U.S. Housing - Booming not Bubbling

In 1895, at the age of 60 and in some financial difficulties, Mark Twain embarked on a speaking tour of the British Empire to pay the bills. He later published an account of his travels in a book entitled: Following the Equator. Among his many pithy observations is one which I’ve always felt was particularly relevant to investing:

 “We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again, and that is well, but also she will never sit down on a cold one anymore.”

As the economy recovers from the pandemic, the housing industry is booming. However many Americans remain wary of real estate, having been badly burnt in the first decade of this century when a U.S. housing bubble ultimately triggered the worst recession since the Great Depression. 

However, the reality is more nuanced this time around. So far, the increase in home prices is more moderate than fifteen years ago, particularly given current super-low mortgage rates. In addition, residential real estate could provide a hedge against now rising inflation. 

In time, of course, the increase in prices and building may become more worrisome and, in the meantime, a housing boom is still a very mixed blessing as it tends to increase inequality and divert resources from more productive activities. However, for investors, as of now, the boom in U.S. housing looks like more of an individual investment opportunity than a general macro risk.

Tuesday’s new home sales and, particularly, housing price data should provide further evidence of the strength in housing. We estimate that new home sales only fell moderately in April from a nearly 15-year high March while the Case-Shiller report on home prices should show a double-digit year-over-year gain in average prices, as did last Friday’s existing home sales report.

The strength in demand is easy to understand. The pandemic has, at least temporarily, enhanced the attractiveness of suburban housing relative to crowded city living. Equally important, strong stock market gains and very low mortgage rates have increased the pool of potential buyers. Indeed, with price appreciation running at 10% year-over-year and mortgage rates at just 3.00%, buyer enthusiasm is easy to understand.

However, it is important to recognize that the market overall still looks reasonably priced. The average price of an existing single family home sold in April was just under $365,000 – roughly 2.6 times annual household disposable income. This is right in line with its average of the last 20 years and 21% lower than its peak in the summer of 2005 at the height of the early-2000’s housing bubble. Moreover, back then the average 30-year mortgage rate was 5.8% - almost double today’s level.

In addition, the mid-2000s was characterized by massive over-building with over 1.7 million single family homes started in 2005. Today, single-family housing starts are running at a much more modest pace of less than 1.1 million units annualized in April.

There is, also, something to be said for housing as an inflation hedge. In the 1970s, when consumer prices rose by an average of more than 7% per year, median new home prices rose by more than 9% annually. In that decade, while long-term interest rates rose, inflicting losses on bond-holders, stock prices only eked out a 2% annual gain, tarnishing the reputation of equities as an inflation hedge.

While we do not expect anything like a return to 1970’s style inflation, even somewhat higher inflation and interest rates will challenge both fixed income and equity markets and residential real estate could outperform both over the next few years.

Having said this, it is important in real estate (as in all investments) to be selective. All housing markets are not booming and apartments in major cities could suffer from a lack of demand for some time as many businesses adopt a permanent, albeit partial, work-from-home model in the wake of the pandemic. Rental properties could also see softer demand in the long run from a slowdown in population growth which has been worsened by the pandemic. In addition, many other parts of commercial real estate will also bear some long-term scars from adjustments in consumer behavior wrought by the pandemic.

It is also important to note that, while the Federal Reserve’s actions in maintaining very low short-term rates and purchasing mortgage-backed securities has provided the nation with super-low mortgage rates, it is a very dubious policy either from the perspective of promoting economic equity or long-term growth. Very low mortgage rates are, of course, part of the reason home prices have risen so quickly. However, for younger and poorer households, scraping together the down payment is a more formidable hurdle than making the monthly mortgage payment and rising home prices are only making this problem worse. In addition, while a healthy home-building industry is obviously a good thing, it does little to enhance the productive capacity of the U.S. economy. An economy which invested more in research and development would presumably see stronger growth in the long run.

Still, for now, while both the pandemic recovery and the economic rebound remain on track, many parts of U.S. equity and fixed income markets appear expensive.  This suggests the need for careful asset allocation and active management. And, with rising inflation, for younger investors in particular, this still looks like a good time to buy rather than rent a home.

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