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Evidence of Slowdown in Housing

It’s pretty clear that home prices have been growing rather quickly. However, recent evidence suggests that home prices will not grow for much longer. Home builder inventories of planned homes and homes under construction are high and growing. This means that homebuilders are in the process of bringing homes to market which will lower prices.

Meanwhile homebuilder inventories of finished homes looks like it’s hitting a low and will start to grow again rather soon. Similarly, in response to a ramp up in home construction demand for homes is falling off. On top of this, home prices have been too strong for too long and are now starting to weaken. Furthermore, FED policy is going to cut into demand for homes strongly and likely will bring a wave of foreclosures.

This post looks at the 3 categories of data which indicate a dramatical fall in home prices at some point in the next 5 years:

  1. Homebuilder inventories

  2. Home price growth

  3. Borrowing cost

Section 1: Homebuilder Inventories:

The New Residential Sales release (accessible on FRED) reports all the single-family houses construction firms sell in a month and have for sale at the end of the month. It reports on fully constructed houses, houses which are in construction and houses that construction firms plan on constructing (all of these categories can be sold by construction firms to realtors).

For the rest of this section I will use the term “home” as a shorthand for single-family homes which is what the data refers to

Subsection 1.1: Homebuilder Inventories of Constructed Homes

The following chart shows a 12-month running sum of home builder sales of fully constructed homes and the completion of unsold homes (calculated as the growth in inventories and the total sales of completed homes).

When the supply of homes (in terms of adding new homes to the market) is higher than demand (in terms of taking homes off the market) this can create an oversupply which creates a buyers market, i.e. prices go down. So, when the blue line (representing construction of unsold homes) is higher than the red line (home builder sales of constructed homes) this indicates a bad situation for home prices (for instance: observe the peak before the Great Recession).

The opposite happened recently, pushing home prices up. This was started around the Covid crisis. While unsold home construction fell off (presumably initially due to production issues and later on due to the pre-selling of yet unfinished homes), demand for finished homes stayed up despite extreme home price growth.

However, sales of new homes seem to have dropped off recently. This could be in part due to declining demand for new homes as prices keep rising. Additionally, increased purchases of homes earlier in the production process may be killing demand for new homes now. In either case, there is no longer a strong negative flow of unsold constructed homes out of home builder inventories. The two lines are merging.

The next chart shows that as well. It depicts 12-month running averages of homebuilder inventories of unsold completed homes. This overall inventory measure is important for who holds pricing power in the market for constructed homes (homebuilders or realtors). Homebuilders do not want to hold onto homes forever and do nothing with them as obviously that is not a profitable strategy. However, they also don’t want to sell their houses for too cheap. So they are willing to hold onto some homes for a reasonable interval of time in order to get a reasonable price on those homes (obviously these ideas are sort of squishy and market-psychology based). While inventories are lower than normal, construction firms likely feel confident in their decision to demand a high price for their homes. However, the inventories seem to be reaching a bottom, and when inventories start to rise, homebuilders will likely be less prone to hold out for such high prices.

Subsection 1.2: Homebuilder Inventories of Homes Under Construction

The following chart shows 12-month running sums of construction starts of unsold homes (calculated as growth in inventories and sales of homes constructed and under construction), under-construction homes sold, and unsold homes completed.

It seems to show that sales of under construction homes (blue line) have already peaked, indicating the buying frenzy for homes may have already passed.

Moreover, when the sales of homes under construction (blue line) went up recently, the completion of unsold homes under construction (red line) went down. That indicates that there are less unsold homes being completed by home builders because those homes are being sold in advance of their completion. The chart below which uses data from a separate release from the same government agency confirms that the completion of single-family homes (in terms of a 12-month running sum) is actually strong. The upshot of this is that while homebuilder inventories of constructed homes might be low, this is not because they are building fewer homes but because they sold off ownership of homes before construction was even completed in many cases.

The next chart shows a running 12-month average home builder inventory of unsold homes under construction.

This measure of the stock of housing supply is actually high and rising. This indicates lower home prices coming down the pipe (assuming unsold homes under construction will be completed and then will push prices down).

Subsection 1.3: Homebuilder Inventories of Planned Homes to Be Constructed

Homebuilders may have gotten together all the necessary contracts and municipal government approval to build a home and may sell the rights to the finished home to a realtor in advance of the start of construction. While no work on these homes have been started it is still an important economic data source to look at. If one wants to predict home price movements in the short term (say the next 5 years) one wants to know what will happen to home supply in the short term. Therefore, planned home construction which tells us how many homes will be available in the next few years ought to elicit some interest.

The following plot uses 12-month running sums of plannings of home construction (calculated as the growth in total unsold home inventories plus all home sales), sales of un-started homes and construction starts of unsold homes.

It seems that all the flows in relation to the earliest stage of housing production (planning homes, starting unsold homes and sales of planned homes) have peaked and are declining in a similar manner to how they peaked and declined following the 2005 housing crash.

However, while home planning has peaked, it is still elevated. This is driving growth in planned unsold home inventories. The next plot of the (12-month running average of) planned unsold houses owned by homebuilders shows this. When all this planned housing finally gets constructed one can imagine a not insignificant downward pressure on prices.

