Higher anxiety

This whole recession business may not be a lot of fun, but it isn’t complicated. COVID blew big holes in both supply and demand. Demand bounced back and then some, fueled by $3.7 trillion in “excess” savings built up during the pandemic.

Supply was bound to take longer, and now recovery alone isn’t enough. Not only do we need more capacity, distribution channels need to be reworked to accommodate a shifting geopolitical landscape plus COVID-driven e-commerce growth.

When supply can’t keep up with demand, the result is inflation. The Consumer Price Index was up 9.1% in June, its highest YoY increase in 40 years. The Federal Reserve is doing its best to pop the bubble gently, but Powell & Co. are up against a formidable force that is bound and determined to push the U.S. into a recession.

That’s right: us.

“Doomsday forecasts coupled with nearly four-decade high inflation have many consumers feeling pessimistic,” notes Fortune in a recent interview with economist Robert Shiller. “As consumers, investors, and companies prepare for the worst and slow down their spending,” Shiller thinks we’re talking ourselves into a recession.

From economists like NYU’s Noriel Roubini (the Dow Jones will fall 50%) and Cambridge’s Mohamed El-Erian (stagflation is upon us) to experts like Elon Musk (recession is inevitable) and rapper Cardi B (we’re already in a recession but “they” are hiding it from you), everyone is on the doomsday bandwagon these days.It’s no wonder a recent Economist/YouGov poll found that 55% of Americans think we’re already in recession

Just for the record, we are not. It takes two consecutive quarters of negative GDP growth to make a recession. So far we’ve only got one: a 1.6% decline in Q1 2022.

But don’t worry—we’ll know for sure in two weeks. Q2 GDP data will be out at the end of July.

Some economists still argue that recession is not a foregone conclusion. They point to the fact that we added a healthy 372,000 new jobs in June, and say the only way that could happen in a recession is if productivity is falling.

Oh, wait. Nonfarm output fell 7.3% in Q1 2022, “the largest decline in quarterly productivity since the third quarter of 1947,” says BLS.

The good news is that a 2008-style meltdown is apparently not in the cards. The average FICO score among all home buyers is 754; even first-time buyers are at 746. Household balance sheets are stronger than they’ve ever been. Banks are well-capitalized and in good position to weather a downturn, says Fitch Ratings. 

If we do slip into recession, the consensus is that it’s likely to be mild. The flip side is that it may drag on for a while. “Elevated inflation may hold the Federal Reserve back from rushing to reverse the downturn,” opines Bloomberg.

So how do you prevent that? Housing costs are the largest single category in the basket of goods and services that make up the Consumer Price Index—40% of core CPI (which excludes food and energy) and nearly one-third of total CPI. If you want to kill inflation, hosing down the red-hot housing market will be at the top of your to-do list.

And there is no question that we are red-hot right now. In the 1980s and 90s, the median home price-to-income ratio was rock-steady at just north of 3.0x. It rose during the 2003-06 bubble, then fell almost back to normal in the 2008-09 crash.

The ratio floated up again during the 2010s due to a perennial shortage of for-sale inventory caused in part by anemic production. Annualized housing starts never topped 1.5 million until Dec 2019, a full decade after the Great Recession. Three months later, the pandemic blew it all up.

Since then, the price-to-income ratio has skyrocketed. According to the Harvard Joint Center for Housing Studies, the ratio hit an all-time record high 5.3x in 2021, an increase of over 29% in just two years.

Freddie Mac says it’s partly our own fault. Our inability to ramp up production fast enough to meet demand made the market more vulnerable to a knockout punch.  There is probably some truth in that, but overall, the housing industry’s challenges are a sideshow.

The post-pandemic supply chain fiasco drove lumber prices sky-high last year, but the run-up was short-lived. Plus, framing only makes up 8% to 9% of permit value under normal conditions. Even at double the normal price, the impact on the total cost of construction would be less than 15%.

Builders grouse that inflated land costs have kept them from picking up the pace. A Harvard Joint Center analysis found that from 2012-19, developed lot prices rose less than CPI-U in over half of the 509 metro areas studied—and actually declined in 148 markets.

That’s not to say there are no badly inflated markets, but it’s a local issue. Among the 100 metros that saw the greatest increases, 83 are either west of the Rockies or in Florida. Everyone wants to live in Boise or Sarasota; that’s not builders’ fault.

