Barron's Streetwise - House Prices Tick Lower. Don’t Count On a Crash

Episode Date: October 1, 2022

Real estate experts weigh in on mortgage rates, price trends, and home builder shares. Learn more about your ad choices. Visit megaphone.fm/adchoices

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then I think that stigma may start to lessen just because people don't know the difference. If it's a New England cottage with three beds, two baths, and it's the same energy rating as a site-built home, to me, I think people are more worried right now about the payment. Hello and welcome to the Barron Streetwise podcast. I'm Jack Howe, and the voice you just heard is Jay McCandless. He's an analyst at Wedbush Securities covering home builders, and he's talking here about manufactured homes,

why they could gain market share now, and which stocks could benefit. We'll hear from Jay about that, and from a pair of economists about whether the recent tick down in house prices from lofty levels foretells a bigger drop to come. to come. Listening in is our audio producer, Jackson. Hi, Jackson. Hi, Jack. Should I start with a 75-minute meander through UK monetary policy, or maybe just give two minutes of bullets on what a guilt is, G-I-L-T, and why everyone was talking about them this past week. I like a good meander, but I'd say go with the bullets.

Okay, fair enough. A guilt is a UK government bond. They're called that because the original certificates had guilted or gold-colored edges. Already fascinated, I know. This past week, gilt prices plunged, and yields spiked to the point where some maturities yielded more than comparable Greek and Italian debt. That's unusual to say the least.

The rise in yields froze the UK mortgage market. Even worse, the price plunge seemed to threaten to topple UK pension funds. So the central bank stepped in to buy gilts, prop up prices and hold down yields. That means that the UK is now having basically a monetary arm wrestling match with itself. It's raising some rates to fight inflation, and it's suppressing others to defend against the panic. And that matters for all investors in the U.S. and elsewhere, and not just because we might have narrowly averted a world financial crisis, or because the Federal

Reserve is raising rates too. The guilt panic seems tied to the new U.K. government's announcement that it would slash taxes without details on how it would pay for that. Bond investors weren't having it. They dumped gilts. Now, we just went through more than a decade where investors across the rich world didn't seem to care about budget deficits, which helped keep interest rates extraordinarily low or even negative and helped propel risky assets from

growth stocks to crypto higher. If investors now care about deficits, it could mean that the days of endless easy money are over and that even once the UK or US bring inflation down, yields and mortgage rates might not return to such low levels, and risky assets might not get back to quite the tailwind they formerly enjoyed. And that is my guilt rant. On to housing. Mortgage rates have shot higher, crimping affordability. You might have seen news reports this past week about dire price movements for U.S. houses. Interest for the search term real estate market crash has rocketed 284% in the U.S. during the

last month. One said that prices had fallen for the first time in a decade. Another said the market was cooling at its fastest pace on record. Those are technically true, but they sound worse than reality, maybe. Yes, the Kay Schiller price indexes had big reductions in their year-over-year growth rates, but from absurdly high levels to still quite high ones. For example, the index of 20 big markets had prices up 16.1% in July from a year earlier. The month before, the growth rate was 18.7%. So that's a decent size downshift, but no homeowner is going to boo over a 16% price run up and no house shopper is going to cheer. Likewise, the same index was down

sequentially from this past June to July, and it was the first decline in a decade for that particular index. But it was a small decline, a fraction of a percent. The reality is, if we look at that same index over the past two years, it's still up 39%. We've never seen prices climb that quickly. And now that mortgage rates have more than doubled from their lows, it raises the question of whether we're headed for a plunge. We're not there yet, but then again, house transactions can take two to three months to close. So the latest data we have is from July. Is it possible that prices are now plunging and we just don't have the numbers yet? I saw one forecaster yesterday say that median prices were going to be down 20% nationally next year. And I just think that's too severe. That's Jay McCandless, who covers

housing stocks for Wedbush Securities, and he does not predict a rapid decline for house prices. and he does not predict a rapid decline for house prices. Having lived through the GFC and my role as an analyst, back then we didn't have the millennials looking to get into household formation. We didn't have the Gen Zs trying to get into the workforce and into household formation. All we had were Gen Xers like me, which is a population that's 6 million less than the millennials. And we certainly didn't have the wherewithal to take down at the worst during the GFC, 4 million existing homes for sale versus the 1.3 million that we have for sale at this point. So from a fundamental backdrop,

we're in such a better position now. That doesn't rule out that we could see some price declines, but I think some of this doom and gloom, about 20% median declines, it seems a little too far afield for me, especially on a national basis. When Jay says GFC, he's referring to the global financial crisis that started when a housing bubble popped about 15 years ago and house prices plummeted. As Jay says, supply and demand look much more supportive for house prices now. He doesn't expect a significant national price decline this time around. Prices could fall in some of the more heated markets, he says, and we could return from skewed pandemic price movements to normal seasonal behavior.

