The Foundations of
Good Housing
"Can't fight against the youth..."
― Bob Marley, Peter Tosh, Neville Livingston, Jailhouse
Whether you think about it as a coming of age milestone, just a roof over your head, or purely an investment, many people here in the US, in one way or another, have real estate exposure. In most of our lives, that’s been good exposure to have. Interest rates have gone down while the equity and housing markets have more or less gone up since the early eighties, at least until 2008. Then, especially if you lived in places like Las Vegas or Phoenix, the housing machine broke down. The financial crisis of 2008 which started with the mortgage market collapse and subsequently led to much higher unemployment drove a bear market in home prices the likes of which many of us had never seen. However, even during the crisis, those with powder viewed the downturn as a buying opportunity. As such, the amount of interest from investors in “cheap” real estate has remained high. Not surprisingly, shortly after the Paulsons of the world made their name on the “Big Short,” investors started buying. First, the safest stuff: multifamily housing and mortgage securities from highly rated pools, but as desire for yield increased and the low lying fruit got picked, investors moved out the risk curve to office, CMBS, sub-prime, et al. The questions for now and the ones addressed in the below are, “where are we now in the cycle?” and “what is the best way to get exposure?”
Where are We in the Cycle?
There is a broad spectrum of topics that fall under the umbrella of real estate-like exposure, so in the interest of simplicity, let’s briefly address a very basic breakdown and then focus on the housing sector and the equity-related opportunity set.
Direct Real Estate Exposure
• Multifamily: Generally the most stable (when people can’t buy, they rent) so got snapped up quickly by investors. Many multi-fam deals are trading in 4-5 cap range now (which is historically quite expensive).
• Single-Family: Started to see this gain traction early in 2013, but saw a bit of a hiccup after the Bernanke “taper tantrum” in May 2013.
• Commercial:
o Office: Office space demand is expected to remain strong with continued improvement in the U.S. economy and steady expansion in office-using employment. Demand growth, coupled with the subdued national development cycle, bodes well for vacancy declines and sturdy rent growth. The booming high-tech sector has been one of the major drivers in the U.S. office market recovery, with the industry responsible for one-fourth of all new office-using jobs created in the U.S. between 2009 and May 2014. Trends of working remotely and more efficient office spaces (fewer privates) are continued challenges.
o Industrial: The industrial real estate market has performed very well over the past few years, with encouraging signs from all the major indicators. We’ve now seen 16 straight quarters of positive absorption. Demand for newer, Class A industrial space in the U.S. is outpacing supply, encouraging more build-to-suit and speculative development activity across the U.S. Much of this demand stems from the rapidly growing e-commerce sector.
o Retail: As the economy has picked up, retail has as well, but the e-commerce trend is a major obstacle going forward as retailers downsize their brick-and-mortar locations and increase the distribution capabilities to accommodate increased e-commerce activity.
• Land/Development: Post ‘08, there was virtually none of this for a few years. While it’s started to pick up again recently, there’s a good argument that it isn’t happening fast enough on the residential side which has created some interesting (and sometimes counterintuitive) effects on the housing market.
Structured Credit
• Agency: After the crisis, with federal support going to the agencies themselves, these became effectively U.S. government securities. The opportunity set there is most likely to be gleaned by the experts trading more minor inefficiencies.
• Non-Agency: Enjoyed a nice run 2011-2012. At this point, the opportunity set is similar to the above.
• CMBS: Also experienced a nice run. While the market is much less efficient then the above and there should be some good idiosyncratic opportunity there, it’s also much smaller than people think and more difficult to get good exposure. • CLOs: This remains the one place in structured credit where good opportunities exist.
With the above as a backdrop, let’s focus more specifically on the housing sector. The U.S. housing market needs, on average, about 1.2 million new homes a year to account for new household formation and obsolesce (according to the US Census Bureau, as calculated from 1990-2010). Certainly, during the boom, there were home builds far in excess of that number, though one could argue many were built in places very few people actually want to live. From 2010-2012, the annual average number of new homes has been closer to 0.9 million (according to US Census Bureau, Zelman and Associates, Housing Data, October, 2013). So, if one assumes a 10-year cycle, starting from 2010, as of 2013 we were 900,000 homes short for the decade and therefore need to average something more on the order of 1.58 million for 2013-2020.
