Housing: A Little Too Frenzied?

It has been a decade since there appeared to be much to worry about in the U.S. housing market. The boom of 2004-06 was followed by a contraction of such proportions that it threatened the stability of the financial markets and the U.S. economy itself. The massive intervention of the federal government allowed the natural restorative properties of a market economy to turn eventually. The housing sector has been pretty much quiescent since.

All things pass, however, and there are signs that there are potential sources of trouble. They do not appear at this point to risk a replay of the 2008-09 fiasco. That is attributable to two factors. The first is that human beings seldom repeat their most foolish errors twice in a row. The pain is too recent. The other is that, if the error was of sufficient magnitude, rules may have been applied to prevent repetition of the most egregious mistakes. The second rule remains in effect in the U.S., in the form of the Dodd-Frank legislation and related changes. While some argue that the rulemaking was excessive, the worst of that boom is unlikely to repeat.

It is nonetheless wise to eye the horizon from time to time. That is particularly true in housing, for multiple reasons. The first is that the asset class is very large. By market value, it is of the same order of magnitude as the stock market, which together are among the largest asset classes. Such size means that mispricing, if material, can in time threaten the economy and thus livelihoods.

The second reason to keep a wary eye on the housing market is that it involves a high level of leverage. Houses are expensive and most people must borrow to buy them, which has wonderful results when the asset rises in value. That is what has been occurring recently, of course. The pandemic changed behavior patterns in ways that favored single-family real estate in particular. The results have been rather spectacular:

When an asset class has this sort of transformation, from a useful asset to a financial phenomenon, itoften attracts speculation and growing volumes of bets that it will continue. The use of financialleverage supercharges the returns, and for some venturesome borrowers, the more the better. Theproblem, invariably, is that the more of this that occurs, the greater the risk that something will comealong to cause prices to stop rising, and turn to declines in time. Leverage raises the risk to theborrower if the asset then falls in value.

It appears that residential real estate ownership is undergoing a change in composition. Most single-family homes are occupied by their owners. Historically, there was some ownership for the purposeof generating rental income, but this was fragmented and generally limited to individual proprietors.That began to change after the financial crisis of 2008-09 when the federal government initiated aprogram that allowed investors to purchase homes that had entered foreclosure by Fannie Mae. Theprogram was a success, and large investor groups entered the home market. The shift was encouragedby the difficulty that some households had in affording the homes they wanted, and choosing to rentinstead.

Purchasing homes with the intent of renting, rather than occupying, rose in popularity. The rise ininvestor ownership has further accelerated as they chase the recent vertical move in home prices, asshown in Chart 2:

The near-vertical performance of this series is worrisome, though it is not yet at the level of 2006.But combining multifamily buildings with single-family, to which each category contributes roughlyhalf, produces a result that only a developer can love in Chart 4:

Such optimism in the trade is heartening. Whether it is wise is another question. Inflation hasreawakened from a slumber of four decades, and is affecting any number of things, including livingstandards. Since this is not only an economic issue, but a political one as well, the Federal Reservehas shown a newfound conviction to fight inflation. It still recalls, for some, the resolve of the Fedunder Paul Volcker to do so on his appointment to Chairman in 1979. The Fed raised interest rateswell into double digits, even raising the Federal Funds rate to 20% twice. At the prospect of Fedbehavior that even approaches such rigor, the fixed income markets have gone blue with fear.According to the futures market, the probability of the Fed raising the funds rate several times, fromnear zero to 2% or more by late in the year, has gone from zero to firm conviction in a remarkablyshort period of time (Chart 5):

This would appear to imply the possibility of some sort of accident. If the Fed follows through,tightening monetary conditions will not reward the ebullience of the real estate developers. Theirapparent confidence is all the more puzzling when we consider demographics.

In Chart 6 we consider the latest numbers on U.S. population growth:

It is important to note that these data are the latest from the government, and end in 2019. This is thusbefore the pandemic-induced “baby bust.”

Cycles take time to reach their destinations, so the current robust development activity may go on fora while. But eventually the need for more real estate must arise from the need for shelter. Withpopulation growth failing to ratify the enthusiasm of the building trades, the Fed may find that achange of plan is in order.