Long Live the Housing Market!

While it was toilet paper that may have first grabbed our attention, it’s the housing market and what’s been going on there that has been the big story. For the COVID crisis changed something in the dynamic of housing markets around the world and especially here in the US. It started off as a positive story. “Hey, something interesting is happening with house prices around the country.” Despite everything, people were moving. Houses were selling and prices were even ticking up. And it evolved rather quickly into something else. From the outside it kind of looked like a frenzy or a time warp. All of a sudden, we were back in the go-go days of the housing bubble that felt more like 2004 or 2005 than 2020 or 2021. Line-ups outside open houses. Bidding wars. Properties selling overnight with multiple “all-cash” offers, often going for significantly over list price. Rather quickly, the median house price in America shot up 40%:

The last time the housing market acted like this the banks had to, well, abandon most if not all of their underwriting standards, lever up 33-to-1 loading their balance sheets with more and more exotic derivatives and almost took down the entire global banking system in the process.

For a solid decade preceding the COVID crisis, the housing market was kind of dead. House prices recovered from their post-crash lows and were on a steady uptrend but volume was subdued and the new construction market in particular was moribund. What started as a post-crash demand shock morphed into a rather serious supply problem. Housing production is not only capital intensive but also an increasingly long-term game. It’s an industry riddled with regulatory hurdles and burdens and dominated by local political corruption. So, back in 2007–2009 when land developers and homebuilders across the country walked away from a whole bunch of planned developments, it created a kind of hangover in the market. Housing supply, unlike toilet paper, personal protection equipment or hand sanitizer — remember all that? — isn’t something you can just turn on.

One of the big tragedies of the housing crash is that it destroyed much of the entrepreneurial spirit in the industry. Today the market is absolutely dominated by the big public builders — the Lennar’s, KB’s and Pulte’s of the world — but that wasn’t always the case. In the pre-crash days, there was a whole bunch of smaller private players doing the hard work of assembling tracts of land, getting pesky local governments to approve projects and even building homes. My great friend and longtime business partner was one of those entrepreneurs. His company, Young Homes, which built over 4000 homes in the Inland Empire, survived the crash but found that it was increasingly difficult to make sense of building homes. There just wasn’t enough return to justify the risk, especially in the face of an increasingly harsh regulatory environment here in California. They ended up pivoting to multifamily and doing really well there. And Young Homes was unique in that they actually survived the crash. Most of these private entrepreneurial players did not.

Without these players around housing production was left almost exclusively to big public companies. These companies emerged from the crash having learned some very tough lessons about being overextended and had unforgiving shareholders. As a result, as a group they displayed a persistent reluctance towards the risk of land development and home building. In some sense, they got smarter and better at understanding the nature of demand and how to make consistent returns from what is a pretty low margin business. But the market was never the same and we went into the COVID crisis with a housing market that was fundamentally under-supplied.

With housing production so low and the homeownership rate on the downtrend, people were theorizing that things had fundamentally changed in America. The popular mythology was that the Millennial generation was somehow “not interested in owning” and “preferred the flexibility of the rental lifestyle.” And many Boomers had gotten so financially traumatized by the housing crash that they “never wanted to own again.” The American Dream was evolving. We were no longer going to be the “ownership society” but rather the “sharing economy.” Yeah right!

Look while things were indeed changing in America, the dream of owning a home never really vanished from our cultural consciousness. What we saw after the crash was more a matter of a “dream deferred” than some real, fundamental change. At the end of the day, isn’t this homeownership thing the immortal, inexorable wish of the American experiment?

When COVID hit, it’s like the housing market just woke-up from a very long hangover. In the face of fresh pandemic-related traumas Americans were finally “over” the distant traumas of the crash and ready to engage in the perennial game of the American experiment. “Let’s buy a house!”

