Blue Pebble Market Insights - January 2023
The Year Ahead
The Skim:
Welcome to 2023
Demand Continues to Slow
Supply Building Slowly
Last year was all about the Fed – How quickly will they raise rates? What is the terminal rate? How will quantitative tightening affect the mortgage market? While some of the answers to these questions are more certain than several months ago, the true impact of the Fed’s moves won’t be known until later this year. The Fed is driving the car by looking in the rearview mirror and steering with a 6-month lag on the wheel. On the micro side, earnings season is kicking off for major, US corporations, and there will be a lot of news about pending job cuts and corporate budgets for 2023. So far, the residential real estate market has shown resilience in the face of the Fed’s tightening, and we expect that trend to continue.
Welcome to 2023
This year will be defined by a transition to the “new normal.” The initial shock of the interest rate increases was digested by the market last year, and it appears the train hasn’t fallen off the track, yet. However, the real estate market is shifting in several ways as a result of the Fed’s actions:
Less Demand – the price a buyer can afford to pay for a home is based on a set of mathematical equations that balance the buyer’s ability to pay the mortgage with their income. As a result, prices are directly proportional to the buyer pool’s income level and inversely related to interest rates (as rates go up, the cost of a mortgage goes up, and affordability goes down). Even though wages across the country are going higher on the order of 5-7% per annum, the cost of a mortgage increased 25-40%. It’s not surprising that macroeconomists are predicting a peak-to-trough price decline of 25-30% in order to adjust the cost of ownership to more affordable levels.
Less Supply – there is a whole generation of homeowners who refinanced prior to 2023 and are locked into their mortgages at low 3% mortgage rates. A material number of these refinanced homes are owned by retired Baby Boomers (or those with generally lower income levels) and will generally not be able to qualify to buy another home at prevailing rates. Homes owned by these Baby Boomers won’t transact for 20-30 years.
On the capital markets side, we’re in a really, really weird spot. Money supply (both M0 and M2) peaked in the first half of 2022, and it’s hard to see how corporate earnings continue to increase in that environment. Additionally, unlike the Fed’s behavior in the early 90’s, 2000’s, and pre-financial crisis, when liquidity was aggressively put into the market as the economy started to turn, this time is different. ISM New Orders data was recessionary for six out of the last seven months of the year which is not a good sign for corporate demand going forward. It seems the plentiful cash reserves built up by consumers during the pandemic are proving a cushion against inflation and less demand — it will be interesting to see how long that holds up.
The most important determinant of the housing market’s health during this slowdown will be the unemployment rate. Our team is holding a thesis that it will be possible to experience a corporate earnings recession without a broad, labor market dislocation. That situation would be constructive for residential assets. Once someone buys a home, it’s typically a life event like the loss of a job, transfer, or another life event that “forces” them out; with rents at sky-high levels and a whole generation of homeowners financed at 3% or less, it will take a huge dislocation to really cause an excess supply in the housing market. (For anyone who wants to chat about the commercial market, we don’t think that’s nearly as safe. There are a number of assets that will need to be recapitalized in a higher interest rate environment without great operating metrics, and that will cause some pain across commercial sponsors.)
Demand Continues to Slow
Let’s check our trusty table summarizing real estate market activity in the area surrounded by a circle with a 10-mile radius around Union Station in downtown Denver:
All data taken from REColorado Jan. 10-15, 2023
The same themes from 2022 are continuing in 2023. Even though new supply is hitting the market slower than the year prior, demand is down even more, and the combination of these factors is allowing active supply to build. The most direct evidence of this situation can be found in the AVG DOM (Days on Market) over the last six months. Each month since the summer has seen a slight increase in the time that listings are on the market versus a year prior.
I’ve also included a comp line of current conditions to the market data in December 2019. You might recall during the height of COVID when active supply was 80% less than 2019 levels and it’s clear the stress from that environment has gone away now that there are only 20% fewer listings. Additionally, Pending activity is starting to slow faster than new supply, and this gives us confidence that supply will continue to build over the next few months. With all this being said, it’s still extremely important to remember that our metrics are nominal and *not* per capita. Since 2019, the population in our market area has increased significantly, so these metrics show a much bigger slowdown in the market when normalized across the population.
Supply Building Slowly
There is a structural shift to lower supply occurring in the residential real estate market that will lead to a high plateau in prices. Baby Boomers were planning on “aging in place” prior to the pandemic, and now that rates are causing the cost of ownership to skyrocket, there is significantly less incentive for them to move. We have to assume that there will be fewer listings and that will create a buffer to any major price correction driven by macroeconomic factors.
Another consideration that I had in the last few weeks was there will be less supply as a result of all the activity from the last two years. Here’s an article that suggests 8% of all homes bought last year are already underwater, i.e. have a negative equity balance, and that nearly 40% have less than 10% equity. If you assume these buyers were likely maxed out to get these homes, and that it will take a few years for home prices to get back to peak levels, then those who bought and are underwater are also going to hold off on selling as long as possible.
Unlike the market shift in 2007, there is no “excess supply” and builders will not be forced to firesale homes or lots. The number of specs on the market is significantly lower than 15 years ago, and national home builders are much better capitalized (and structured) heading into this recession. Our opinion is that 2023 will be a great opportunity to buy a home, and that opportunity likely starts to fade as we get into 2024/2025.
