Category Archives: Real Estate

Buying Homebuilders (NYSE:ITB)

My bullish view on single family housing starts (as detailed in a recent post), coupled with the recent sell off in homebuilders caused me to buy the iShares US Home Construction ETF (NYSE:ITB). I tweeted about it late Wednesday night and will track it in my portfolio page using that day’s closing price of $22.17 as my initial price.

Although housing starts stagnated over the past year due to the rapid rise in home prices and interest rates, there are reasons for optimism. According to the Case-Shiller index, year-over-year home price growth has softened from just over 10% late last year to 5.6% in July. In addition, the most prevalently quoted conforming 30 year fixed rates dropped below 4% last week for the first time since June 2013.

As for the state of home buyers, employment continues to grow 200,000+ per month with moderate wage growth, while household debt to disposable income continues to decline.

A potentially positive recent development was the report of a likely deal between Fannie Mae, Freddie Mac and mortgage lenders to loosen lending. This could make mortgages more obtainable for lower income families.

Over the past year, homebuilders’ stocks have flatlined along with housing starts, while significantly underperforming the market.

$ITB Performance vs. $SPY

Despite little growth in new home sales, homebuilders have been able to grow their top and bottom lines by raising prices. So if sales begin to increase again, they could easily grow EPS by 20%+ and achieve 2015 analyst estimates.

As shown in the following chart, the largest homebuilders currently trade for 12x next year’s earnings compared to S&P 500’s 14x its lofty estimates.

Homebuilder Valuations

Looking beyond, past housing recoveries suggest housing starts could increase 15-20% for several years allowing homebuilders’ operating leverage to grow earnings even faster making their stocks attractive long term investments.


Single Family Housing Starts Set to Reaccelerate

In my view, one of the most obvious secular growth stories is the rebound in single family home construction. Although single family housing starts increased off of exceptionally depressed levels in 2011, they have stopped growing over the past year and remain less than half of past cyclical peaks.

Housing Starts

This has resulted in a lot of bearish commentary predicting a ‘new normal’ for housing where starts will never again rise to its historical average. I believe the stagnation in home construction over the past year can be attributed to rapidly rising interest rates and home prices.

Interest rates surged last summer causing the 30 year fixed rate to rise from 3.35% to 4.5% in just 2 months. This resulted in anyone taking out a $300,000 mortgage having to pay roughly an additional $200 a month.

Economists at Goldman Sachs have found that “the effect of monetary policy shocks on [building] permits persists for 3-4 quarters.” Now that interest rates have stabilized and the market has had over a year to digest 4%+ rates, its negative effect should wane.

Mortgage Rates

In addition, home prices were increasing at an unsustainable double digit rate last year which was certain to inevitably cool off demand. This year, however, home price gains are moderating and should continue to slow down leading to more demand.

Home Prices

The National Association of Realtors’ Housing Affordability Index, despite sharply dropping last year, is still at a historically high level. There is room for home prices and interest rates to rise some more without jeopardizing affordability.

Housing Affordability Index

While many housing bears cite tight mortgage lending standards as a reason home sales will struggle to rise, going forward credit can only loosen. In fact, there is evidence that banks are easing credit standards. According to the July 2014 Fed survey on bank lending practices: “a moderate net fraction of domestic banks reported having eased their standards on prime residential mortgages, on net.”

The US population has been growing by 3 million people a year. This population growth would require 1.2 million additional housing units per year. Given that 250,000 homes are demolished each year, roughly 1.5 million homes need to be constructed annually. Instead housing starts have averaged approximately 850,000 per year as household formation rates have collapsed.

As the economy normalizes, there is huge pent up demand for new housing. I expect single family housing starts to return to its historical average of 1.2 million by the end of this decade.


Foreclosures are the Solution, Not the Problem

In the WSJ, there is a well reasoned argument by Ramsey Su of why government attempts to prevent the current surge of foreclosures from occurring is actually harmful. A house is foreclosed on when either the homeowner is unable to make his mortgage payment or when he refuses to pay even if he has the capacity to make the payment because he has negative equity in his house. In the first case, a foreclosure relieves the homeowner of an expense that is too burdensome. In the second case, a foreclosure immediately improves his balance sheet because his mortgage debt is wiped out.

Some of the measures being proposed to stem the tide of foreclosures are intended to lessen the mortgage payments and/or balance as to improve the financial obligations of the homeowner. But this would be difficult to achieve under current laws since many mortgages were securitized where there are junior lien holders who would need to agree to such a modification. The problem is that such a modification would immediately wipe these investors out. They would be better off foreclosing and hoping to salvage some value later on.

Then there is the prospect of Congress passing mortgage cram-down legislation which will allow bankruptcy judges to force creditors to accept a reduction in mortgage principal and interest. This sort of government intervention only further adds uncertainty to the MBS and CDO markets and scares off prospective investors.