We all know what happened. House prices raced higher all across the country, in secondary and tertiary cities and even in rather remote locations. Interestingly, housing went up in the big cities too, a very unexpected result for places that actually saw declining population. Many of the high-profile housing analysts and demographers are looking at all this and arguing essentially that demographics can explain a big part of this move. The argument is that if you look at the Millennial generation, the largest of all the generations, the period from 2020–2024 is the window when we’d expect these households to be in peak buying mode. I do think there’s some undeniable truth to this argument but it’s more than that. As my faithful readers will know I became convinced back in 2020 that something about the nature of housing demand itself changed fundamentally.

Let’s just rewind the clock a few months to the start of 2022. Despite trouble brewing in Ukraine, a growing sense that inflation was starting to be a serious, non-transitory problem and a Fed signaling an aggressive rate-hiking cycle, households across the country were still jockeying to outbid each other in highly competitive situations. At Metros Capital, we listed a house early in the year on a very busy street here in Los Angeles. While we did an amazing renovation, I was a little nervous about the listing simply because of the location. It was on one of these crazy busy streets that is basically bumper-to-bumper during rush hour. Just getting out of the driveway is a real challenge. Nevertheless, given everything that was going-on, our broker convinced us to price it high and it still went over ask by a substantial amount! Back then at least, it felt like the game was still on.

Then, in the face of the war, COVID and the impossible logic of the Central Bank conundrum, rates did, well, what they were supposed to do:

While in absolute terms this doesn’t look like much of a move, for an economy and system addicted to low-cost debt, this represents a substantial tightening of financial conditions. Consider housing for a second. After home prices rose 40% in 2 years, the price of borrowing money went up by 60% in just a few months. What this translates into for buyers of the median home in America is an increase in the monthly payment from $1300 to over $1900.

The stark reality of this arithmetic hasn’t gone unnoticed by American households:

Same goes for the market. The homebuilders, which had been flying high since COVID, have sold off aggressively:

Is the market right here? Is this the end of the story for the housing boom? It certainly feels that way right now. The market is signaling that the housing market is in for a serious reckoning. But I don’t think that is necessarily true.

A few weeks ago, I tweeted this:

The point I was trying to make here is that while rates are, of course, important, they might not be determinative of the whole story this time around. Remember, we have been living in a low-interest rate world for a long time, way, way before COVID. Rates have been pinned to the floor for a decade basically but it wasn’t until COVID hit and shook things up that we saw this mini-housing boom. I’m convinced that what’s been driving house prices higher these past few years is more a function of changing demand and low inventory rather than low rates. In my view, the COVID crisis sparked a once-in-a-generation migratory reshuffling and there were simply not enough homes — existing or new — in the right places. As things stand today, supply demand imbalances are as bad as ever and potentially about to get worse. Imagine what a deep recession will do to housing production.

As we discussed new home construction basically never recovered from the crash and for years housing production trailed household formation. As you all know, this imbalance was already wreaking havoc on standards of living across the country, despite curiously not showing up in the official inflation statistics. Anyway, we went into the pandemic with a massive housing shortage — by some estimates as much as 6M units — and when COVID hit, things only got worse as cities and neighborhoods across the country were literally not physically prepared for the arriving migratory waves. Smaller cities, in particular, were completely unprepared for the influx.

Consider for a second a place like Denver — not exactly a small city but staggering nonetheless. From 2019 to 2022 the population increased by 107,000 (from 2,790,000 to 2,897,000, a modest 3.8%). Yet during that entire time new home sales averaged only about 400 per month!

Depending on which city we’re talking about the mismatch is somewhere on the order of 5x to 10x. No wonder prices have gone crazy!

I’ve got this idea in my head that the rest of the country is going to very quickly look like California, at least when it comes to housing affordability. Several times in the post-war era, California experienced this population explosion, absorbing millions of new households over short periods of time. Even in a more business friendly era of California history, housing production just couldn’t keep up. Fast forward to today and many of the most expensive housing markets in the US are here in California.