Two years ago, three years ago, when we had normal seasonality, you would see prices typically move down sequentially from call it July to about November, just because the higher price, the bigger homes typically would sell in the summer. And then more of your median price, submedian price homes would trade hands during the colder months. I think that's what we're returning to now is more of that normal seasonality where prices are going to drift a little bit lower. I asked Jay if he would recommend to a friend or relative that they buy a house now if they were in the market. He said, yes, as long as they were a long-term buyer. He also said that although mortgage rates might not fall right away, the entire industry is hoping that recent rate volatility, both up and down at times, settles down soon. You look at mortgage rates yesterday, so what the 27th or 28th was yesterday, and you had at the start of the day mortgage rates were sitting, I think, just over 7%. They went up to 7.25% and then ended the day down at 6.58%. Well, if you look at that swing on a $300,000 mortgage, your payment went down $150 in the

space of a day. And so with that type of volatility that we've seen, everybody in the housing ecosystem wants mortgage rates to settle down. Let's come back to Jay in a moment about stocks. I want to share some other opinions about what's next for house prices. There's plenty at stake here, and not just for people who are looking to buy or sell soon. We've had Yale economist Robert Schiller on this podcast. He's one of the researchers the Case-Shiller Index is named for. Years ago, he and Carl Case were co-authors on a study of the link between asset prices and consumer spending. It found that changes in house prices were a far stronger

predictor of spending than changes in stock market value. So a sudden tumble in house prices would be terrible for the economy, although the flip side of that is that the run-up in prices and rates has been discouraging to say the least about those who are in the market. Lizanne Saunders, the chief investment strategist at Charles Schwab, recently shared this data point. If you shopped for a house at the beginning of 2021 and you could afford a 20% down payment and you wanted to keep principal and interest payments to $2,500 a month, you could

afford a $759,000 house. If you're shopping with those same parameters now, you're going to afford a $476,000 house. Real estate is, of course, highly local. There might be a good deal near you, even if the broader market looks expensive. Okay, so I asked Skylar Olson, the chief economist at Zillow, the housing data site, where she thinks house prices are headed. Like Jay at Wedbush,

she noted that recent mortgage rate volatility has contributed to buyers and sellers freezing up. We were seeing a really big slowdown and I think we will continue to see prices slow down into the winter. Our forecast absolutely has that being the case. We're currently seeing this dropping prices a little bit, right? And one of the ways to think about that is, you know, the typical home across the nation is maybe fifteen hundred down from where it was in June. So not a huge drop, especially if I think about like it's a hundred grand up from pre pandemic. Right. So it is a slight drop, but we do expect it to continue falling. And then the big question is, depending on what interest rates do, when will it turn around?

Because when interest rates came back down to five during August, we saw new home sales increase a lot. New home sales numbers were just out a couple of days ago and we saw August new home sales perk back up. So we know the demand is right there. We know it wants to move forward. It's very discouraged because of affordability. Volatility in mortgage rates has to come down and then prices will start correct. And then that will make, you know, ease affordability challenges, discourage buyers return. Skylar says that recently hot markets like Austin, Phoenix and Seattle could see more significant price drops. But on the whole, she thinks the market will fall a bit during winter, then come back next summer and end up a little over 1% higher a year from now, not adjusted for inflation.

Let's go to Lori Goodman. She's an economist who studies housing for a think tank called the Urban Institute, and she too says that recent price changes look seasonal to her, and that she's not convinced the prices will go negative year over year on a national level, even though she doesn't expect mortgage rates to come down right away. It's sort of interesting. When you look historically, what you find is that the relationship between interest rates, between changes in interest rates and changes in home prices, it's very, very weak, but it's positive. You have to sort of scratch your head for a second because you say, wait a second, higher interest rates, doesn't that cramp affordability? And wouldn't that make home prices decline? I mean, that would be the logical

thought process. But in fact, what you find historically is that the relationship is extremely weak and actually slightly positive. And the reason for that is periods of rising interest rates are both generally accompanied by a strong economy, rising wages, higher inflation. Lori says that putting aside the epic housing bust 15 years ago, house prices typically don't go negative in nominal terms. She thinks they might go flat for a while, which means they would only be falling in real terms or adjusted for inflation. Lori says that a housing supply shortage will help to hold up prices. I mean, we are definitely, definitely short housing supply relative to the number of households out there. We can argue about how short we are.

The lowest estimate I've seen is about a million. The highest is about five and a half million. But there is definitely a housing supply shortage and we have no viable way to mitigate that easily. Lori talked about why housing supply is so short. She mentioned factors like raw materials costs and a construction labor shortage. But she focused on two key factors that could have more lasting effects. One is that although the U.S. mortgage market is fairly efficient and liquid, it's surprisingly difficult to get a loan to renovate a fixer-upper. The denial rate on those loans is 38%, which is about triple the denial rate on typical mortgages. And renovation loans are going to become more important

as the housing stock grows even older and more homes become obsolete. If you assume the obsolescence rate is 0.4%, you wipe out 560,000 homes a year. And if you assume it's a half of 1%, you wipe out 700,000 homes a year. Again, in a world where last year we completed 1.34 million units. So obsolescence is actually going to be an increasing problem

in the years ahead. The median home in the United States was built in 1978. That means it turns 44 this year. Obsolescence is going to become an increasing issue, which means that preservation financing should be user-friendly and relatively easy to obtain. The other factor is zoning, which is a polite catch-all term for local lawmakers creating rules to discourage what they see as overbuilding or what they view as the wrong kind of building. In town after town, it can be spurred on by people thinking things like, we don't want a bunch of manufactured houses going up overnight and driving down our property values. But most people are too politically correct to say it exactly that way. What they will say is, well, I would obviously welcome this development. The problem is that we just don't have the infrastructure to support it. That's sort of the politically correct version of what you just said.

