Tailwinds 2022 Q3: “Housing Amid Hurricane Season”

By Deron T. McCoy, CFA®, CFP®, CAIA®
Chief Investment Officer

Don’t worry. We’re not about to step into the shoes of Al Roker or Willard Scott to opine on the weather, brewing tropical storms, and cones of uncertainty. Rather, when we say, ‘Hurricane Season,’ we’re referring to the many financial storms battering investors here in 2022. First, earlier in the year, investors were forced to navigate historic selloffs in both equity and bond markets – both here and abroad. Now, in the back half of the year, investors may also face a potential slowdown in the U.S. economy which JPMorgan CEO Jamie Dimon refers to as a hurricane warning, but “we don’t know if it’s a minor one or Superstorm Sandy. You better brace yourself.”

Hurricane season typically involves many hurricanes. And 2022 is no different – as one investment related storm finally begins to subside just as another economic related storm begins to strengthen. And this jibes with our recent commentary. Back in June, when markets were trading near their lows (i.e., the S&P 500® around 3650) we suggested that the pain on Wall Street may have already run its course. But with economic weakness on the horizon, the pain on Main Street may lie ahead. What does pain on Main Street look like? Unfortunately, it may take the form higher unemployment and lower home prices.

So, while we’ve spilled a lot of ink here in 2022 centered around the pain on Wall Street (stocks, bonds), for many people the bulk of personal wealth resides in the pain on Main Street bucket (their primary residence). With an economic hurricane coming, what does the next twelve months have in store for housing? That’s a tough call considering that real estate is typically a local market issue (does the area have an abundance of stable and higher paying jobs, a good school district, parks, weather, etc.). In critical analysis, it’s sometimes better not to focus on what an asset will do, but rather what it won’t do. And through this lens, many homeowners can take comfort in knowing that a repeat of 2008-2012 seems very unlikely. Why? Let’s compare and contrast the current environment with prior cycles to gain a better understanding of what the future may hold.

How did we get here in the first place? The short answer is the pandemic. With COVID causing many to start working from home, families suddenly found themselves in need of more space – causing demand to rise for single-family suburban homes (as well as vacation homes, but that’s a different story). Low interest rates artificially sustained by pandemic-related emergency monetary policy further fueled demand; as the cost to acquire homes plummeted. What was the result? Home prices rose 1% every single month from August 2020 through May 2022 (climbing 8.9% in the first five months of 2022 alone).

But then came summer. The yield on the 10-year Treasury bond broke materially above 3%, causing mortgage rates to push towards 6%. Not surprisingly, high mortgages on top of high home prices have caused activity to dramatically slow – with new home sales now running at the slowest pace since 2016 (even including the onset of the pandemic).  People are now beginning to fear a repeat of the Great Financial Crisis; where prices fell 25% and new home sales plummeted 81%. But Brian Wesbury, Chief Economist at First Trust, is convinced this cycle won’t be a repeat of the GFC – suggesting investors consider the following:  

• The last housing bust was preceded by several years of massive overbuilding. We simply had too much inventory; too many homes available for sale, along with too many homes available to rent. By contrast, the most recent turbulence in the housing market has by no means been preceded by overbuilding. If anything, we’ve built too few homes during the past decade.
• Although home prices have risen substantially since 2020, relative to replacement cost, they’re only up about 2%, and only about 4% higher than the median over the past forty years. Why does replacement cost matter? Because the more it costs to replace your home, the more your current home is worth. So, yes, home prices are up substantially, but if the costs of copper pipe, drywall, lumber, and labor have similarly risen, then it makes sense home prices would be higher.
• Rents are also expected to continue rising at a rapid pace – putting a sturdier floor under home values. In the last housing crisis, not only did home prices fall but housing rents decelerated sharply (temporarily going negative). Think about that: many people were leaving home-ownership but landlords couldn’t squeeze them for more rent because there were simply too many available homes. In our current environment, where higher mortgage rates are persuading some potential home buyers to remain renters, landlords are in a much stronger position. They can keep raising rents because the market isn’t oversupplied with properties for sale.
• Higher rents should therefore keep home prices from falling too much (as with the prior housing bust). The more a home can generate in rent, the more valuable it is.

Wesbury goes on to conclude, “what we are seeing right now in the housing market is a bad case of indigestion from higher interest rates. Due to overly loose monetary policy and other COVID related policies, home prices got too high versus rents in the past couple of years and both prices and rents need to correct. We project continued gains in rents in the next few years as home prices are roughly unchanged. The maximum drop in home prices from the peak to the bottom in this cycle should be around 5%, not a 25% implosion like last time.”

No homeowner wants to lose 5%. But to put this into perspective, if Brian Wesbury is right, the correction would only rewind 5-months of gains during the pandemic boom. In fact, most homeowners might be ok with a mere 5% correction considering both the runup and the fact that most other assets are down double digits in 2022.

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The information contained herein is for informational purposes only and should not be considered investment advice or a recommendation to buy, hold, or sell any types of securities. Financial markets are volatile and all types of investment vehicles, including “low-risk” strategies, involve investment risk, including the potential loss of principal. Past performance does not guarantee future results. For details on the professional designations displayed herein, including descriptions, minimum requirements, and ongoing education requirements, please visit seia.com/disclosures. Signature Estate & Investment Advisors, LLC (SEIA) is an SEC-registered investment adviser; however, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. Securities offered through Royal Alliance Associates, Inc. member FINRA/SIPC. Investment advisory services offered through SEIA, 2121 Avenue of the Stars, Suite 1600, Los Angeles, CA 90067, (310) 712-2323. Royal Alliance Associates, Inc. is separately owned and other entities and/or marketing names, products, or services referenced here are independent of Royal Alliance Associates, Inc.

 

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