For nearly a decade, the No. 1 barrier to housing production has been the cost and availability of trade labor, especially in framing. It’s true that the median hourly wage for production workers employed by framing subs rose 15.7% from 2018 to 2021.

But the total single-family square footage completed rose 10.6% during that period even though the number of employed framers fell 3.1%. That’s a 14.1% productivity increase that almost fully offsets the impact of rising wages.

Most analysts agree that the real culprits behind home price inflation were rock-bottom mortgage rates, a pandemic-induced spike in demand for suburban single-family homes, and a surge in demand from Millennials entering their peak home-buying years. But recently another perpetrator has come into the crosshairs.

“Hesitation to name investors as one of the pillars of the Pandemic Housing Boom is no longer necessary,” reports Fortune. “It’s now abundantly clear that investors did help accelerate the housing boom and drive up U.S. home prices.”

When the post-pandemic boom began in mid-2020, investors “flooded the U.S. housing market,” says Fortune. “Home flippers returned with vengeance,” along with mom-and-pop landlords, Airbnb hosts—and, increasingly, equity-backed single-family rental (SFR) corporations like Blackstone and Invitation Homes. 

SFR investors have always been in the housing market, of course. The National Rental Home Council (NRHC) says they currently own one-third of the single-family homes in the U.S.

They’re scary to anyone who needs a mortgage because they’re cash buyers. But that’s always been the case, too. The part that has people concerned is that they’re gobbling up market share.

According to the Harvard Joint Center for Housing Studies, SFR investors’ share of total home purchases averaged 16% from 2017 to 2019, then edged up to 19% in 2020. Last year their share jumped to 28% overall, including 29% of homes sold in the bottom third price tier. The effect, says the Joint Center, has been that “investors have reduced the already limited supply available to potential owner-occupants, particularly first-time and moderate-income buyers.”

Equity-backed SFR corporations are of particular concern since their cash reserves are so deep. Axios thinks they’re “hogging American homes,” and their appetite for homes in popular Sunbelt markets—which have seen the biggest price hikes—gives them an outsized impact. Moreover, equity-backed SFR firms are now in the new construction market. In Q4 2021, built-for-rent or BFR (or sometimes built-to-rent or B2R) homes made up “26% of properties added to the portfolios of single-family rental home providers, compared with just 3% in the third quarter of 2019,” reports Professional Builder.

Worried yet? Freddie Mac thinks we all need to chill out.

By its estimates, equity-backed corporate investors own just 4% of single-family homes, and “even that overstates their impact.” Some of them are iBuyers who buy homes online sight unseen, then flip them. Unlike SFR companies, iBuyers “are not decreasing the supply of homes available for purchase,” says Freddie Mac.

Equity-backed SFR investors apparently aren’t big enough to be the villain in this drama. But you can make a case that investors make home price inflation worse—and that they may make it more difficult for the Fed to tame inflation. Rental housing costs also go into CPI, and rents are skyrocketing—up 14.1% YoY as of June, says Redfin. By cutting buyers out of the purchase market, higher interest rates will tend to fuel demand for rentals. That may help push rents up further.

Redfin says the number of homes purchased by investors fell sharply from Q3 2021 to Q2 2022, from 93,260 to 77,829. They aren’t going away, though. They just hit the pause button, “hoping prices will drop so they can get better deals.”

That’s probably a safe bet. Assuming a recession is coming, Moody’s Analytics thinks we’ll see “a 5% decline in national home prices and a 15% to 20% decline in significantly overvalued regional housing markets.”

Likewise, BFR investors are licking their chops, “betting that lower demand from consumers will lead builders to offer discounts,” says Bloomberg. That looks like a safe bet, too. Up to this point, builders have been killing it when they sell subdivisions to BFR firms, sometimes doubling their normal profit. “It’s a buyer looking for an income stream,” says Bill Wheat, D.R. Horton’s CFO. “It’s not a family stretching to qualify for a mortgage for their home, so you can certainly underwrite to a higher valuation on land for single-family rental.”

That will probably change. Analysts expect builders to pursue BFR investors more aggressively as the owner-occupant market dries up, and more competition would help balance the market out.

That may mean more price pressure on suppliers, but it doesn’t have a huge impact—someone’s going to sell the materials no matter who buys the homes. A sustained shift toward BFR may also tilt the scales slightly in favor of offsite construction.

Right now offsite doesn’t make economic sense for most single-family projects; the engineering costs offset the efficiencies. But speed is critical when you’re building income-producing homes. Fewer unique designs would minimize engineering costs and make offsite more competitive.

