For years, I have described US housing market conditions with some of the following color:
- “this is not what a durable recovery with escape velocity is supposed to look like”.
- “a housing market recovery and house price recovery are two completely different things”.
- “something other than fundamental, end-user, shelter-buyer demand for houses is driving this sector”.
- “a bubble is a bubble is a bubble”.
- and one of my favorites, “the great demandless house price recovery”.
They all hold true.
After seven years of ZIRP and QE and three years after “nirvana” was first uttered, the CEO of a large builder was quoted last week as finally seeing “green shoots”. I got an instant migraine when I heard that term…again.
If all we have are “green shoots” after this many years and trillions spent on a housing “market” recovery, we are in a lot more trouble than I have been forecasting.
This note analyzes the drivers of Bubble 1.0 versus the present housing market and reveals, “it’s not different this time around, not even in the slightest”.
In this note, whether we are in a housing bubble isn’t the question I aim to answer. Rather, how far will house prices fall this time when the Shadow Demand loses control of the mix to end-user fundamentals?
1) Bubble 1.0 and Bubble 2.0…Déjà vu all over again
There is lot of housing bubble 1.0 comparison talk lately. And 10 times that amount of paid forecasters and media to immediately stomp on it with mainstream data, fancy talk, and meaningless charts. This is identical to when housing bubble 1.0 was at full-girth.
In fact, the “it’s different this time” faction uses 2007 – and the era’s exotic loans, toxic securities, and little regulation – as the prime reasons housing couldn’t possibly be a bubble today.
They all say “loans today are traditional, credit is tighter, down payments are required so we can’t be in a bubble”.
They are completely missing the 10k pound elephant in the room, the forest through the trees, and the hair in their couscous.
2) Both Bubble’s 1.0 and 2.0 were blown by “Shadow Demand”, which is a feature of “cheap and easy credit and liquidity”
Looking back at Bubble 1.0, legacy exotic loans were born out of cheap and easy credit and liquidity and a quest for yield in a falling interest rate environment. As rates flattened out and then rose from 2004 to 2006 loans became ever more exotic in order to keep the monthly payment trajectory from rising at the same pace as house prices. Low monthly payments for completely unaffordable houses kept lenders lending in order to feed the securitization machine. If they didn’t create exotic loans, mortgage lending would have largely dried up in 2003/4. In fact, by time exotic loans really become mainstream in 2004 the bubble was already well underway.
Back in 2004, 30 year mortgages were at about 6%. Exotic loans brought payments down so low that effective payment rates were in the 2%’s. Clearly, this allowed house prices to detach from end-user, shelter-buyer employment, income, and macro-economic conditions of surrounding regions.
Fast forward to 2010 and 30-year fixed rates were at about 5%. Subsequently, the Fed’s easy money policies brought rates down to the 4%’s by 2010, the 3%’s in 2012 and broaching the 2%’s today.
If rates weren’t in the low 3%’s today houses would be completely unaffordable to end-user, shelter-buyers on a monthly payment basis, just like back then.
Further, if US Treasury yields weren’t sub-2%, a 3% cap-rate on a single-fam rental or apartment building would be a negative return.
Bottom line: The only difference between leverage in finance and cheap and easy credit and liquidity in bubble 1.0 and 2.0 is that Wall St investors and banks quietly pushed effective rates to the 2’s back then and the Fed took over the job, overtly, this time around.
3) The “Shadow Housing Market”…What lurks in the shadows can suddenly leave without anybody being aware it.
Now that we have established that the downward manipulation of effective mortgage and payment rates can be a house price driver, who is buying the houses? This is a very important question.
In both Bubbles 1.0 and 2.0 there were two competing housing markets, one lurking in the shadows.
“Shadow Demand” is simply unorthodox, or non-traditional demand – as opposed to end-user, shelter buyer demand – with access to cheap and easy credit and liquidity that becomes the dominant driver of both incremental demand and prices.
I coined the term “Shadow Inventory” back in the early days of the foreclosure crisis and the term “Shadow Demand” fits both Bubble 1.0 and Bubble 2.0 perfectly.
Pundits will argue that Bubble 1.0 was driven by speculation, as exotic loans turned every buyer into a millionaire for the purposes of qualifying for a loan. They also say this housing market lacks the same speculative fervor because there are no exotic loans so it can’t be a bubble.
Let’s run with that.
Bubble 1.0) In Bubble 1.0 the Shadow Demand came from all of the risk-takers riding a wave of cheap and easy credit and liquidity — exotic mortgage loans — who needed no money down and all made $500k a year for the purpose of buying a home with a mortgage loan. In other words, because of exotic loans in Bubble 1.0, a large percentage of house buyers were coming into the transactions as wealthy millionaires. At least that’s what they said on their loan applications. This is just as the pundit’s state. And because of the real estate appraisal comparable process in the US, by which three house sales in a one-mile radius sets the values of all other houses and so on and so on, it didn’t take much for this cohort of Shadow Demand — with its cheap and easy credit and liquidity and increasing market share — to drive up the values of all real estate, nationwide.
