Hanson: House Prices Are More Vulnerable Than Most Think

Submitted by Mark Hanson Advisors

Dear Fellow Housing Market Observers,

This is my last note of the year and it deals with house prices into the next cycle.

There are numerous similarities between the Bubble 1.0 era and the past several years. This essay reviews Bubble 1.0 and the present and draws on key parallels that drove house prices that few ever point out (i.e., this time demand wasn’t a feature of surging house prices; this time houses have been a forced savings account, which are key differentiators).

Even if house prices in the CS 20 drop 10% to 20%, I am not sure what that means in the context of record untapped home equity (as opposed to last bubble when everybody could extract every dollar of equity all the way up), a solid employment and wage backdrop, rates that have likely topped and technology that will blow open the buy-box in the next couple of years to include those 10s of millions with irregular income or artificially low credit scores.

I do, however, have a better idea on what this means to pure-play housing, finance, related-retail, appliance, etc, which I will be focusing on in 2019 along with my favorite tech, fintech and advanced credit companies aiming to add liquidity to the housing market and dive into Opportunity Zone ideas.

There are some great trades to be had.

Mark

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The “Mortgage Loan House Price Governor” has been strapped on again.

The common thesis is that “it’s different this time”; house prices are largely protected from a sharp downturn like from 2008 to 2010 because post-crash lending has been conservative, buyers didn’t get over their ski’s, employment is strong, home-equity is at record highs and there have no exotic loans originated than can blow-up borrowers.

While all that may be true and sensical, end-users getting mortgages to buy their shelter homes aren’t the ones who provided most of the energy that pushed house prices past peak-2007 bubble levels in key regions from coast to coast.

I operate on the thesis that house prices will always gravitate to “end-user, mortgage-needing, shelter buyer” cohort affordability – based on ‘local’ employment, income & credit fundamentals and market rates – using a typical 30-yr mortgage & minimal down payment.

At times prices can detach from these fundamentals like from 2002-07 when “unorthodox demand using unorthodox capital & credit” became the main driver. But, they always reattach over time.

Case in point when all the high-leverage loan programs went away at the exact same time in 2007-08 and prices reattached to end-user fundamentals and traditional 30-year fixed-rate loans, which resulted in a 30%+ price drop.

But the 2011 to 2016 era wasn’t dissimilar from the 2002-2007 bubble. That is, “unorthodox demand using unorthodox capital & credit” became the main driver of demand and house prices…all those buy-to-rent, flip and floppers; institutions; foreign lock boxes; money laundering schemes; and EB5’s.

And based on the historical divergence between end-user affordability and house prices in top metros in the nation today house prices could fall at least 30% and only be fairly-valued. I have plenty of local level data & models proving this.

Unless rates fall/incomes rise sharply; the mortgage sector introduces higher leverage programs; unorthodox demand rushes back; or the sector evolves intelligently to include 10s of millions of prime-risk credits left out of the prohibitive FICO/DTI based credit boxes (this IS coming, but it might not be soon enough) my thesis will be tested soon.

The “Mortgage Loan House Price Governor”

1) In a normal housing market — ~ 80% of all purchases to end-users most using “full-doc” mortgage loans — prices are solidly rooted to end-user economic fundamentals. That is, the mortgage loan with its LTV and DTI guidelines is the “house-price governor”; it’s virtually impossible for house prices to detach from local economic employment and income fundamentals unless credit goes haywire. Sure, there have exceptions to this over the decades. But, overall housing has been a pretty simple asset class that for decades leading into the change of the millennium remained mostly in-check to fundamentals and a great inflation hedge.

2) Enter 2003 to 2007, when the “mortgage-loan, house-price governor” – a term I coined — was removed by the introduction and wide acceptance of exotic loans; i.e., stated-income for wage earners, interest only, pay-option arms, etc. Through the power of high-leverage lending the ‘incremental buyer’ always earned $200k a year and had a million dollars in the bank when it came to qualifying for a loan to buy a house…credit went ‘haywire’. This allowed house prices to completely detach from end-user fundamentals.