One of the main concerns with foreclosures is that they can cause a flood of homes to come on the market pressuring prices and worsening the current real estate downturn. But the current real estate downturn stems from the fact that the supply of homes greatly exceeds the demand. Therefore, a sharp decline in prices is needed to restore equilibrium. Foreclosures help to speed up this process and the time needed for the market to recover.

A Tsunami of Foreclosures Lies Ahead

Because this housing downturn ranks, by several measures, as the worst since the Great Depression, it’s quite likely we will see an unusually high number of foreclosures. It’s important to understand the magnitude of the defaults because that would provide color on the mortgage losses that banks will face.

I concede that it’s extremely difficult to estimate the number of future foreclosures, however I believe that by employing some thorough analysis one can at least come up with a ballpark figure that could be useful.

In my previous post I concluded that homes prices are likely to fall by around 30% from peak to trough which will be reached by early 2010 if not sooner. According to the following graph, that kind of price depreciation will lead to 20 million homeowners being underwater on their mortgages; that is, their mortgage balances will exceed the value of their homes.

Homeowners With No EquityGraphic by Calculated Risk, Data by First American

Since most mortgages are non-recourse, homeowners with negative equity have an enormous incentive to simply mail their keys to their lenders and abandon their homes. Of course, the majority of homeowners won’t do this for at least three reasons: first, they may believe their homes are worth more than what the statistics say; second they would not want to damage their credit rating which would hamper future borrowing; and third, they would want to avoid the social stigma of foreclosure.

That said those people who speculated in residential properties are likely to mail in their keys and accept an investment loss. Also, those people who suddenly need to move will realize that they can’t quickly sell their homes for a high enough price to pay off their mortgage balance and will instead simply default.

However, in most cases negative equity will only lead people to foreclosure when they are facing financial difficulties at the same time and are having trouble servicing their debt. Refinancing or selling their houses, options which in the past saved delinquent homeowners, are now off the table.

A major ticking time bomb is rate resetting mortgages which are widespread and, as the following graph shows, hundreds of billions of dollars worth of them are about to reset to much higher rates.

Monthly Mortgage Rate Resets

As a side note, this graph fails to convey that the majority of the option adjustable mortgages will begin to recast next year rather than 2011 as depicted because most borrowers have been paying only the minimum required resulting in negative amortization which has caused their mortgage balances to reach their principal caps much sooner.

Many of these homeowners will come to the realization that it doesn’t make sense for one to give up most of his income to service a mortgage with an 8% interest rate on a house that is worth less than the amount of the loan.

I believe it’s safe to assume that one-fifth of all homeowners with negative equity could ultimately default on their mortgages. So if home prices fall by 30%, 20 million homeowners will have negative equity and 4 million mortgage borrowers could default.

Plus another one million homeowners with positive equity could also face foreclosure due to an inability to maintain mortgage payments arising from resetting interest rates or loss of jobs (after all, we’re in an economic downturn with rising unemployment) with no option to refinance.

Thus, we are facing 5 million foreclosures or 10% of all owner occupied homes with some mortgage. Already the delinquency rate is spiking as the following graph shows:

Delinquency Rates For Single-Family Residential MortgagesSource: Federal Reserve

If lenders try salvage part of their investment by foreclosing on millions of homes and dumping them onto the market, the supply of existing homes for sale would surge from its current level of 4.5 million which is equivalent to 11 months of supply at the current sales pace. This would prevent a housing recovering from taking form for many years.

Now it is quite likely that major government intervention could significantly reduce the number of foreclosures — but the losses will then have to be absorbed by taxpayers as well as by lenders. In any case, the US economy will suffer.

How Low Will Home Prices Fall?

Until recently the bubble in the housing market played a major role in stimulating economic growth and, now that the bubble has popped, housing is again taking center stage but this time in contracting the economy. Therefore, in order to estimate where the economy and the stock market are headed it is necessary to formulate an opinion on how low home prices could fall.

The house price-to-rental ratio is a useful indicator to evaluate how expensive homes are to purchase compared to simply renting. It’s similar to the price-to earnings ratio for stocks. Rental units are a substitute product to homes and the rational buyer will select the most affordable option. The price-to-rent ratio had been fairly stable until this decade when the ratio skyrocketed to uncharted territory.

House Price-to-Rental Ratio

The above graph implies that the ratio will need to decline by 30% from its peak to bring it back to its historical average. Now to determine how much home prices will fall in nominal terms, we need to estimate the future direction of rents.

The following graph by Calculated Risk shows that the rental vacancy rate remains near an all-time high at around 10% implying that there are an excess of 750,000 rental units that would need to be occupied in order for the rental vacancy rate to return to its historical mean. Thus, there will be hardly any pressure on rents to rise for the next few years.

