Home prices have risen rapidly as real estate and mortgage investors picked the housing market’s lowest-hanging fruit: high-quality properties in states with short liquidation timelines and cooperative borrowers. Now, we believe the market is beginning to settle into a new equilibrium of steadier, gradual growth and recovery. (See our previous Viewpoint, “Hold Your Houses: The Housing Recovery May Take Longer Than You Think to Reach Consumers.”)
During 2013, home prices, as measured by the S&P/Case-Shiller index, increased by 13.5% through November. Fundamental growth in prices – thanks to low interest rates and a strengthening economy – was further supported by technical factors, including the rise of institutional rental investors, as well as legal settlements with mortgage servicers that encouraged principal modifications and short sales. The process of clearing the rest of the delinquency backlog from the foreclosure crisis, however, will be slower and more labor-intensive.
PIMCO expects house prices to transition to steady secular growth, with nominal price increases of 5%–10% cumulatively over two years, as investors reach for properties on the higher branches.
Key trends for the years ahead
Even after recent house price and mortgage rate increases, housing remains historically affordable in most markets. We estimate that house prices would still have to rise 30% in order for buying a home to be “fairly” priced relative to renting, if rates remained steady (Figure 1). Over time, gradual price appreciation and a normalizing interest rate environment should bring the buy/rent ratio back into equilibrium.
It will be important to monitor the development of increasing institutional rental financing in the months ahead (Figure 2). The continued improvement in financing of this asset class potentially sets a “floor” for various housing markets. If funding remains viable, the institutional community should be able to arbitrage the carry – in other words, rental housing investors constitute a house price “put” in that whenever the buy/rent ratio becomes too unbalanced, institutional money flows in to support prices.
Our highest-conviction expectation remains that single family housing starts (at 661,000 annualized during Q4 2013) are simply too low. Our longer-run expectations are for an eventual return to 1+ million annual single-family starts, driven by improving employment and household formation, as well as immigration, foreign buying and second/vacation homebuying, combined with replacements for obsolescence and post-crisis deferred maintenance (Figure 3).
Despite modest expectations for home price appreciation over the next few years, we do think pressure is building for housing starts, rental growth and/or home prices, or some combination of the three. The ultimate resolution determines valuation and relative value for many housing-related investments, including homebuilders, land, non-agency residential mortgage-backed securities (RMBS), multifamily development and single-family real estate investment trusts (REITs).
Regional differences still matter
In addition to employment and income growth and net migration, states’ approaches to the housing market fallout have varied. For example, states with judicial foreclosure processes, such as Illinois, New York and, to a certain extent, Florida, still have many more delinquent properties to work through, some of which have been vacant for years. While home prices in those regions remain low historically, there is still downside risk that requires careful analysis. On the other hand, regions such as Arizona and Nevada have normalized more quickly as a result of strong institutional investor activity and may be due for a slowdown.
We see upside in areas with strong growth in employment and income, as well as positive net migration, such as Colorado, North Carolina, Minnesota and parts of South Florida. As we analyze investments, we focus on opportunities in regions and products where we believe the potential upside from house prices and construction isn’t fully or even partially priced in.
Mortgage credit remains stagnant
In contrast to improvements in the broader U.S. housing market and the notable growth of non-mortgage consumer debt (credit cards, autos and student loans increased by 27% since bottoming in mid-2010), the growth of mortgage debt, which represents 76% of outstanding consumer debt, will remain sluggish. In May 2013, we projected a year-end mortgage balance of $9.90 trillion, and in fact, $9.86 trillion was outstanding as of Q3. For 2014, we project a decrease of $0 to $50 billion from this figure, with the year-end balance between $9.81 trillion and $9.86 trillion.
Our projection is based on our expectations that new home sales should remain historically low, reaching only 525,000 in 2014, alongside modest home price appreciation and slow cash-out refinancing due to continuing tight credit. We believe that recent changes in the regulatory environment will continue to limit access to mortgage credit to borrowers with clean credit histories. At the same time, delinquent loans should continue to be liquidated gradually, with the resulting buyer often paying cash or taking out a corporate loan.
In part because of limited credit availability, homeownership continued to fall throughout 2013 (Figure 4), and household formation was dominated by new renters (Figure 5). Increases in rentership do not create mortgage credit, but they do create credit to the extent that the properties are financed in the form of REIT debt or securitization. This is an important change to the housing market, because it affects the businesses of mortgage originators, title insurers and mortgage servicers.
Even in the owner-occupied segment of the market, credit availability drives value. The focus on high-quality borrowers drove prices of higher-end housing and higher-end markets to outperform since 2009 (Figure 6). However, wealthy homebuyers are also the least likely to monetize their new home equity to increase spending. We continue to believe that the transmission mechanism between home equity and consumer spending is impaired and will only recover when more borrowers are able and willing to monetize their home equity through second liens or cash-out refinancing.
We expect the cash-out refinance mortgage market to recover over the next few years. While the mortgage origination business currently looks challenged, we believe that laying the foundation now for a future recovery in mortgage origination is critical.
Investing in a gradual recovery
As we have discussed in the past, housing-related investments often benefit from, but do not always require, strong home price appreciation in order to earn attractive risk-adjusted real returns. In fact, an environment of reduced volatility and steady gradual growth may result in tightening risk premia and spreads as the market begins to price in this new dynamic.
At PIMCO, we continue to seek out varied housing-related investments and carefully evaluate their performance as the market stabilizes, while remaining cognizant of the remaining macro and regional risks. Most importantly, over the coming years we will focus on whether the underbuilding of single-family homes is ultimately resolved through housing starts, rental growth or continued price appreciation.