The Dividend Cafe - Housing Comes Center Stage

Episode Date: May 27, 2022

I really do not know how today’s Dividend Cafe is going to be received. I obviously believe in every word of what I have typed or I wouldn’t have typed them, yet I have found two things to be the case in my efforts at thought leadership in matters of markets and economics: (1) People sometimes do not like it when I veer off of a stock market focus, and (2) People do not like hearing what they do not want to hear The first one is more problematic when it comes to things like the bond market or public policy or monetary policy or alternative investing – the excitement of the stock market sometimes has to take a backseat to other matters that are absolutely integrally connected to it! But the second one is what I am worried about today. In over 20 years of professionally stewarding client assets, I have never seen investors be as emotional about any “asset class” as they are about housing. And if all that meant was “people are nostalgic and protective about where they live” – that would be one thing. But that is not what I mean. Opinions about the residential real estate market are, shall we say, sometimes laced with emotion, sometimes perhaps delusion, and often with various presuppositions that are hard for me to make sense of at times. Housing is back front and center in financial discussions, and all I want to do today in the Dividend Cafe is make sense of it, and give you some wisdom and insights that I believe will be useful in a holistic commentary of the day. So to that end, I work. We’ll still be friends if anything I say bothers you. Let’s jump into the Dividend Cafe for a special Housing edition … Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to another Dividend Cafe, kind of special edition this week as we get ready for the holiday weekend. I do hope you all have a nice Memorial Day weekend and get ready for the sort of launch of summer, if you will. We will not have a DC today on Monday because of the holiday, but then we'll be back in normal office mode and writing mode by Tuesday, which, of course, will also be the last day of the month of May. And we'll get ready to kick off June in the middle of next week. But with that said, I do think that this week's Dividend Cafe is sort of a fun one in the sense that I am so used to writing Dividend Cafe every week with a heavy center around financial markets,

macroeconomics, monetary policy. Obviously, the stock market fits into all of that front and center. And I'm purposely today devoted exclusively to the subject of the housing market. And I'm even going to get a little bit personal and kind of biographical to some degree. But I think this subject is going to become one of the major topics in financial press for the rest of the year and into next year. And I'm hoping that there can be a few nuggets of wisdom shared here today that will be useful to you and how you think about the housing market. Now, look, housing is not something that is going to be coming up or is starting to come up now for the first time. The mother of all bubbles that burst in 2008 had at its ground zero the U.S. residential housing market. And I think that

there is a tendency to always believe that the next crisis or problem is going to look like the last crisis or problem. And when people ask me what my outlook is on housing, it is uncanny how often they are contextualizing that question with some form of, will it be another 08? Are we looking at 08? How do we avoid what happened in 08 and so forth? And I'm pretty public about the fact that I'm quite pessimistic about this notion of housing prices going higher. And the much better way for me to say that is I'm optimistic because I believe housing prices desperately need to correct and will be good for the economy when they correct. But that's what the whole point

of this Dividend Cafe will be. So I'll hold on to the lead a little bit. I am of the opinion that a little background is in order when we talk about how we think about housing and some of the nuggets I want to share with you today. I bought my first house in 1997, and it was a little two-bedroom condo in Newport Beach. And I bought it for $165,000. And I sold it for $194,000 two years later and bought another condo for $242,500. And I sold that one two years later for $356,000. So in 2001, I had had two condos that I had both bought and sold, lived in each one. I used the equity money I'd made from the first into the second. And that second condo was what I lived in. I was a single guy. It had a full panoramic view of the ocean in Newport Beach. It was really a beautiful place. And I was reinventing from a career standpoint to some

degree that basically meant I was taking a 75% pay cut. I was a newlywed and I was really happy with the money I'd made in these condos and of the opinion, you know, what could go wrong. And throughout 2002, three, four, five, I was building out a business. I was doing fine. I was happily married. We didn't have our first kid yet. He came in 2005. But essentially, the thing that I never could have thought about in 2001 when I sold that second condo was what was about to happen. Because if I thought that the 20% gain in the first condo and the 40% gain in the second condo was bonkers, which I did. What happened next was really bonkers. And that condo I sold for $356, ended up selling for, I believe it was $749, like a couple of years after that. And we all know what kind of happened.

For those of you around the country, whatever happened in your market, I assure you, Orange County, California was even like another degree of just kind of craziness. But the analogy I want to make about this, I spent those years believing things were overcooked, overpriced, and they were. And particularly, there are people buying homes that I didn't understand relative to their income, didn't seem to make sense. And we, of course, now know the degree at which loan underwriting and no down payment and no verification of income and all the equity extraction for the financial crisis. That was a big part of what was happening. But all I knew is that something didn't make a lot of sense and didn't have the way to articulate or express it. We ended up buying a home when our first son was born. And then we bought the next home before our daughter was born. And that ended up being where we kind of like put a foundation in as a family. And Ray, you know, our second two

kids came home from the hospital, that home, we lived there for almost 10 years. And we've done a lot of other real estate things since. But my point being, there's two points I want to make. First, in those years of 2002 to 2006, it didn't matter if you were right when you were early. And the analogy I use is people have seen the movie, The Big Short, and we are familiar with the famous hedge funders like John Paulson or one of the ones in that movie, Michael Burry. You understand that these guys ended up making billions of dollars being right about housing being overpriced. But during 04, billions of dollars being right about housing being overpriced. But during 04, 05, 06, unlike me, where I was just not in the market saying something doesn't make sense,