In 2008, when the mortgage loan governor was strapped back on – due to the sudden loss of all the exotic loans over a short period of time — house prices quickly “reset to end-user, employment and income fundamentals”. House prices stopped plunging in 2010, as affordability using new-era 30-year fixed rate, fully-documented loans recoupled with real income and asset levels.

This “bottom” should have set the stage for housing to once again be rooted to fundamentals / governed by contemporary mortgage lending guidelines.

But, that didn’t happen.

3) Enter the mortgage mod craze. Millions of the worst mortgage offenders and house over-spenders were bailed-out through Government and bank sponsored 2% interest-only mortgage mods, so exotic they would have made Lehman and Bear blush.

Instead of these homeowners experiencing foreclosure, renting, replenishing savings and becoming de-levered, credit-worthy boomerang buyers down the road several years, they got to squat in their own home at 2% interest only for five years before their rates started adjusted higher, squeezing them all over again. In fact, mod annual rate increases began in earnest in 2016 and are still occurring every year.

4) Don’t forget in places like the Bay Area how tech companies with double-decker busses have been exporting high Bay Area incomes to adjacent counties an hour or two away where the native population makes half as much. This artificially pushes prices up in the metro periphery, forces out legacy owners and is an implosion waiting to happen in the next employment cycle downturn because the local economies don’t support house prices 50% higher than local employment and income fundamentals.

5) But, overshadowing all this, from 2010 to 2016, the “all-cash”, new-era “spec-vestor” phenomena developed, which in my eyes was a repeat of the 2003 to 2007 exotic loan era in the effect it had on house prices. That’s because the incremental (almost majority) all-cash buyers work without a ‘house price governor’, instead base their purchase and pricing decisions on individual, random, emotional, uneducated, criminal or hopeful models or guesses.

Some bought for rental income, some for appreciation, others to flip, flop, hide money from foreign governments, or to simply beat the yield of a 2% 10-year Treasury. In any case, without a mortgage loan governor the “price” they pay for a house is often subjective vs objective.

Most analysts disregard the all-cash investor demand and supply cohort because they look at companies like Blackstone and Starwood and say, “these institutions only own 500k houses, not enough to make a difference”.

But what they fail to take into consideration is that those 500k houses are highly concentrated within eight to ten major metros. Furthermore, all of the other spec-vestor cohorts – like small two to ten house independent speculators – out purchased institutions by ten-fold from 2011 to 2016. In fact, there have been over six million single family homes taken out of the end-user owner category and turned into rentals, thus the “lack of supply” screed, artificial as it may be, everybody repeated for years.

In the “all-cash”, “spec-vestor” segment, it was very easy to overpay for a house by 20% or 30% in the heat of the deal and when competing against a dozen other all-cash buyers. This is impossible if end-users, mortgage loans and appraisals are required because when end-users overpay, or bid higher than the appraised value, they must come up with the difference in cash, which few have.

As the bubble blew in key markets around the nation and prices become ever further detached from end-user fundamentals there were always greater fools that chased the market keeping it elevated for a period. But, outside of the all-cash cohort the number is finite.

Some will say “all-cash buyers for rentals are rooted to fundamentals…that’s rents”. I say “hogwash”. I have seen many of the single-family rental assumption models from some of the largest investors, and they are beyond rosy. I can easily change two numbers and turn their 6% cap rate into an 6% loss.

Bottom line: It was very easy for demand cohorts – as large as this era’s all-cash insti, private and foreign segments – to push national house prices well above what the average end-user can pay.

And that’s exactly what happened from 2011-16 and why in leading indicating regions from coast to coast in which new-era investors flocked first, demand is plunging and supply surging against a backdrop of rising rates. Just like in 2006/7.

If history rhymes at all, house prices have already gapped down — the lagging indices just haven’t printed it yet — and house prices are more vulnerable than most think.