This piece originally appeared in the March 2023 edition of DS News magazine, online now.
Prior to 2022, analysts across most markets predicted a continued run of good fortune. Perhaps it was denial or simply the hope that the Federal Reserve would achieve the soft landing that (so far) eludes us. No matter the root cause, analysts saw their hopes shatter as, for example, consensus estimates of the S&P 500 striking 5,225 by year’s end fell short by more than 40%.
A confluence of factors spun together to create the perfect economic storm we’ve experienced: rampant inflation, geopolitical uncertainty, nearly a decade-long bull run, overinflated valuations, and (perhaps most devasting) a series of rate hikes marking the end of the pandemic era’s environment of cheap debt and soaring investments.
What Happened in Housing?
Anyone paying attention could have predicted the impact of rate hikes, especially on the housing market. Rock-bottom rates led to a 50-year low in fixed-rate mortgage average at just below 2.7%, while supply chain chokepoints led to a housing supply shortage, and economic stimulus led to soaring home prices as investors speculated wildly which drove values upward. And, as with most other markets, the fall happened nearly as fast as the meteoric rise.
Logistics caught up, and new starts began again. Economic uncertainty and the highest fixed-rate mortgage average since 2000 (6.95%) caused supply to catch up and surpass demand.
The few who could sell at the top considered themselves lucky as home sales slumped, the median days on the market for home sales doubled, and prices for homes that did sell dropped by nearly 30% in less than six months.
The housing slump is easily the economy’s most significant casualty in the Fed’s fight against inflation—even if the full scope isn’t yet apparent.
Volatile equities can generally be counted upon to revert to a mean over time. Fixed-income investing is enjoying a new resurgence, despite inflationary pressures on even the best Treasury rates. Home valuation inflation means many late-2021 and early-2022 buyers may be seeing underwater mortgages in their future. Dormant new builds are sitting on unfortunate developer balance sheets, with little reprieve as financially insecure Americans hunker down, unwilling to brave near-double-digit mortgage rates.
Early Warning Signs
But, despite the blaring alarms towards the end of 2021, careful observers spotted red flags as we ended the previous decade. Post-2008’s “Great Financial Crisis,” housing prices hit a low in mid-2012 before rebounding and climbing with limited headwinds for the rest of the 2010s.
A decade-plus of quantitative easing began, ending before the pandemic reared its head, and 2019’s interest rates began nosing around 4%—the highest they had been in more than a decade, and considered high for the time. Many thought the pandemic’s emergence would end an eight-year housing bull run. The prediction proved untrue as home prices enjoyed a V-shaped recovery alongside equities. That reversal interrupted what would have otherwise been a predictable dip in naturally occurring market cycles (albeit triggered synthetically).
Today, the early warning signs were true portents of things to come, and the full extent of the fallout has yet to be determined.
Auction.com, a real estate auction site offering existing and aspiring investors access to (mostly) distressed assets, generated very revealing information about the state of real estate assets throughout 2022. Auction.com’s end-of-year reports showed 6.5 million unique users active on the site throughout 2022. However, just a fraction of those ultimately used the platform as an auction house to buy investment properties.
Primarily populated by smaller, local investors rather than or private equity/debt funds, Auction.com’s bidders and buyers are effectively community developers buying properties, improving them, and investing in the areas they live. Typically, the post-purchase cycle extends through three to six months of property renovation before renting the home as a long-term investment and cash flow vehicle, or simply flipping the property.
The site’s reports are a good barometer for what may be coming: a proverbial canary in the coalmine where the auction house’s relatively small population acts as a proxy for the national home buying and real estate market. Over the year, buyer behavior began a subtle but dramatic shift. Between the first and third quarters, bidding became much more muted and conservative; buyers set their bids at around an 11% discount on foreclosures in Q1. That discount fell to 23% below the as-is value by Q3. This sign of things to come shows that if the trend continues and the aftershocks of rate hikes extend to the real estate market in toto, we may see a complete slowdown by March 2023.
The data points to a comparison between public equities and the real estate market, albeit on a slowed timeline. As the first rumblings of quantitative tightening began, the riskiest high-P/E stocks with limited fundamental bases collapsed from their sky-high valuations as an initial casualty.