Bubble 2.0) Fast forward to Bubble 2.0 and its Shadow Demand, which consists of four pillars, I have identified. They are:
a) Relentless institutional buy-to-rent demand – riding a wave of cheap and easy credit and liquidity — using housing as a bond-replacement trade;
b) Private speculators with cheap and easy credit and liquidity chasing said insti’s buying at a pace of 10:1 for rentals and flips;
c) Unsustainable high tech & energy sector growth – on endless cheap and easy credit and liquidity — driving outsized demand in key leading indicating regions;
d) And foreigners with rich foreign currencies relative to the US dollar, which was depressed due to cheap and easy credit and liquidity, looking at US dollar denominated real estate as cheap.
So, what’s the real difference between the two?
Bottom line: What do the exotic loan users of Bubble 1.0 and four pillars of demand in Bubble 2.0 have in common besides both being Shadow Demand cohorts? They were both born of falling interest rates, the quest for yield, or both, due to cheap and easy credit and liquidity. Further, “shadow markets/demand” define housing bubbles; that is, prices driven by something other than end-user, shelter buyer demand. This is not much different than when certain stocks are driven by a cohort of speculative, momentum investors far past their fundamental share value. Sometimes the fundamentals catch up. But, more often than not the stock price resets to the fundamentals.
4) Anatomy of a housing market dislocation; Or, simply a natural “reset to real, end-user fundamentals”
To further drill down on the previous topics, if everybody always had to purchase owner-occupied properties using the same down payment amount and a market rate, fixed-rate mortgage then house prices would always reflect the employment, income, and macro-economic conditions of the surrounding area.
But, when ‘Shadow Demand’ cohorts enter the market using cheap and easy credit and liquidity prices can detach from local-area economics, especially if the Shadow Demand continues to gain market share.
Heck, in the greater Phoenix region, over 50% of all households can’t afford the going rate on a two-bedroom apartment, yet house prices are some of the strongest in the nation. Obviously, this isn’t due to strong end-user, shelter-buyer fundamentals.
As Shadow Demand continues to gain share over end-user buyers, they settle for lower respective returns on their housing investments and prices continue to rise.
Then, when appraisers use properties purchased by Shadow buyers — for unconventional purposes with cheap and easy credit and liquidity — as comparable sales, all property values rise. Sure, there are end-user, shelter-buyers who will be able to chase the market all the way up. But, the larger the bubble blows the more the end-user, shelter-buyer demand will get crowded out and/or turn into increased supply as they liquidate. We are seeing this happen all over the nation.
In Bubble 1.0, Shadow Demand continued to gain market share until it blew up. And we know that beginning in 2011 the four pillars of unorthodox, Shadow Demand — beginning with the distressed market — controlled housing demand and still does.
The implosion of the mortgage securitization market in 2007 didn’t crash housing. Rather, when the Shadow Demand – reliant on cheap and easy credit and liquidity largely driven by securitization — left the market, housing “reset to end-user, shelter-buyer fundamentals”. In other words, the pendulum swung back to the fundamental, end-user, shelter-buyer with 20% down and a market-rate 30-year fixed mortgage, which was 30% lower. Again, this isn’t a housing crash per se, rather a demand-shift and a reset, or reattachment, to real fundamentals.
Bottom line: History will repeat because the drivers are identical. Bubble 2.0 will end with house prices once again “resetting to end-user fundamentals”, or to what the end-user shelter buyer can afford with a typical down payment and 30-year fixed rate mortgage. And it doesn’t have to be an MBS market blowing up to cause house prices to reattach to end-user fundamentals. It could be anything that swings this pendulum from being driven by Shadow Demand, which is where we are today.
5) The pendulum is already swinging…Supply up 100% yy
In fact, the pendulum is already moving, as we are seeing clearly in the So FL, San Fran Bay Area, and several higher-end markets across the nation.
Based on my research May condo supply in the popular tech and condo haven of San Francisco is up roughly 100% while demand is at 5-year lows. Prices are volatile and slipping. By some estimates there is up to 8-years of condo supply backed up based on present demand conditions. One thing is for sure, when my good buddy, Herb Greenberg, and I first started studying the housing bubble in 2005-06 we never found regions with supply up 100% year-over-year.
This is a toxic mix for house prices and rents, a leading indicator to the health “unicorn economy”, and an interesting analog to what’s occurring in South Beach, another mega-bubble region, which by some estimates is sitting on “decades” of supply given present demand conditions.
6) Leaving you with simplicity
I am a simple guy. And if all of the fancy comparisons above hurt your head, as they did mine when I wrote them, this is what I fall back on with comparing Bubble 1.0 and today’s housing market.
If 2006 was a known bubble with housing prices at “X”, affordability never better, easy availability of credit, unemployment in the 4%’s, total workforce at record highs, and growing wages, then what do you call today with house prices at X+ 5% to 20%, worse affordability and credit, higher unemployment, weakening total workforce, and shrinking wages? Whatever you call it, it’s a greater thing than “X”.