Clearly, there are other factors here as there’s some leftover excess from the previous boom (which might suggest a slightly lower number) and on the other side of the coin, demographic shifts, namely a very large Millennial generation (which might suggest a much higher number), but the base case is probably a fair place to start. This would suggest that we’re in about the fourth inning. To carry the analogy further, there’s a good argument that the infusion of some young blood (Millennials) into the game ought to make future innings pretty interesting and drive that average formation number up closer to two million.
Zelman and Associates, Macro Housing Forecast, June 20, 2014
The lack of new household formation from the Millennials since 2008 is a factor that is often overlooked. Other detractors make the argument that the young no longer want to “create households” which seems spurious to me. Even with a slightly declining marriage rate, people still need shelter. I find it hard to believe an entire generation has decided they want to live with their parents ad infinitum. More likely, they’ve merely decided to push off moving out, living alone, starting a family, et al until they were in a place financially to do so. It is not surprising that the millennial demographic was hit the hardest during the job crunch. According to Zelman and Associates 2014 Macro Housing Forecast report, the job loss for 20-34 year olds in 2008 and 2009 was an aggregate 7.4%, compared with 5.7% for other cohorts. While this demographic accounts for only about one-fifth of the total population, it accounts for about two-thirds of new household formation. Fortunately for that demographic (and for parents who have their 25-year-old living in their basement), that trend is shifting. In the first five months of 2014, employment for 20-34 year olds increased 2.6%, compared with 1.3% among other age groups. Very simply, as employment for that section of the population normalizes, household formations will follow, and new construction demand will accelerate.
Zelman and Associates, Macro Housing Forecast, June 20, 2014
What is the Best Way
to Get Exposure?
If we assume the above is a fair assessment of the market, then, at the very least, homeowners will feel a little better about the value of their house looking out a few years. Additionally, housing is wonderfully pro-cyclical. Said differently, an increase in the housing supply actually raises demand, because the construction/remodel of a home employs any number of people and is directly tied to certain sectors of industrial production. This provides both a bullish backdrop for the sector, and importantly, for a much wider investment universe.
Let’s start by addressing the most traditional answers to the above question about how best to get exposure.
1) Buy homes: While there are a few groups out doing this in fund form, in general, this approach is logistically difficult. The idiosyncrasies of local markets make geographic diversification difficult (from both a value assessment and a management perspective). It’s also not particularly liquid. Lastly, you’re probably long this type of exposure already.
2) Buy homebuilder stocks: Obviously a lot more liquid than actually buying houses, but one could make a good argument about the “richness” of the sector. The homebuilder constituents of the S&P are trading at a premium to the index itself and at a forward PE multiple of 15.9x (according to http://www.bidnessetc.com/21142-xhb-rises-3-key-risks-attached-to-your-investment-in-homebuilder-stocks/). Additionally, the homebuilders are more sensitive to interest rates than are some other housing related equities.
3) Multifamily REITs: Very much the same as above. In light of low rates and the Fed success in effectively eliminating good yield across much of the fixed income spectrum, investors have turned to REITs. The not-so-surprising result is salty pricing. Additionally, they are highly sensitive to the rate environment. Without getting into a lengthy macro discussion, a slightly higher rate environment is probably likely for the next few years in the U.S.
So how can one invest at advantageous pricing while minimizing local and macro risks? The pro-cyclical nature of the housing sector combined with both its complexity and omnipresence means there’s actually a much wider investment universe. Liquid equities that are well positioned within the context of a growing housing market and a new supply chain paradigm stand to benefit from its resurgence. While the economic downturn of 2008 changed and/or ended many of the cogs in the housing machine, now as it gets up and running again, there are opportunities to pick the new winners. Whether among specialty finance companies or those making particle board or cement, there will be outperformers. This also fits in the context of a broader equity market more likely to reward fundamental concerns (versus the largely macro-driven market of the past few years).
Investments in the right housing related equities will allow investors to capture the cyclical upside of the housing market, while being positively positioned to benefit from events (M&A, etc.) and take advantage of fundamental equity research. At the same time, investors can mitigate some of the local-centric and/or logistical risk from direct real estate investing, get a much better liquidity profile, and more defensively position against impending higher rates.