What’s really scary about this new post-COVID paradigm is that this same dynamic — i.e. rapid migration-fueled population growth — is happening all over the place all at once. Redfin is reporting that a record 32% of homebuyers using their platform in Q1 were looking to move to a different city suggesting that the migratory reshuffling is still alive and well. And all these cities and towns across the country are just not prepared nor set-up to deal with it.

A close friend of mine is on the city council of a suburb in one of the nation’s hottest housing markets. Things have gotten so crazy for him already, I hesitate to tell you all who and where he is. For he’s doing great work and I’d like to see him get reelected! Anyway, this is a market where the underlying pre-COVID zoning was pretty restrictive. Minimum 1-acre lot sizes. Very little opportunity for by-right multifamily development. That kind of thing. Since COVID, minimum house prices have jumped 50%+ and you cannot really find much for less than $1M. The place is basically out of reach for locals already. Yet, when developers come before the city council with zoning change requests for denser developments, the NIMBY groups come out in full force and start talking about “preserving the character of the neighborhood” and make disparaging comments about “greedy developers.” It all sounds so Californian, right? Look, the supply side of the housing equation is so messed-up, so challenging, I think this shortage problem is here to stay. Ultimately, this is very bullish for house prices.

Housing, rather than being the frontier of opportunity for the American Dream, has become one of the main channels for the proliferation of wealth inequality. Basically, it’s a classic case of have or have not:

America is increasingly evolving along these dangerous insider-outsider fault lines. If you owned a home going into COVID, great! If not, well, then you’re screwed.

Our politicians are picking-up on this. Despite all the obvious evidence from places like NY and LA that rent control measures aren’t all that helpful at solving the problem of housing affordability, many cities across the country are considering introducing new measures or doubling down on old ones:

They are also considering things like taxing owners of vacant properties and introducing measures that make it harder for Wall Street firms to amass single family rental portfolios. Of course, none of this will work. For what we are dealing with here is the perennial problem of capitalism: the built environment just cannot keep up with the population.

Anyway, as this is getting long, let me try to wrap things up. I think that essentially what’s about to happen is that this inflationary pulse will resolve itself in a recession. Neither the market nor the economy itself — both of which are completely addicted to debt — can stomach the ruthless combination of serious inflation and rapidly increasing borrowing costs. We got the first serious sign that I might be right about this already. Q1 GDP came in unexpectedly at -1.4%. The technical definition of a recession is 2 consecutive quarters of negative GDP. Half way there!

In the short-term, this is probably bad for the housing market. In a recession, I have to believe we see a slowdown, probably in terms of both sales volume and price appreciation. It looks like it’s already happening actually. How bad this is going to be is really a function of how serious of a recession we get and how much damage we see in the labor market as a result. The unemployment story is tricky to forecast because we have this dynamic where we have weak and declining labor force participation, low headline unemployment and yet somehow have record number of job openings. This has been explained away as a skills gap — i.e. a mismatch between what employers need and the skills of the workforce — and there’s probably some truth to that. We’ve certainly seen this at Metros Capital, where it’s very challenging to find skilled construction workers. As of today, my gut is telling me that this recession we’re about to get isn’t going to be too bad in terms of jobs.

If I am right about this, a little recession is probably a net positive for the long-term prospects of the housing market. It’ll take some of the craziness out of the price action in the market and allow things to settle in to a healthier dynamic. But slowing down prices is only half the battle. What we need in this country is to build and to build a LOT as the housing market is structurally undersupplied. If this little recession scares the big builders around the country too much, we could find ourselves in another crazy market in the not-too-distant future. For all these reasons, despite all the macro headwinds, I find myself feeling quite bullish on the housing market here in America. Today is probably not the right entry point given all the turmoil in global markets but I’m convinced there will be a great buying opportunity sometime soon.

Nick Halaris is a real estate investor and developer. He’s the founder and President of?Metros Capital?and publisher of Profit.

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