LOCATION STRATEGY CHARTBOOK

I thought this week we would use the chartbook to update our thesis on the housing market.

Executive Summary

There are huge demographic tailwinds to housing that continue to drive costs upward. None of the factors influencing housing costs are addressed by the Fed’s current monetary policy but housing is directly effected by these efforts because housing costs are 40% of CPI.

Location Strategy believes Fed’s monetary efforts are being undone by the White House’s ahistorical deficit spending and further that “higher for longer” risks the collapse of as many as 300 regional banks because they are overweight on commercial real estate loans.

The Details

Housing has a huge demographic tailwind right now as the US is experiencing the largest wave of thirty year-olds in its history. Historically this age group has driven new home sales growth.

In fact now we are seeing the opposite - because of pricing new sales have fallen to levels seen in the 1960s - when the total US population was about 195 million; population today is about 341 million.

They’re not buying existing homes - the level of existing home sales has remained unchanged for almost 18 months - in fact in April it fell 2% YOY.

Existing product isn’t moving because the average mortgage rate is far below current mortgage rates (approx 95% of houses have rates 0.25 bps below current 30 year rates) and beyond that 40% have no mortgage at all. People aren’t bringing this product to market unless they have to.

These challenges are reflected in the MBA Purchase Index which remains at its lowest level in the last 10 years.

One of the ways younger home buyers are compensating is by moving to states with lower costs of living.

Two problems remain: high mortgage rates reduce purchasing power and inflation is still making housing too expensive. Let’s do inflation first.

The chart below shows Case-Shiller National and Top 10 Metro price trends along with CPI and the Owners’ Equivalent Rent. The OER is our favorite home price measurement because instead of actual transactions, it measures home price increases via a telephone survey that asks homeowners to estimate what their house would rent for. Do you know how much your house would rent for?

CPI, OER and rents have increased about 20% since 2020; the Case-Shiller metrics show home prices have increased closer to 45%-50%.

The Fed’s mandate is to keep inflation below 2%. Housing prices (through the OER) represent almost 40% of CPI. So if you are going to attack inflation, you’re going to attack housing prices. The Fed can’t increase labor, can’t reduce restrictive land use regulations or create new supply chains to increase availability of affordable materials. What it can do is wreak havoc in the mortgage markets, and we’re familiar with the result: the average mortgage on the median priced house in the US is almost 2.5x higher than it was in 2020.

There’s been all sorts of wishcasting about where rates should go this year; the latest concensus is that we should see 2 rate cuts in 2024. Location Strategy subscribes to this view. But comments from the Fed have discouraged this thinking because the economy is not responding to current monetary policy.

Forecasting inflation based on current observations show the economy will stay above the Fed’s target of 2%.

Why isn’t the Fed’s strategy working? Let’s review some basic macroeconomics. GDP is the sum of personal consumption, private investment, net exports and government expenditures.

Government spending is propping up the economy and supporting inflation above the Fed’s target level.

In 2021 we had the largest deficit in US history at $2 trillion, followed by 2023’s at $1.7 trillion - 6% of GDP. And the current budget forecast shows deficit spending at 5-7% of GDP for the next 10 years.

Well, but we have two presidential candidates - surely it makes a difference which candidate gets elected? The answer is not really. Although there are wide philosophical differences in candidate positions, both of them have announced their intention to implement highly inflationary policies.

The basic problem is the federal government takes in about $5 trillion in revenue and spends about $7 trillion.

Under current spending and debt scenarios (not to mention the US has to refinance $14 trillion in debt in the next 12 months) interest on the national debt could reach $1.7 trillion next year. Fiscal policy is playing a large role in preventing monetary policy from controlling inflation.

So what are the consequences of the Fed and the White House working against each other? One is that there is almost $1 trillion in CRE assets maturing in 2024 (47% of assets that were to mature in 2023 were delayed until 2024).

About 35% of these assets are held in regional banks

As many as 20% of all CRE loans would default if refinanced at rates today, and the National Bureau of Economic Research found doing so could cause the failure of upto 300 banks.

Here’s leading NYC commercial real estate broker Bob Knakal describing how office buildings would need a 42% increase in rent to break even if refinanced at current rates. (click to view video)

In a nutshell, the Fed is playing chicken with the President over fiscal vs monetary policy and the result is high interest rates and high rates of inflation. What hangs in the balance is our ability to sell homes, and the future of regional banking in the US.

Enjoy the rest of your Saturday.