The bursting of the US housing bubble — which was driven by excessive speculation supported by easy credit, including from poorly understood and inadequately regulated complex financial products such as collateralised debt obligations (CDOs), where subprime mortgages were pooled, packaged and sold as low-risk instruments at low interest rates — was the key catalyst that triggered the Great Recession in 2007 and the global financial crisis (GFC).
Total home sales and prices plunged sharply in the ensuing years, given that both homeowners and homebuilders were highly leveraged as active participants in the housing bubble. Many ran into financial problems, defaulting on their loans, with some even falling into bankruptcy. That then led to a decade of slow consumer demand, dragging on the economic recovery, and underbuilding, as households and homebuilders repaired their balance sheets. It also resulted in the current situation in the US housing market — a chronic shortage, ageing homes and rising prices.
Last week, we explained why consumption — which accounts for two-thirds of the US economy and the key driver of growth — will slow and its repercussions on the equity market, which is already trading near the high end of historical valuations. This time around, however, the housing market (we think) will be resilient in the expected economic slowdown. We also think that homebuilders as well as major retailers in the home improvement industry are defensive plays — supported by both underlying demand and supply dynamics.
Housing sales constrained by high interest rates and low inventory
The homeowner vacancy rate — the percentage of homes that are vacant and available for sale (see Chart 1) — is hovering near the lowest levels in nearly seven decades of available data. In other words, homes for sale are being quickly snapped up. This is indicative of strong demand, especially from millennials, a big demographics group that is now in prime household formation and home-buying age. The US job market is tight and the unemployment rate is near historic low, bolstering financial security and confidence to take on such huge, long-term financial commitments (mortgages).
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At the same time, there is a chronic housing shortage due to a confluence of factors including the aforementioned underbuilding post-GFC, zoning restrictions and regulatory issues, labour shortage and, in recent years, sharply higher mortgage rates. Unlike mortgages in Malaysia and Singapore, which are based on variable interest rates (monthly mortgage payments change with interest rate fluctuations), the US mortgage market consists predominantly of long-term, fixed-rate loans. Many homeowners have locked in ultra-low mortgage rates, especially during the pandemic. If they were to sell and upgrade, they would have to give up their existing low-rate mortgages — the mortgage rate for roughly 80% of existing homeowners is below 5% — for much higher rate mortgages today, currently hovering around 7%. Hence, many existing homeowners are simply staying put, for now.
Construction of new homes, though rising, is also being constrained by declining home affordability due to both prevailing high mortgage rates and rising house prices (with demand exceeding supply) — compounding the shortage situation. Case in point: Median prices for new and existing (resale) single-family homes rose at breakneck speed in 2022 and 2023, outpacing anything we’ve seen in the past four decades. The median prices of existing and new single-family homes are currently near all-time highs (see Chart 2).
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According to the US National Association of Realtors (NAR), monthly mortgage payments (principal plus interest) on median-priced existing single-family homes have more than doubled from 2020 (see Table). Consequently, the qualifying income for a median-priced existing single-family home has risen from US$49,680 in 2020 to US$106,032 currently. In other words, while there is strong demand, many first-time buyers are being priced out of the market. To improve affordability, homebuilders are reducing house sizes and increasingly having to offer incentives and discounts such as mortgage rate buydowns to complete the sale, which affect their margins.
Imminent interest rate cut bodes well for homebuilders and home improvement industry
As such, we believe the imminent interest rate reduction by the US Federal Reserve would bode well for the housing industry. Make no mistake, it is unlikely that mortgage rates will return to the low levels during and prior to the pandemic, at least not in the foreseeable future. However, existing homeowners and buyers are adjusting to this new reality. Hence, we think that the fall in mortgage rates, even if not back to previous lows, will entice existing homeowners back into the market. Bear in mind also that these homes would have built substantial net equity over the years, given the price uptrend.
An increase in resale supply would rejuvenate overall sales and perhaps even help keep a lid on further increases in house prices. And, of course, lower mortgage rates will improve home ownership affordability, which would clearly benefit the homebuilders such as D R Horton, Lennar, KB Home and PulteGroup. As we explained above, the appetite to purchase a home remains robust. We acquired shares in D R Horton for the Absolute Returns Portfolio.
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Post-GFC, homebuilder business models have become much more resilient than in past cycles. Many have shifted to asset-light strategies, such as using options to purchase land rather than outright ownership to reduce exposure to market fluctuations. More prudent management of balance sheets also translates into low leverage levels while cash generation has been strong.
We are even more upbeat on the outlook for the large retailers for home improvement, such as Home Depot and Lowe’s. We saw a huge uptick in home improvement activities (including some pulled forward demand) during the pandemic lockdown, but total spending on home improvement and repair is expected to drop in the current year, the first annual decline since the housing bust in the late 2000s. Retailers are reporting a significant drop in big-ticket transactions, especially those requiring financing on the back of rising interest rates and borrowing costs. Some homeowners are probably deferring major renovations-remodelling in anticipation of imminent Fed rate cuts.
Of note, the resale market makes up some 85% of total home sales in the US (see Chart 5). According to the 2021 American Housing Survey by the US Census Bureau, the median age of all owned homes was 41 years and homes built in the 1980s or earlier make up about 60% of existing stock. Typically, homes of these ages tend to see 15% to 20% more renovation projects than average, in terms of critical replacements and upkeeping, as well as modernisation and home performance improvements on energy efficiency, air quality, comfort, durability and safety.
We foresee that a rejuvenation in the resale housing market will, once again, spur renovation activities by existing homeowners, new buyers as well as sellers, including large remodelling projects to enhance home performance and resale values (sprucing up before listing). This is the reason why we have also added Home Depot to the Absolute Returns Portfolio.
The Absolute Returns Portfolio fell 2% for the week ended June 26. As mentioned above, we disposed of our holdings in VOO and Sun Hung Kai Properties and reinvested the proceeds in D R Horton and Home Depot. The top gainers last week were Itochu (+3.6%), Microsoft (+1.3%) and OCBC (+1.1%). Airbus was the biggest loser, falling 12% after warning of aircraft delivery delays due to component shortages because of persistent supply chain issues. Home Depot (-4.4%) and Swire Properties (-3.9) too ended lower for the week. Sentiment for Home Depot is hurt by falling home sales with mortgage rates staying high, for now. Last week’s losses pared total portfolio returns since inception to 0.7%.
The Malaysian Portfolio fell 2.4% last week, led by declines for IOI Properties (-6.9%), UOA Development (-6.2%) and Insas Bhd – Warrants C (-5.2%). Only Maybank closed marginally higher, up 0.2%. Total portfolio returns now stand at 208.1% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 13.1%, by a long, long way.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