Section 2: Slowing Rate of Home Price Growth

One measure of the strength of the housing market is the rate of growth of home prices relative to some baseline. I think a good baseline is inflation or expectations of inflation (if inflation is 100% a year and everybody knows this and has factored that information into their price-negotiating decisions then a 20% home price growth rate is actually rather weak). Hence, the chart below plots the annual log-%-growth rate of the Case-Shiller U.S. National Home Price Index and the Case-Shiller 20-City Composite Home Price Index against the annual log-growth rate of the CPI as well as the median expectations recorded by the SPF for CPI inflation over the next 10 years (converted to log-%-change per year from a %-rate per year).

There is evidence of an inflection point for home price growth. While the baselines have either stayed constant or come up recently; the rate of home price growth has peaked and seems to be plateauing or falling. This means the rate of growth of the comparative rate of growth of home prices is at least no longer positive and may be negative.

The chart below shows relative home price growth more recently and gives a clearer view of recent trends.

If we assume some tendency towards mean reversion in relative home prices (in that home prices cannot overshoot consumer prices forever, and if they have done for a while there is likely to be a reversion) then the prospects for continued home price growth are unlikely.

Section 3: Rising Borrowing Costs/FED Policy

A big contributor to housing demand is the interest cost of mortgages (which is essentially almost as important as the price in determining an individual’s regular payments). This is true for two reasons. First, new homebuyers can be attracted by low borrowing costs to leverage up and buy a house. Secondly, rising interest rates affect the level of mortgage defaults. This happens by making variable-rate mortgages more expensive and making it harder to lower costs by refinancing a mortgage at a lower rate. If someone cannot make regular payments or get a cheaper mortgage to handle the costs, they will get foreclosed upon which means a bank will sell their house (increasing supply on the market).

There are two types of mortgages: fixed rate and variable rate. Both are likely going to get more expensive which will drive defaults and hurt future housing demand. The first 2 subsections will focus on these types of mortgages.

The third subsection will focus on rising borrowing costs for the commercial business sector and its effect on investor interest in housing.

Subsection 3.1: Variable-Rate Mortgages

If I was a scumbag mortgage lender who wanted to take advantage of people with low financial literacy, I would offer variable rate mortgages. The way a variable rate mortgage works is it is set equal to a stable short-term market interest rate plus a certain penalty (say 1.5%) and is reset every so often (say 6 months) so that the borrowing cost is always equal to the short-term borrowing cost big banks pay in the marketplace plus a penalty.

A lot of variable-rate mortgages are set at the Secured Overnight Financing Rate (SOFR) or the 6-month treasury bill interest rate. The reason I would lend at a variable rate to low-information people if I was a scumbag is that those short-term interest rates are going to go up a lot and every financially literate person knows that. The FED is expected, for instance, to raise SOFR up between .25% or .5% in March. By this time next year (as of February 26th, 2022 according to CME Group’s FEDWatch tool) the SOFR will have likely gone from its current level of between 0-.25% to around 1.75%-2%. This means (assuming the penalty on top of the variable rate is around or less than 1.75%) a lot of people’s mortgage interest cost will have effectively doubled in the next year.

Because a lot of financially illiterate people are getting variable interest rates now, and they will be unable to refinance at a reasonable rate in the future (as the FED works to push up interest rates) one can expect rising default rates. This will slow future mortgage lending (reducing home demand) while raising future foreclosures (raising home supply).

Subsection 3.2: Fixed Rate Mortgages

Fixed rate mortgages might not surprise people and cause a sudden rise in defaults in response to FED policy. Nonetheless, the more financially well-off and literate side of the market that stays away from variable rates will be sensitive to fixed rate mortgage costs.

The chart below calculates inflation-adjusted 30-year mortgage costs by using implied inflation expectations in the bond market. It shows real borrowing costs for a typical 30-year mortgage from Freddie MAC in terms of log-% per year. The conclusion that this chart gives you is that the Covid-era incentives to borrow to buy a house are now evaporating.

Subsection 3.3: Investor Borrowing Costs/Stock Market

There is a lot of emphasis recently on corporate and financial speculation in the housing market. Fundamentally I would argue a financial-driven housing bubble works the same way an individual persons-driven bubble works. A lot of money (largely borrowed) gets spent buying up houses. In the last bubble this was done by individuals who would buy up multiple homes with mortgage debt. Right now, this is done both in that way and through individuals and hedge funds who borrow on margin to invest in REITs (“Real Estate Investment Trusts”) which exist to buy up real estate and rent that real estate out. Home production starts to rev up in response to high demand, but the quantity supplied of existing homes is largely fixed over a really short-term window. Therefore, as demand keeps increasing, home prices shoot up. However, eventually home production can get really high, and the demand side will run into problems associated with rising interest cost and debt repayment. Eventually it will be clear the whole thing was a bubble and all the invested wealth in houses and the residential construction industry will tend to go to waste.

As the FED policy tightening ramps, up we can see evidence of financial demand for housing getting more expensive just as mortgage rates were. First of all, borrowing money to invest in the stock market usually works like adjustable-rate mortgages (you pay something close to the SOFR plus a fine). As this ramps up, people who are bullish on REITs might have to lower their leverage due to rising interest costs.

Secondly, we can see increased inflation-adjusted borrowing cost for risk private sector industries. The aggregate inflation-adjusted borrowing cost of Bank of America designated “C index” corporations has been rising in recent months due to FED tightening.

As it gets harder to borrow, as individuals buy homes less and default on them more and as new home supply gets pushed through the production process investors will increasingly look to sell off their ownership stake in REITs.

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