

First-time buyers dropped to 27% of total home purchases, down from 34% in 2021.

Affordability

Affordability may be the major factor that ultimately ends the bull market in real estate.

Aside from the massive increase in the cost of a new home, the putative buyer also has to deal with close to double-digit increases in his rent, fuel & food bills. This is a battle he cannot win.

The median-priced house leaped from 4.2 times median household income in 2019 to 5.6 times in 2021, exceeding the 2005 record high of 5 times, when the subprime mortgage bubble was in full swing. The National Association of Realtors housing affordability index dropped from 180 in 2021 to 151 today

Sentiment

The Eagles are my all-time favorite band. Aside from their best-known songs, there are many more tunes that many may regard as ' album fillers ' but I consider them to be masterpieces, both for the quality of the music and the beauty of the lyrics. One such gem is " After the thrill is gone " from the album " One of these Nights "

I think it's appropriate to finish this review of the real estate market with a section from the chorus of this wonderful song. Consider the words carefully when reviewing your real estate portfolio.

" Same dancers in the same old shoes, Get too careful with the steps you choose You don't care about winning, but you don't want to lose, After the thrill is gone "

The thrill of rocketing house prices has likely gone and gravity is about to take hold.* Special thanks to Bloomberg & Wolf St for the charts that I liberally borrowed

Life Lesson #12 - 1990 - Local knowledge trumps everything

As my career moved quietly on in the trading room of BNP, the bank progressively grew its market share in Ireland, as its small but well-managed team gained a foothold in several areas. By this time, I had risen first to Chief Dealer level and not long became Head of Treasury, replacing my predecessor, who had been promoted to a similar role in the bank's Singapore dealing room.

While our trading team was making consistent progress, our corporate banking team was starting to gain a foothold in several areas of the Irish corporate market, none more so than the agri-business sector, which was still amongst the most important of the country's business sectors. Although BNP's market share was small, in a market dominated by the Irish clearing banks, Bank of Ireland & AIB, our corporate bankers created a few specialist lending products which enabled us to take a disproportionate share of the agribusiness sector and most especially in the meat business. Whereas our overall share of the corporate market was less than 4%, we had more than 20% of the meat market.

When talking about meat, the majority of it was beef. Irish beef was in high demand as cattle grazing on Ireland's lush green farmlands tended to make beef of a quality not bettered anywhere in the world. There was also a huge export trade in live cattle, especially to the Middle East as importers liked to ensure that the cattle were slaughtered in the Halal method required by the Muslim faith.

Ireland's largest exporter was the Larry Goodman-owned Anglo-Irish Beef Processors (AIBP), followed by Halal Meats owned by Sher Rafique. AIBP was Europe's largest beef processor and dominated the market but Halal Meats also had a sizeable operation. Our business with these two companies alone formed a significant share of our corporate banking profits.

Everything went swimmingly for several years until August 2nd, 1990 when Saddam Hussein invaded Kuwait and suddenly the game changed completely. Irish meat companies had a combined exposure of several hundred million pounds on beef exports which would no longer be paid. As the meat companies had borrowed the lion's share of this money from their banks, these banks were now ' on the hook ' for huge amounts.

In our case, we were looking at an exposure of the order of ￡50 million. To put that in perspective, the bank's annual profits in Ireland at that time were less than ￡4 million so this was literally carnage.

And this is where the local knowledge comes in. The banks who moved fastest would be the ones most likely to survive. None of these meat companies were based in Dublin, where BNP's only office was. Most of their plants and their Head Offices were in small towns dotted around the Irish countryside. Unlike BNP, the Irish clearing banks had branches in all of these towns & ' when the sh*t hit the fan ', these local banks were the first to cop on that there was trouble brewing. The local bank managers drank in the same pubs as the meat company employees, processed their salary payments, and provided mortgages & car loans to their staff. Essentially, they had a whole smorgasbord of data points to enable them to maintain an ongoing ' health check ' on these firms.

Meanwhile, ' back at the ranch ', ( pardon the pun ) in Dublin, our corporate bankers were the last to know what was going on. It was like they had the internet whilst we relied on the bush telegraph. AIB moved quickly to recall their loans and by the time BNP sidled up to the table, there was nothing left.

Luckily, we had a very well-endowed parent bank that quietly recapitalized our balance sheet to the tune of ￡50 million. The good point was that we drew up very long-term repayment agreements with both companies and, 12 years later, we had recouped the full 50 million, thanks to the tenacity of our corporate banking guys.

Nevertheless, the whole episode left a deep impression on me as to the extreme importance of local knowledge and the awareness that those who ' had boots on the ground ' would always have ' first-mover advantage '.