Capital Markets Update
Strong Fundamentals Make the Housing Market a Good Bet
By Justin Parker
For a second, imagine taking on one of the world’s most intense roller coaster rides. Now imagine doing that blindfolded, never knowing when the next flip or stomach drop will occur, and never knowing when it will end or where it is going. For many, that feeling is likely a similar sentiment to trying to understand the state of the housing market and what lies ahead. This article will help shed some light through that blindfold and provide a better understanding of where we are, how we got here, and what lies ahead.
Housing Market Fundamentals
To fully understand the current state of the housing market and what potentially lies ahead, it is important to understand some of the key fundamentals and some of the driving forces which have played a role in the last 24 months following the COVID pandemic.
Housing Supply and Demand
One of the most common fundamentals present over the last few years has been the imbalance of housing supply versus housing demand. As of the end of 2021, the US Housing Market was an estimated 5-6 million homes undersupplied compared to its respective demand. With this imbalance, we have witnessed more seller-friendly transactions, shorter days on market for listings, and unprecedented home price appreciation.
Historically Low-Interest Rate Environment (Through EOY 2021)
Stemming from COVID, the Fed opted to stimulate the US Economy and Financial Markets. Two areas, in particular, led to the rapid decline in mortgage rates: the Fed Fund Rate and purchasing of MBS Securities. Regarding the Fed Fund Rate, before COVID, the Federal Fund Rate ranged anywhere from 1.50% to 2.50%. In March of 2020, the rate was strategically cut down to 0.00-0.25%, which mirrored a similar tactic utilized during the ’07-’09 crisis. This decision was made to support spending and to lower the cost of capital to lending institutions nationwide (as of 2022, the Fed has begun raising the Fed Fund Rate via incremental increases in efforts to combat the inflationary environment we are in).
As for purchasing MBS Securities, to help maintain a strong housing market, the Fed also set out an initiative to purchase tremendous volumes of Agency MBS paper in the secondary market. In doing so, this also drastically reduced the cost of capital to originate mortgage loans (in 2021, the Fed tapered back the purchasing of Agency MBS securities, slowing increasing the cost of capital for lending institutions).
As the Fed put together initiatives to lower mortgage lenders’ cost of capital, this allowed for mortgage lenders to begin reducing interest rates for their customers, and as the market became more competitive, this led to what many considered a “race to the bottom.”
Home Price Appreciation (“HPA”)
In 2021, the median home value in the United States appreciated nearly 20% on average. For context, 2020 saw roughly 8.5% appreciation and 2019 roughly 4%. This is a direct result of an under-supplied housing market, as well as a historically low-interest-rate environment. This combination has given sellers immense power in transactions, allowing for bidding wars and continued price hikes across real estate nationwide.
Overall Economy
» Inflation // A direct result of the Fed’s aggressive fiscal response to the COVID pandemic, demand surged and as a result, we have seen a steady rise in inflation figures, with recent data supporting ~8.5%.
» Employment // As the United States continued recovering from COVID, employment figures continued to strengthen, supporting unemployment rates in the mid-3% range in the first parts of 2022.
» Nominal Wages // While watching inflation and employment, it is also important to keep a close eye on if wages are keeping up with the increased
cost of living. As of April 2022, nominal wages grew 5.6%. While that figure is high, it is nearly 3% less than the increased cost of living as seen via inflation.
Market Update
The Fed did exactly what it had to do following COVID, and that was to make decisions that stimulated the economy and prevent a crash. That said, we all know that for every action there is a reaction. And that reaction is what brings us to the present day, which is as of April 30, 2022. In a market where volatility feels normal, interest rates are rising rapidly, and questions loom about where housing is going over the next few years. Let’s start with the hot topic so far, interest rates.
Interest rates, as seen by many, have skyrocketed in the first part of 2022. This has been seen across both agency and non-agency mortgages in significant fashions, and while the interest rate increases were inevitable and expected, what has created some shock to the market is the speed in which these adjustments have occurred, particularly in the Non-QM and DSCR markets. Lenders within these two markets have been hit the hardest in 2022, particularly due to extremely heavy reliance on the securitization market (as compared to the conventional agency which has Fannie/Freddie).