And that's what you hear over and over. Thank you, Lori and Skylar. More from Jay on stocks in a moment. Note that Morgan Stanley just revised its house price forecast downward this past week. It said its analysts expected to see month-over-month price declines beginning in September or maybe in August, but they were surprised to learn that they had already started in July. Previously, they expected a 3% price gain for U.S. houses next year. Now they predict a 3% price decline. We'll be back after this quick break. we could go surfing. Ah, love that. A redwood forest would be cool. I'm in. Ah, ski slopes.

Let's do it. Um, can a girl go shopping? Yeah, baby. Wait. Did we just invent California? Discover why California is the ultimate playground at visitcalifornia.com. Welcome back. welcome back jackson i know i rambled on too long about house prices but i'm gonna get through this stock part with the speed and stealth and efficiency of movement of a ninja that's kind

of hard to picture i'm a little heavy to be a ninja i grant. I don't have the throwing stars. Do you have the ninja suit? I've got L.L. Bean fleece thermals in all black. That's close enough. For stock buyers wondering whether concerns over the housing market have set up an opportunity in home builder shares, the answer is maybe. Prices there are down a lot this year. builder shares, the answer is maybe. Prices there are down a lot this year. Lennar stock has lost 35% so far this year. Pulte Group is down 32% and Toll Brothers is down 41%. Jay McCandless at Wedbush Securities recommends two approaches to this awkward period for home builders. The first is the focus on builders that are best able to deliver homes quickly. The builders who I think are moving to where the market is from a price perspective

and can get the home closed, get that buyer in faster, they're the ones who are probably selling more homes right now than a builder who says, hey, yes, would love to take your money and we'll deliver you a home in 10 months. It's just right now, people aren't willing to wait that long. Jay's favorites there are D.R. Horton, ticker DHI, Meritage Homes, MTH, and Century Communities, CCS. All of them have price to earnings ratios in single digits. Homebuilders trade cheaply because investors are worried about the market and also because earnings across the group are high. Many

builders are selling finished houses on land that has shot up in value since they bought it. Jay's second strategy is to think beyond traditional site-built houses when it comes to affordability and focus instead on what are called manufactured homes. That's a broad name for houses that are built in whole or in part in a factory and then moved on site. Mobile homes are a type of manufactured homes, so are prefab and modular homes. Jay uses the term HUD code home to refer to homes that meet government standards laid out back in 1976 and says there have been dramatic improvements in quality and appearance over the years, including just recently. The problem that you had back in the 70s, 60s and 70s was

the manufactured housing as an idea really took off, but you had very wide standards of quality. really took off, but you had very wide standards of quality. You had some houses that essentially were bowing out because they didn't build the walls with enough timber lumber in them to keep the weight of the roof from buckling the house. And so that was basically what the HUD code in the 70s was designed to address, that you have to build at least to these minimum standards so that the house is safe and that the house will last more than five years, 10 years. The homes that are being built right now, very energy efficient, much better from a design standpoint and from a curb appeal standpoint than I think even 10 or 15 years ago. That, along with the payment and the fact that the federal government is starting to look again at ways to introduce manufactured housing as part of the larger affordable housing problem that we have in this country. Very exciting time, I think, to be looking at this space.

As you heard at the top of this episode, it can be difficult today for the untrained eye to tell a manufactured home from a site-built home. The main appeal of a manufactured home is price. Jay did a recent analysis and found that the median U.S. rent is now $1,682. That's up 13% a year. An entry-level site-built house costs $2,100 a month. That's assuming that you live where you can get a house for $300,000 and the mortgage rates dip back to six and a half percent, and that you get a first-time homebuyer loan with a down payment of three and a half percent, or a little over $10,000. But Jay reckons that a typical HUD code home costs $125,000. If you add $25,000 for a modest piece of land in a rural area, the monthly payment might be just over $1,000, much cheaper than either renting or buying a site-built home. The typical buyer for a manufactured home, Jay says, is a blue-collar worker or retiree. There

are also companies that own land and buy these houses to create or upgrade rental parks. The typical location is what Jay calls the third ring away from the city, exurbs and rural areas. Year to date through July, manufactured home shipments were up 14%. Jay says the category could be poised to gain market share, both from rental park upgrades and from rural buyers choosing handsome manufactured homes over site-built ones. The two names he recommends favorably are Cavco Industries, ticker CVCO, and Skyline Champion, ticker SKY. Both trade at forward price-to-earnings ratios of under 10. Thank you Jay and Skyler and Lori, and thank all of you for listening.

Jackson Cantrell is our producer. Subscribe, rate, review, share, follow, or you can just play it cool and listen without doing any of that stuff. See you next week.