Rental Vacancy Rate

Therefore, if rents don’t rise and the house price-to-rental ratio returns to its historical average then home prices will have to fall by at least 30% from peak to trough. Indeed, the Case-Shiller index is already down 18.4% from its peak so a 30% decline seems quite attainable, especially when one considers the nation’s huge glut of housing stock.

Consider that although new home sales have plummeted to levels typically marking cyclical bottoms, the 3-year rolling average of new home sales is still high pointing to the immense supply of homes that were constructed in recent years.

New Home SalesGraphic by Sudden Debt

Also, the following graph shows that the homeowner vacancy rate is 1.4% above its historical average and with about 75 million owner occupied homes in total, there are over 1 million vacant homes that need to be absorbed.

Homeowner Vacancy Rate

And it is worth watching the level of foreclosures which could greatly increase the supply of homes for sale during the next 2 years as a large wave of mortgages will be resetting at much higher interest rates resulting in possible default.

Monthly Mortgage Rate Resets

So the excess supply of rental units and vacant homes, and the increasing level of distressed sales is likely to cause home prices to fall by around 30% from its recent peak which would bring the house price-to-rental ratio back down to its historical average.

No Near-Term Relief for Housing

Last January, I wrote about how calls for a housing recovery this year were premature. As the following graphic illustrates, housing has resumed its downward spiral which is in early innings compared to the last bear market in housing.


My primary concern at the moment is that a huge number of mortgages are due to reset at a time when interest rates are rising.

Source: Lamont Trading Advisors, Inc.

And I don’t think we have heard the last about those troubled subprime mortgages. As a result, I am initiating a short position in Countrywide Financial (NYSE:CFC).

Can the Fed Save Housing?

Yesterday the market got a lift from the FOMC statement which was interpreted to indicate that the Fed no longer held a tightening bias, setting the stage for a possible rate cut later this year. The expectation is that Fed easing will help the troubled housing sector by making it easier for people who are struggling to meet their mortgage payments to refinance at lower interest rates.

I can’t see how lower interest rates can save the housing market. First, the rise in defaults on subprime mortgages have prompted all the major lenders to tighten lending standards. As this graph shows, the last time lending standards were substantially tightened was in 1990 and 1991, which were terrible years for housing. Despite lower costs for mortgages, tighter lending standards may make getting a mortgage approved more difficult.

Second, inventories are at record levels and may continue to rise due to a large number of homes currently in the foreclosures process. In order for housing activity to recover, the large supply of homes on the market needs to be reduced. Even if lower interest rates were to increase demand, it could take a while for this inventory to be worked down.

And third, stagnant prices over the last year may have shaken investor confidence. Speculators, who were a significant source of demand for homes during the last few years, are not likely to be persuaded by Fed rate cuts to jump back in. More likely, they will wait until there is clear evidence that home prices have recovered before jumping back in with both feet.

The Fed was unable to save the internet/telecom sector in 2001. However, that monetary easing did spark a boom in the housing sector. It is possible that Fed easing will again help fuel a bubble in another sector of the economy. But housing can’t be revived so quickly.

Will the Subprime Turmoil Spread Upwards

While the recent rise in defaults on subprime mortgages has become front page news, the most common viewpoint is that this will not have a significant impact on the economy since prime and Alt-A mortgages represent 45% and 20%, respectively of all mortgages outstanding and we are yet to see significant defaults in theses loans.

The source of the problem is that about 80% of subprime mortgages today — many of which were taken in the last few years — are adjustable-rate mortgages (ARMs) that have been nicknamed “exploding ARMs” because they have low fixed-interest payments in their first few years but then usually adjust to higher interest payments. Many of the sub-prime mortgages which were taken during the last few years have recently reset at higher rates leading to a rise in bad loans.

As many as 30% of the prime and 60% of the Alt-A mortgages taken out in the last few years were also ARMs. However, they have longer reset periods — 2 years or more — than subprime, which means we have yet to see the impact of higher payments on this segment of borrowers.

Already we are seeing seeing higher delinquency rates among prime borrowers, although not yet at alarming rates. 2.57% of all prime mortgages are now delinquent compared to 13.3% for subprime, according to the Mortgage Banking Association. Since almost half of all mortgage originations are prime, only a small rise in default rates is required to cause severe financial loss.

The reason many subprime borrowers are defaulting is the lax lending standards which allowed people to get mortgages who never should have. The lenders did not mind because there was a huge demand for mortgage-backed-securities (MBS) from investors. Common sense suggests that this insatiable hunger for MBS surely would have caused lenders to be similarly liberal when it came to originating prime and Alt-A mortgages.

That is, the current Alt-A borrowers probably would have been classified as subprime, and prime borrowers as Alt-A in the past. Thus, there is a substantial risk that the default rates for these mortgages could rise to significantly high levels, similar to what we are now seeing in the subprime group.