While most Non-QM and DSCR lenders were preparing for incremental increases to interest rates, what was unexpected to many was the drastic reduction in appetite from investors in AAA-rated bonds. For context, most AAA-paper coming into 2022 was printing in the context of swaps + 80-90bps. Within a 30-day period, as the Fed rolled out rate hikes and investors began their search for yield, the price of those deals quickly widened out to swaps + 175-195bps. Otherwise said, lenders throughout both markets had to adjust to an unexpected 100-150bps, all of which occurred within a few weeks.
Couple that with the fluctuations seen in swaps/treasuries, and both markets quickly found themselves in one of the most volatile price discoveries seen since March of 2020. Additionally, as mortgage rates rose rapidly, sensitive variables which drive prices, such as prepayment speed and discount rate, began to fluctuate rapidly. In a historically low-rate environment, the expected prepay speed of a mortgage loan differs significantly from that of a higher rate environment, as borrowers are more likely to prepay at higher rates versus lower rates (ultimately impacting the modeling and price point of valuing a mortgage security).
As interest rates have risen and the Fed battles to stabilize inflation, it also has raised concerns regarding housing affordability. Home prices continue to rise, albeit at slightly lower levels than last year, due to the significant undersupply of homes throughout the US. Interest rates continue to rise, and inflation remains very real in our everyday lives. This means it is harder for citizens to afford to purchase a home.
And while purchase volume has picked up (primarily due to focus being taken away from refinances in a low-rate environment), it is becoming increasingly more apparent that affordability is becoming more of an issue to many. Why is this important? As affordability concerns strengthen daily, this inherently subsides housing demand. And as housing demand subsides, this allows supply to start catching up.
In April, it was reported that inventory was 12% lower YoY, which is the lowest decline since 2019. As these fundamentals continue to gain traction over the next 6-24 months, it is expected that we will see home price appreciation stabilized, reducing to levels more normalized with prior years pre-dating the COVID pandemic
Specialized short-term lending products, such as Construction, Rehab Lending, and Residential Transitional Lending (“RTL”), have remained very active during this time, but not unphased by the volatility seen. Supply chain disruption, most of which has stemmed from COVID, remains a problem for many builders getting materials needed to
complete projects in a short period.
Short-term interest rates such as LIBOR and SOFR have spiked, which is generally the benchmark rate tied to the financing of this paper throughout the space. The cost of goods has also skyrocketed, making it tougher to put projects together yielding returns similar to years prior. While these impacts have been seen, and prices have begun to rise, it remains a very bullish sector of the overall marketplace, as the US needs to solve undersupply, and construction financing is a very savvy strategy to address this need
Market Outlook
So, the biggest question amongst many is where do we go from here? Uncertainty and volatility continue to loom, so is there reason for concern? Well, much of that answer is to be seen in the near term. As the Fed continues to raise rates, the question becomes, “Is a recession looming?”
As long as rates increase, the answer to this is likely, yes. The goal, however, is to make that recession as small and non-impactful as possible to reset the market. There will continue to be price discovery in the secondary markets as investors search for yield and attempt to understand the Fed’s rate outlook over the next 6-12 months. As rates rise, home price appreciation will stabilize, but still appreciate due to the lack of supply. Affordability will taper mortgage activity as many American citizens will struggle to afford a home, and higher rates will de-incentivize refinance activity. This will lead to more rental housing opportunities, which can combat the increased costs with rent increases (2021 single family rental rates rose at a YoY increase of ~15%), and alternative rental strategies such as Airbnb and other short-duration rental strategies.
The credit and performance of housing remain very strong, as sound lending practices stemming from lessons learned from the ’07-’09 crisis continue to produce high-quality, well-leveraged loans. And while we have certainly seen more and more “low down payment alternatives,” home price appreciation continues to naturally inflate homeowner’s equity within a property, which is a great indicator of strong mortgage loan performance and sound housing fundamentals. In short, it is really hard to bet against the housing market with many of the strong fundamentals in place.