Over time, the blue-chip and fundamentally-sound equities also saw a steep drop. It just took longer. So, much like high-risk/high-reward tech stocks suffered long before the aristocratic market mainstays, the foreclosures point to future turbulence in cornerstones like single-family homes and long-term rentals.
A Matter of Speculation
An eventual crash’s beginnings aren’t just evident in the foreclosure and physical investment market. Speculative investors are managing their portfolios and positions as well, expecting a substantial leg down to come. Traders dealing in futures contracts of the Case-Shiller 20-City Composite Home Price Index traded the Index projecting a 327 high throughout the past year.
Now, futures contracts peg the January 2024 price at 268. The Index trades, as of December 2022, were right around 306.
The consensus surrounding a drop to 270 puts physical real estate investors in a bind. Roughly translated, a move close to this magnitude would bring home prices more closely aligned with pre-pandemic values. A fall that far makes a comprehensive portfolio with holdings and futures hedging flat, but a crash into the 230s that many analysts project profits from the hedge but is likely insufficient to offset the unrealized losses in property values.
While financial engineering with these instruments may prove beneficial for purely speculative plays, the reality is that they serve a real and valuable purpose as a hedge for investors if the pessimistic outlook rings true. Investors’ hedging, though, must be exhaustive in due diligence and modeling calculations that account for as many contingencies and likelihoods as possible to ensure the most viable and cost-effective hedging strategy.
Nothing New Under the Sun: Viewing 2008 As A Playbook for Today?
Some in the industry see 2008 as a historical playbook to learn from, but the parallel may not hold up under today’s real-life conditions. Institutional investors and portfolio managers used loans to compensate for 2008’s property value losses.
Their thesis that origination fees could wholly counteract or bridge property value losses proved legitimate, as many buyers with liquidity rushed to snatch up distressed or discounted housing assets.
Today’s environment is different, as the supply and demand curves are effectively inverted compared to 2008. Typical demand, expressed as “homebuyers per year,” was pulled forward significantly during the pandemic. Rate cuts made dirt-cheap mortgages too good a deal to pass up.
Not willing to wait until a planned 2023 or 2024 purchase, many snatched up a great rate near the bottom in 2021, or caught a mortgage on the upswing as 2022’s tightening began.
Instead of a typical demand pool over the next few years, many who would have filled those ranks were pulled forward, and a portion of the remnants can no longer afford a 7%+ mortgage rate, even if offset by a lower purchase price.
This unwillingness to buy compounds further as rampant inflation and an increasingly shaky job market make future economic circumstances less predictable. Since psychology drives much of the consumer housing market, this confluence of factors creates a spooked and psychologically fragile demand sector that is increasingly unlikely to buy.
Investor reactions vary based on endless factors, much like reactions to any disturbance in a market. Right now, most fall into two primary camps: First-to-Market and Long-Term Holders.
Our “First-to-Market” class saw the writing on the wall, which, in hindsight, was clear but obscured by the overall market exuberance that typified 2020 and 2021. Much like warning bells sounded for some in 2006, letting them escape 2008’s slaughter unscathed, our First-to-Market group moved to fractionally and strategically liquidate some or all of their portfolio over six to seven months. These investors are also the likeliest to ride the market back up. True to form, they’ve been strategically sitting on a cash reserve to rebuild their portfolio.
The second group, “Buy-and-Hold,” is effectively “stuck” with their real estate assets. Whether intentionally as part of a long-term investing strategy, or caught unaware and underwater on the investment, these investors often have a much deeper bench of real estate assets to contend with, typically numbering in the dozens. However, hundreds of properties aren’t uncommon, and these investors must weather the storm while waiting for the market to stabilize to reorient their strategies.
Even rental property investors can’t escape today’s new reality. The dependable cash flow that exemplifies effective rental property investing may prove less resilient in today’s economic landscape than in the past, especially if we try to apply lessons learned from 2008. Whereas past rental booms amid housing market depressions were primarily fueled by foreclosures forcing a transition to rent, today’s mismatched supply and demand instead place downward pressure on rental prices as the rentals’ value also falls.
Renters can leverage the threat of leaving the property to buy their own. Sufficiently motivated renters can now access a newly-created pool of desperate sellers who need to offload portions of their holdings. In effect, the possibility remains omnipresent and at the forefront of owners’ minds despite prospective buyers not actively buying new properties; the scales are tipped heavily in the favor of tenants.
