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Mark R. Kiesel
People often ask me about my outlook for the U.S. housing market – my friends and colleagues at PIMCO, clients and consultants, and readers of our Global Credit Perspectives. Over the past eight years, I have written several pieces on housing, including “For Sale,” “Still Renting” and “Back In.” I have lived in Southern California for over 17 years, renting for almost half of them. In the second quarter of 2006, I sold my home after owning for eight years, and then rented for six years until I bought my current home in the second quarter of 2012. Throughout my career at PIMCO, I have learned a great deal from many of our firm’s housing experts in credit research and portfolio management. This has helped shape my real estate views, outlook and home address (whether I own or rent).
So what do I say when asked about my outlook on U.S. housing? Well, put it this way: I don’t plan on selling my home in Newport Beach anytime soon. In fact, over the past year and a half I’ve been “settling in” and doing what many homeowners have to do given the aging of America’s housing stock: repair and remodel.
The outlook for U.S. housing is improving, and that is constructive for consumer spending, confidence and jobs. Higher housing prices should lead to a pickup in home sales, more housing starts, a gradual increase in bank lending and a boost in remodel activity. The mortgage market, previously refinance-driven, should increasingly “hand off” to growing home purchase loan originations. And a gradual recovery in the labor market shouldn’t change the outlook for Federal Reserve policy, which will likely remain dovish and support the housing market, particularly given today’s low inflation and still-elevated unemployment.
Investors looking to capitalize on an improving outlook for U.S. housing have several options – there are many ways to invest directly and indirectly in companies that should benefit from higher housing prices, a pickup in repair and remodel activity, and residential investment spending. We continue to favor select investments in homebuilders, building materials, appliance manufacturers, lumber, home improvement, banks, title insurance, mortgage origination and servicing, and non-Agency mortgage-backed securities (MBS).
The outlook for U.S. housing U.S. housing prices have recovered +22% over the past 18 months through the end of the third quarter of 2013 (Figure 1). However, they are still -21% lower than the peak hit during the second quarter in 2006. While future double-digit annual gains in home prices are unlikely, the housing market could still experience mid-single-digit annual gains for the next few years, particularly if low inflation allows the Federal Reserve to maintain accommodative monetary policy.
Higher interest and mortgage rates are a risk for housing, which is why investors are focused on the Fed and when it will start to “taper” and reduce the size of its balance sheet. However, if mortgage rates rise, it would most likely be because the Fed tapered due to an improving economy and solid recovery in job growth. A stronger labor market and improving private sector would likely offset a gradual rise in interest rates as consumer confidence and banks’ willingness to lend would likely improve. As such, gradually rising mortgage rates in the context of stronger job creation should not have a significant impact on a housing recovery. Finally, the Fed understands the importance of housing to the overall economy and will therefore likely err on the side of easy policy, which should support a continued recovery in both the labor market and real estate prices.
In terms of consumer and housing activity, rising confidence, gains in consumer net worth and improving job growth are leading to a recovery in sales (Figure 2). Sales of existing and new homes are up +6% and +22% year-over-year, respectively. Housing starts and permits have picked up, but they remain significantly below long-term averages (Figure 3). Starts are currently less than 900,000 annually, compared with a long-term average of almost 1.5 million. As a result, there is further upside in new construction and residential investment spending with improving consumer fundamentals.
On the demand side, household formation is critical to monitor. Currently, the U.S. economy is forming just over 400,000 new households per year as of the third quarter of 2013, significantly below the long-term average of just under 1.2 million (Figure 4). Given current population growth, America should be forming roughly 1 million new households each year. However, the latest recession was so severe that it continues to suppress household formation. One piece of evidence: A growing percentage of young adults aged 18-34 are living with their parents (Figure 5). Fortunately, the labor market outlook is improving (Figure 6). Jobless claims are near six-year lows and private sector employment is picking up. U.S. household net worth has also improved and has increased $14.2 trillion, or +10.7% annually over the past two years, according to the Federal Reserve as of the third quarter of 2013. We believe the “American Dream” of home ownership is intact and note the recent uptick in the home ownership rate as evidence of pent-up demand and an improving outlook for household formation given rising wealth and stronger job creation.
In terms of valuations, home prices remain attractive on both a price-to-rent and price-to-income basis (Figure 7). U.S. housing also looks increasingly attractive relative to international housing markets. It’s no surprise that foreigners have been a significant source of support for many regional markets across the country. Another contributor may be potential homeowners who increasingly see houses as attractive “stores of value,” particularly should inflation or inflationary expectations rise.
On the supply side, inventories are probably the most important driver of housing prices. Only 2.1 million existing homes and 183,000 new homes are for sale (Figure 8). The absolute level of inventory is near a 14-year low. In addition, the combined total of today’s existing and new inventories for sale divided by the working age population is near 30-year lows (Figure 9). And foreclosures and distressed inventory levels and homeowner vacancy rates are improving significantly. New home supply will also be constrained by lot inventory, as builders have quickly absorbed their existing inventory of pre-crisis finished lots and development of new lots has been constrained since 2006. Overall, tight supply, gradually increasing demand and attractive valuations remain supportive for U.S. housing prices and residential investment spending.
One area is homebuilders, given our view that housing prices are likely headed higher over the next several years. We have focused our investments on select homebuilders that either serve a niche market (e.g., luxury) or have an advantageous land position in key markets where job growth is healthy and land supply is constrained. We believe these factors have allowed homebuilders to report healthy order backlog growth. Given improving demand, homebuilders should continue to enjoy strong pricing power on new developments in markets with strong employment growth.
We also favor appliance manufacturers and lumber, home-improvement and building-material companies that should benefit from a pickup in new construction as well as in repair and remodel activity. Few homeowners put money into their homes when their mortgages were “underwater.” They delayed large-scale projects, such as replacing the roof or the heating, ventilation, and air conditioning (HVAC) system, for as long as possible. As homeowners went into a negative equity position, remodel spending underperformed the overall economy (Figure 10). However, today’s outlook for repair and remodel is significantly brighter, with home prices, homeowner equity and consumer confidence rising.
Settling in U.S. real estate should remain an attractive place to invest as the economy and private sector heal. Home prices will likely remain supported by an improving labor market, accommodative Fed, healthy pent-up demand, gradually easier credit and bank lending, supportive valuations and low inventory.
Rising home prices will also help repair and remodel activity pick up as homeowners “settle into” their homes. They will also encourage new construction given a favorable supply and demand outlook.
It is clear that investors looking to capitalize on companies that benefit from these trends have many options.
Mark Kiesel Managing Director
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The S&P/Case-Shiller Home Price Indices measures the residential housing market, tracking changes in the value of the residential real estate market in 20 metropolitan region across the United States. In addition, the S&P/Case-Shiller® U.S. National Home Price Index is a broader composite of single-family home price indices for the nine U.S. Census divisions and is calculated quarterly.
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