Homes are where many people live, work and play, but housing is also a dynamic market segment and the biggest source of wealth for many Americans. We delve deep into the evolution of residential real estate and its potential path ahead.
A quick scan of the headlines in any publication makes it clear that the COVID-19 pandemic and its lasting aftereffects have transformed the US housing market. But it’s not the first transformation: any discussion of how today’s landscape came to be must start earlier, in the years leading up to the global financial crisis (GFC) and its aftermath.
From the GFC to COVID-19: Disruption in the US Housing Market
When the housing bubble burst in 2008, many homeowners walked away from mortgages, leaving a glut of available homes. In response, homebuilding—and related jobs—plummeted.
Residential lending from alternative capital providers dried up, and mortgage lending became dominated by government-sponsored enterprises (GSEs). The struggles of GSEs forced them into conservatorship, and credit risk–transfer securities (CRTs) were created to enable them to transfer some mortgage risk to private investors. Banks, stung by recession-related loan losses, needed extraordinary help from the Fed and US government.
Even as a chill hovered over home construction, a potential home-demand boom was building under the surface. The US population continued to grow, and millennials, many still living with their families, began to enter prime home-seeking age. Eventually, housing activity began to pick up.
In the years immediately before the COVID-19 pandemic, the Fed’s 2019 reversal from tightening monetary policy to cutting interest rates, combined with a recovering economy and growing household formation, stoked demand for single-family homes. Stronger housing demand, low rates and strong lending activity drove home prices up, but the housing shortfall intensified.
The pandemic initially brought a massive wave of government and Fed activity that further reduced rates. Many people sought to flee cities and buy homes even as the housing gap remained, creating a sellers’ market. Many homeowners took advantage of low rates to refinance. Then, just as rapidly, the Fed hiked rates to cool economic activity and inflation. With more expensive mortgages and lofty home prices, affordability fell to historic lows. Home seekers became less willing or able to buy, and homeowners with low-rate mortgages stayed put, leaving few existing homes for sale.
Where Does the Housing Market Go from Here?
With a tenuous housing equilibrium built on relatively thin levels of supply and demand, interest rates are the key to unlocking the market and enabling a healthier state. Lower rates aren’t a prerequisite for more activity, because demand still exists. But ultimately, mortgage rates need to fall.
In fact, mortgage rates can decline without Treasury yields moving lower. If interest rates becomes less volatile, the yield spread charged on mortgages above Treasury yields could shrink. If inflation continues to moderate, it could push Treasury yields themselves down and mortgage rates with them, unlocking more buyers and sellers and fostering a healthier equilibrium.
As this process plays out, investors will likely see new potential emerging to complement existing opportunities in the US housing market.
Assessing Potential in Housing-Related Firms
The lack of existing home sales and stable housing prices have been a boon for the homebuilding sector over the past year. Indeed, since the GFC, many homebuilders have evolved for the better, cutting leverage and industrializing their manufacturing processes.
Many building-materials distributors have evolved, too, developing the ability to produce custom-fit components for builders on-site. This streamlined process has carved out a much larger role in the new-home value chain. On the other hand, distributors exposed to existing home sales, including home-improvement retailers, have lagged. When new home sales rebound, their fortunes could change.
One of the most direct plays on the existing home market is through financials, such as title and mortgage insurers. With business volumes that depend on existing home sales, these firms have slumped. Also, they’re not a pure play on residential housing, given their exposure to commercial real estate, where uncertainty remains—especially in offices.
Multifamily rentals have been challenged recently, with heavy building putting downward pressure on rental rates, while at the same time higher interest rates hurt valuations. In our view, trends should become generally favorable once excess supply is worked off.
In contrast, single-family rentals are flourishing and many smaller operations have grown into sizable national players that own nearly 100,000 homes. We think this segment will continue to benefit from the preference for single-family homes, and there’s room for greater penetration in this segment.
Stronger Homeowner Equity Bolsters CRT Opportunities
Home prices have been on a steady upward climb over the past decade, and have enjoyed an even stronger surge since mid-2020. In the process, rising home values have boosted homeowner equity, enhancing the attractiveness of CRTs, which GSEs began issuing in 2013.
Representing pools of thousands of mortgages that pay investors regularly based on underlying loan performance, CRTs are carved up into numerous tranches with distinctive combinations of loss exposure and yield. We tend to see more value at the top of the CRT capital structure—essentially bonds that are paid first. They’re fairly short-term securities with attractive yield spreads, and we think they’re likely to hold up well under a range of scenarios, including those of extreme housing stress.
These CRTs are also floating rate, priced at a yield spread over the Secured Overnight Financing Rate (SOFR). If the SOFR stays elevated, which could happen in a higher-for-longer rate environment, these CRTs could carry that high base rate plus a spread of as much as 2% for a three-year period. In our view, that’s pretty attractive for an asset that carries little credit risk.
Financing Transition Is Driving Private-Lending Potential
Sharply higher interest rates have pressured balance sheets of many banks, given that they typically hold long-duration assets—including mortgages. In response, many have retreated from mortgage lending. Looming Basel regulatory requirements would likely lead to a further pullback.
As this broad evolution plays out, it will change the shape of lending markets and create opportunities for private lenders, which we see playing out in two ways. The first is absorbing mortgage loans that banks are offloading from their existing books of business. Given the rapid surge in rates, those agency mortgages can range from a 2.5% coupon all the way up to 7.35%, offering private creditors a broad variety of risk/return profiles. Investors willing to provide capital can pick their spots based on how they expect market conditions to evolve.
The second opportunity is by originating mortgage loans as a specialty finance provider through a broad range of loan types that creates diverse risk/return. It’s somewhat of a “back to the future” development in the mortgage market, and we think the trend is likely to take hold across the consumer spectrum, including in home improvements and parts of the auto finance market.
- Richard Brink
- Market Strategist—Client Group