This negative reinforcement suppresses any rent increase that could come close to offsetting inflation for owners. The new renter/owner dynamic increases the risk of downside movement in average rental prices as inflation reduces the real value of that cash flow, and ongoing supply chain issues increase maintenance costs for owners and managers.
So, what can we expect in the future, even in the short-term? As 2021 was a clear seller’s market, we’re transitioning into a distinctly buyer-biased market. But we’re not there yet.
Although home prices flatlined and began a downward climb, they haven’t yet broken into negative territory. Few (if any) pre- or mid-pandemic buyers are underwater on either their home or investment properties. Stagnation will be the watchword over the coming months.
Investors and prospective buyers alike will wait with bated breath to see a flip into buyer’s market territory precipitated by values dropping close to zero or even dipping into the red in some sensitive markets. This waiting game is a tricky proposition for many investors and buyers, who are sitting on enough dry powder to leap into the market when conditions are right. Still, inflation is reducing the value of that war chest daily, and some fixed-income investments are increasingly attractive as alternatives to waiting for housing.
Owners are also in a tight spot, as falling prices have impacted net portfolio values. Declining balances make the continued maintenance of assets risky, especially for highly leveraged accounts. Eventually, conditions will be so bad that they must sell to the droves of buyers waiting in the wings. Ultimately, this creates a stand-off between buyers and sellers, each waiting for the other to blink in a national game of chicken that will only materialize after a long period of stagnation anxiety.
Hedging Helps: How Derivatives Can Offset Losses And Improve Access
Today’s world, while chaotic, is also more technologically-driven and innovative than ever. Moving forward, a likely outcome of the turbulence in housing combined innovation is an opportunity for increased access to derivatives as either a hedge for real estate portfolios or as speculative assets.
Firms are already offering index-based home price futures contracts, and futures options are seeing a spike in user count, and subsequent contract transaction counts. The critical factor in the broader adoption of these financial instruments to pad and buffer flagging markets is better youth and renter awareness of products.
Sellers of these derivatives are a captive audience. Owners hedging their capital gains in value appreciation, flippers sensitive to a rapid decline in pricing, and even construction firms on a fixed 12 to 18 month timeline all need futures and similar products to balance their risk.
The buy-side of the equation still has room to grow. As a broad class, young professionals and renters don’t yet have the means to buy a home, and that ability will decline if economic conditions worsen. The lack of equity (financial and social) cuts these classes off from the idealized conception of home ownership and generational wealth, which is bad enough, but also denies access to shorter-term gains as liquidity as home inevitability stabilizes and creeps back upwards.
Because of how these contracts function, access to home price index futures allows buyers to invest in and manage slices of home equity—much like fractional investing lets anyone buy a portion of Apple or Microsoft stock, for example.
Participation in the futures market allows renters and others unable or unwilling to purchase property due to life circumstances or lack of interest to capitalize on housing with decidedly less capital and risk.
After the past few years, there is undoubtedly some investing fatigue in less-experienced or less financially savvy Americans. Despite this, using home price indices as a stable alternative to the whipsaw equities market is an exciting proposition that market makers and firms offering these products must move on. Expansion of these futures markets serves a dual purpose of increasing equitable access to wealth-building strategies while stabilizing the housing market as more market participants buoy prices and reduce volatility by closing the bid/ask spreads on contracts.
Hindsight is 20/20. Nothing is set in stone. We can’t predict the future. This set of simple platitudes has never felt as applicable as they do when applied to the past two years and the immediate future. Despite this, while not guaranteed, the odds are good that we have yet to see a bottom in the housing markets. Rate hikes may slow but are unlikely to stop in 2023 and are even less likely to come back down. This snowball effect on mortgage rates, coupled with inflation and supply chain woes, means turbulence in housing is all but guaranteed.
The fall and winter of 2022 saw the broad housing market pricing downturn begin. We’re likely to see a further leg down before an eventual flatlining as potential buyers and unwilling sellers have a proverbial staring contest to determine which direction cash reserves flow.
In the meantime, investors and homeowner hopefuls can take advantage of new, innovative products that hedge against market downturns and provide equitable access to previously marginalized communities that are historically denied the chance at generational wealth through home ownership and equity. In the end, nothing is guaranteed. For investors, owners, and buyers alike, patience, education, and a cautiously optimistic attitude is the best course of action.