Context is key. Context is important because it gives meaning to communication. I loved this quote I read on the internet – “Content is King, but Context is God!” (courtesy – Gary Vaynerchuk). For instance – if I tell you that the latest Existing Home Sales in the US is an annualized rate of 4.8mn homes, it doesn’t really make much sense standalone. But if I put that in context by adding that US population is 330mn or total housing units in the US are 143mn or that the highest existing home sales number recorded during the pre-2008 crisis was 7.5mn, the number starts to make a lot more sense.
So I am going to start this blog post with some big picture numbers to provide context before we dig deeper into the US Housing Market.
US Population : ~330mn
Civilian labor force : ~165mn
US residential mortgage debt outstanding (all inclusive) : US$18.7 trillion
US Average New Home Sales 2001 to 2021 : 694K
US Average Existing Home Sales 2005 to 2021 : 5.23mn
So what are the high level takeaways in this blog post?
- The period through 2020 – early 22 was incredibly interesting and unprecedented for the US Residential Housing market. Consider this, even though the number of residential real estate purchase transactions were much lower in this period compared to the 2003-2005 period, the increase in home prices was substantially higher!
- But now US Housing transactions are collapsing rapidly. Home prices have continued to stay elevated so far but are likely to fall significantly over the next 6-18 months
- Falling home prices should eventually make their way into the Shelter component of CPI calculation and result in a reduction in Headline and Core inflation
- But in the process the collateral damage to US GDP and other sectors of the economy is likely to be substantial. US Residential Housing is a major component of US GDP and has significant second order effects on multiple other sectors
Lets dig deeper and understand the story with some pictures and graphs.
- The period through 2020 – early 22 was incredibly interesting and unprecedented for the US Residential Housing market. Consider this, even though the number of residential real estate purchase transactions were much lower in this period compared to the 2003-2005 period, the increase in home prices was substantially higher.
New home sales had touched a record high of 1.4mn homes (annualized)in July 2005. In contrast, New home sales peaked at 1.03mn homes (annualized) in August 2020.
Similarly, Existing home sales touched a record high of 7.25mn homes (annualized) in October 2005. In contrast, Existing home sales peaked at 6.8mn homes (annualized) in November 2020.
Yet median home prices rose much higher in the 2020 – 22 period than in the pre-GFC bull run. To be specific – 32% price increase from Q2 2020 to Q2 2022 vs. 11% from Q1 2005 to Q1 2007. Why was it so?
The answer to that question lies in 2 facts.
First, these guys below were much less “enterprising” during the 2020 – 22 bull phase. In other words, unlike the pre-GFC period, creative financing solutions resulting in monstrous credit appetite was missing in this period. Partly, this is due to all the commendable regulatory work that has gone into de-risking the banking sector post GFC. Needless to say, I dont mean these “actual guys”. I mean the banks they represent/ed.
The second reason lies in the supply side of the residential real estate market. US residential housing construction fell to its lowest levels in the post GFC period resulting in a structural shortage of housing.
And hence home prices shot to the moon post 2020. And we heard all sorts of crazy stories including one where the buyer committed to naming their first born after the seller if the seller agreed to sell him/her the house !
- But now US Housing transactions are collapsing rapidly. Home prices have continued to stay elevated so far but are likely to fall significantly over the next 6-18 months
Mortgage rates have increased from a low of 2.65%in late 2020 to 6.0% in September 2022.
New home sales have fallen from a high of 1.03mn homes (annualized) in August 2020 to 511K homes (annualized) in July 2022.
Existing home sales have fallen from a high of 6.4mn homes (annualized) in January 2022 to 4.81mn homes (annualized) in July 2022. A fall of 25% in 8 months!
Housing inventory, which had fallen to historic low levels is gradually creeping up.
It seems almost imminent then that house prices, which have held up nicely so far, will trend downwards as well. What is difficult to say at this stage is whether the trend downwards will commence in late 2022 or is it a 2023 event and finally will it be a slow and mild trickle or a cascading waterfall?
- Falling home prices should eventually make their way into the Shelter component of CPI calculation and result in a reduction in headline and core inflation
The good news is that falling house prices should eventually make their way into the CPI calculation – and in a big way ! Shelter, and within Shelter – Owner’s equivalent rent of residence – has large weightage in the overall CPI calculation. See below (taken from the BLS website dated Mar 29, 2022).
I will explain this concept a bit further. The shelter service that a housing unit provides to its occupants is the relevant consumption item for the CPI. Most of the cost of shelter for renter-occupied housing is rent. For an owner-occupied unit, most of the cost of shelter is the implicit rent that owner occupants would have to pay if they were renting their homes, without furnishings or utilities. Once home prices come down, owner’s view of implicit rents would come down as well. And because it is 24% of overall CPI, the CPI index itself should also come down substantially. The second order effects of falling home prices are reflected through reduced consumption as home owners are less encouraged to spend when they see the value of their homes go down (also called the Wealth Effect).
- But in the process the collateral damage to US GDP and other sectors of the economy is likely to be substantial. US Residential Housing is a major component of US GDP and has significant second order effects on multiple other sectors.
The bad news is that the housing market is a very substantial portion of the US economy and a slowdown in the housing sector means substantial pain for the overall economy and population.
Housing gets reflected in GDP in 2 ways. First, through residential fixed investment which includes the construction of new single family and multi-family homes and some other related activities. In 2021, Residential Fixed Investment contributed $1,086 billion to US GDP (4.7%). Second, through all spending on housing services which includes renter’s rents and utilities and home owners implied rent and utility payments. In 2021, this category contributed approx. $2.8 trillion to US GDP (12.2%). Together, housing as a sector, hence contributes about 17% to US GDP. A sizeable number !
Here’s the most important bit though. Residential fixed investment has been rather soft over the past few quarters already. A slowing housing market and falling home prices will result in residential fixed investment causing a further drag on GDP over the balance of 2022 and probably into 2023 as well.
This chart probably explains it even better. Real private residential fixed investment has been falling over the past few quarters.
In summary, the outlook looks far from rosy for the housing sector and consequently for US GDP. While everything stated above lends a strong justification to a weakening housing sector, there are also some other factors to bear in mind as well.
Demographics play a key role in housing demand. I have not elaborated on the underlying demographic trends in this article. Big picture: Declining birth rates and declining immigration are headwinds for residential housing demand.
Another important factor to consider is increasing wages. Mortgage is a fixed rate product. i.e. the interest rate is locked and hence interest payments are fixed in nominal terms. In an environment of increasing nominal wages, it leaves more disposable cash flow for the home owner and strengthens the home owner’s balance sheet. Also, once a home owner has locked a super low mortgage rate, he/she is not motivated to sell the house since new mortgage rates are now substantially higher. This reduces housing inventory and puts upward pressure on house prices.
Lastly, economic data has still been significantly strong on many fronts – Industrial production, ISM PMI, job openings, unemployment rate, etc. A stronger overall economy can continue to drive wages further up which can be a tailwind for housing demand.
Happy Investing!
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Disclaimer and Disclosure: Not meant to be investing advice ! Do your own research!
