Housing Shock Therapy

It’s been a challenging couple of years for apartment owners, but, as I have been writing about over the past year or so, there is definitely light at the end of the tunnel. This is because apartment construction while having been at historically high levels, is dropping quite significantly.

With mortgage rates at their highest level in over 20 years and record-high home prices, rentin.  it’s been since 2000, even more so than during the subprime bubble of the mid-2000s.

According to a report from Realtor.com, these are the metropolitan areas that are most favorable for renting. CWS is invested in four of the top five and five of the top ten.

In spite of rentals being very well positioned, apartment developers are still facing many economic headwinds to produce new units. Both debt and equity are more complex to access because the combination of higher construction costs, inflation in operating expenses, higher interest rates, and rents being squeezed by so many units available in the market have changed the economics of building apartments. It is far more difficult to justify building because the returns are not high enough to compensate for the risk. This is why we don’t think we will see apartment starts pick up materially until newly constructed apartments can obtain much higher rents.

Now let’s shift our attention to single-family housing. We’re now starting to see a pullback in construction in the single-family sector as well. This is not surprising given how the housing market has undergone some serious shock therapy. It starts with mortgage rates because that’s the fuel that most people need in order to purchase a home. One can see how they dropped dramatically in the wake of Covid.

The drop in rates and the work from anywhere economy led to a significant increase in demand for housing. People wanted more space to work from home and to move to locations that offered a better quality of life. This led to a huge increase in housing starts, particularly in the apartment sector. This chart shows that while construction activity is dropping it is coming down from record high levels.

Starting in April 2022, the Fed started raising short-term interest rates. Mortgage rates went up significantly, and long-term interest rates followed suit, rising by over 4%.

In addition, the Fed stopped purchasing mortgage-backed securities, which took away a huge demand driver, and without this massive buyer in the market, the premium required by investors to own mortgage-backed securities relative to risk-free Treasuries exploded higher. This chart shows how the spread over 10-year Treasuries breached that of even the Great Financial Crisis when real estate collateral was significantly impaired, and loans were far riskier than they were in 2023 when this spread peaked. This blowout in the spread has added 1.0% to 1.5% to mortgage rates on top of the increase in long-term Treasury yields.

Not surprisingly, home sales dropped significantly, but not just because people couldn’t afford to buy homes given the much higher mortgage rates. More impactful was the constrained supply of homes for sale due to homeowners who locked into very low rates having very little incentive to sell and buy more expensive homes using much higher-cost debt. This kept home prices at record levels as demand still exceeded the very diminished supply and locked millions out of the housing market.

Home builders must sell as they don’t have the luxury of waiting for better market conditions. They can offer incentives such as free upgrades and mortgage buydowns, which are unavailable to individual sellers of existing homes. Despite this, builders are contending with more inventory they need to sell and more constrained pricing power.

In order to better balance supply with demand, builders have started to slow down their construction activity, which was clearly evident in the data released last week.

With a more challenging economic backdrop, home builders’ sentiment is pretty negative.

Lumber is a good barometer of the health of housing construction and the overall economy. While it is off its lowest levels, it is still down quite a bit from its recent peak, indicating more tepid construction activity.

Here is a longer-term chart of lumber prices. One can see the incredible double spike that took place during Covid. Lumber prices have remained in a relatively tight range since late 2022.

When I started this blog, I discussed how apartments should be well positioned to manage through their oversupplied situation and be in a position to regain pricing power for owners as construction starts have dropped quite a bit. Combine this with how much more expensive it is to own versus to rent, and we should have heightened demand for apartments as people will have to rent longer. The Covid boom essentially pulled forward housing demand due to the very low rates and tremendous monetary and fiscal stimulus. It also catalyzed generationally high apartment construction. This has now been reversed with much higher mortgage rates, the poor financial returns to build new apartments, and very high single-family prices, making it unaffordable for many to buy existing homes as well as newly constructed ones.

As this tweet shows, we are finding ourselves in a situation where the number of homes and apartments being constructed will be less than the number of households that should be expected to form based on demographics.

So what happens when such an important social issue like housing is facing significant challenges? Politicians get involved.

We have been saying for years at CWS that both the federal and local governments will be taking an increasingly intrusive role in housing. This assertion has been proven to be correct, and we have no reason to think that this won’t continue to be the case in the foreseeable future.