Whether BFR investors will be willing to make that sacrifice is an open question. As supply comes back into balance with demand, the rental market will become more competitive. Investors who skimp on marketability to save money may find that it comes back to bite them when demand softens.

Moreover, observers say SFR investors in general are already struggling to get the returns they need. Plus, three out of four single-family tenants say they plan to buy a home just as soon as they’re in position to do so.

It’s possible that the much-lauded SFR movement will turn out to have a shelf life. If so, the housing market could look very different by the time the next recession is in the rearview mirror.

Over the past 20 years, private equity has become a major force in every corner of the world economy. Housing was never a sector of choice. Investors set their sights on housing only after more popular sectors had become so hot that bargains were impossible to find.

There are healthy returns to be had in housing and its supply chain if you adhere to the original concept behind LBOs: Buy assets that are undervalued because they’re underperformers, get them back on their feet, then flip them or turn them into an ongoing revenue stream.

That’s actually a valuable service for the industry, too. Every LBM dealer will tell you that the worst competitor is a poorly-managed one. PE firms that improve the competition benefit everyone. The problem these days is that not all portfolio managers do that. The PE industry is so red-hot that buyout multiples have been rising much like home prices, from roughly eight times EBITDA ten years ago to 12.3x last year, according to Bain & Company’s Global Private Equity Report 2022.

Between 2016 and 2021, over half of the value generated by exit events came from inflation in buyout multiples, not revenue growth or profit improvement. “Buyout investors on average have actually become less adept at improving the performance of their portfolio companies,” says Bain.

Returns based solely on multiple inflation obviously aren’t sustainable—bubbles always pop at some point. When it does, institutional investors will presumably realize that the private equity portion of their portfolios would benefit from closer scrutiny.

The storyline that originally attracted them to housing was that a combination of demographics (Millennials are the largest generational cohort in U.S. history) plus anemic production in the wake of the Great Recession had left us so far underbuilt that the only possible outcome seemed to be the biggest housing boom in history.

Some analysts estimate that we need anywhere from 2,000,000 to over 6,000,00 new units just to catch up with the population. The underlying premise is that there is a “normal” ratio of housing starts to population or households, and we’ll revert to the mean as soon as we get a few obstacles (i.e., land and labor) out of the way.

Turns out that the norm may not be a fixed number. Since the 21st century began, the ratio of housing starts to population has been barely half of what it was between 1946 and 1970.

No one can say for sure, but there is a case to be made that the ratio we saw in the 1950s and 60s will never return. The post-World War II era was a unique period in history for multiple reasons. Even the Baby Boom surge of the 1970s was a one-off in that it rode the coattails of the postwar years.

At this point, population growth itself is petering out. In 1960, the U.S. population was growing at a rate of 1.69% per year. By 2020 the growth rate was down nearly two-thirds, to 0.59%. By 2050 it is projected to fall by half again, to 0.32% per year.

The chances that immigration will pick up the slack are also slim. According to the Harvard Joint Center, net immigration fell by half between 2016 and 2019, then fell another 50% during the pandemic.

Household growth was stronger than expected during the five years leading up to the pandemic, but according to the Joint Center, we were just backfilling. “Much of the jump is among Millennials that had delayed living on their own while in their 20s and 30s.”

On top of everything else, Americans are doubling up. The Pew Research Center says that in the 2010s, the number of people per household in the U.S. rose “for the first time in over 160 years.” That directly reduces the need for housing units.

For years, the rule of thumb has been that it takes 1.5 to 1.6 million housing starts per year to cover population growth plus teardowns and units taken out of service. Some analysts believe 1.3 to 1.4 million starts per year will be plenty to cover our needs over the next decade, and probably beyond that.

That might make you wonder: If the housing boom of a lifetime is no longer in the cards, will that affect PE firms’ enthusiasm for housing-related investments?

Those that are committed to (and capable of) finding and polishing diamonds in the rough probably won’t blink, and that’s fine. They’ll continue to earn healthy returns and they’re doing the channel a service.

Those that are simply riding the wave of an overheated M&A boom might decide to move on, though. Housing is a mature, low-tech industry. Depending on your point of view, we either (a) are highly resistant to change or (b) have our feet planted too firmly on the ground to fall for technobabble.

One way or another, anyone who isn’t willing to roll up their sleeves can probably find greener pastures elsewhere.