these guys had to pay for being wrong. By taking a short position in a credit default swap, you have a collateral requirement. And they were not only having to deal with the sort of reputational risk of having an opinion that was not yet validated by fact. It was an expensive opinion not yet validated by fact to the tune of gazillions of dollars having to be paid out to basically finance their part of the swap transaction. And yet, you know, eventually kind of ended up being right and all that. Well, the second thing I guess I'd say is I believe one's primary residence is an asset in technicality. It sits on their balance sheet. For many people, and I would argue too many people, it might be their biggest asset,

and I would argue too many people, it might be their biggest asset. But to the degree that we are talking about the monetization, the cash flow, selling it, making money, getting income, things like that that are tangible and real in a financial and practical sense, it's pretty immaterial. I don't really know the house that we lived in from 2007 to 2015, what at the low point it would have sold for, because I never thought about it once. Now, first of all, I have a pretty good excuse. During the financial crisis, I was really not focused on my home. First of all, I could afford it. I had equity. I was gainfully employed. But second of all, I was focused on my client's situation, their stock portfolios, their real estate portfolios, the existential future of the firm I worked at at the time at Morgan Stanley. So that was a bigger issue for me just because of what I happen to do professionally.

But also, I believe one's house is a home. And where they raise their kids, where they make memories, where they spend Christmas morning, those things that are where you live are separated, in my mind psychologically, from the balance sheet. And if one can afford the home and has no intention of selling the home in any kind of imminence, I have never understood why people care. And that means two things, why they worry about it being lower than some other fictitious point, but also why they get excited about it being higher at some fictitious point. Unless they're planning to sell, it is a totally immaterial thing in any practical and logistical sense. So when I say right now, I believe housing prices are overcooked and the data is all pointing to a correction, and I'll explain why and how in a moment. And let's say it's only 10%. Let's say

it's as much as 20. I think it's somewhere in that range, but I don't know for sure. I don't know exactly when, I don't know exactly how much. But I also don't know why anybody would care if they can afford the home, if they're planning to stay in the home. I think that this is deeply overwrought. But I'm saying more than that, too. I'm not just saying, so don't worry about this negative. I am saying it is a positive. so don't worry about this negative. I am saying it is a positive.

Right now, the average new home buyer is having to spend 50% of their monthly after-tax income to service the price of a new home. That's preposterous. It is so out of step with historical averages and is commanding such a high percentage of their free cash flow that should be available for other spending, other saving, other investing, other projects, whatever the case may be, that economically it's doing more harm than good. Regardless of the social cost, which I happen to care about, how many young professionals it's keeping from being able to buy a home, how much it's hurting lower paid people that have to pay such an astronomically high amount of their income towards rent and mortgage obligation. I think it's overpriced. And the reason that it got to be that way is the supply, demand, and balance. A lot of people want a home. There are right now, we're living through, just as post-crisis, we went to extended period of a lot of younger millennials that were getting married much later. You had much less household formation. People are having less kids and waiting longer to have kids. All those demographic facts, I just shared four of them. They're the fundamental story. But then you had very little incentive for home builders to build at the volume that was needed

because they had gotten their you know what handed to them in the financial crisis. So then everyone was gun shy. So then the pendulum swung the other way and we didn't build enough new homes. At the same time that then now coming out of this period, all of a sudden, a lot of those people who used to be 26 and not buying a home are now 36 and ready to buy a home. But guess what? There's one little problem. It costs double what they thought it would. And these are not low paid people or unemployed people or underpaid people. They have a good job, good living.

They can't afford to buy a home. So what will cure that? good living. They can't afford to buy a home. So what will cure that? Are they going to go make 40% more money or are the prices going to correct? The cure for high prices has always been high prices. This is a basic law of economics at the fulcrum of supply and demand. But then you have to add to it the key variable is cost of capital. It is a leveraged finance instrument. People borrow generally to buy their homes. And so right now, when the cost of capital went from the lowest in history in the 2.5% to 3% range, and now it's back up higher than it was pre-COVID to 5% to 5.5%,

you have fundamentally altered the economics of home ownership. Well, I don't need to borrow to buy a home. I'm paying cash. That's fine. However, for the person buying a home with all cash, they are still subject to the market market dynamics. And there is still a center point of how prices are set that revolves around the mean. And that reversion to the mean is all I'm forecasting. There's a particular percentage of monthly income that is more reasonable and traditional and acceptable. And we're not at it. And we're going to get to it. Because all of these things are mean reversionary. And ultimately, if I could tell you exactly what that number would be, and when it would happen, and you're about to buy your first home, then maybe you could save a few bucks to wait it out. And I tell you, we're going to hit

that new bottom in August of 2024, or something like that. But I can't do that. Nobody can, not even close. And even if someone could, if they had a crystal ball, that crystal ball would only be good in their zip code. Because my forecast of what happens in Phoenix is different than what will happen in, say, Chicago, San Francisco. On one hand, Phoenix, you say, look, the Sunbelt is one of the most desirable places right now in the country. More people want to go there. There is not enough housing stock to meet demand. And a lot of people like some of the tax and regulatory and job environments, those sunny weather and the enhanced cultural opportunities. It's a wonderful place to live. My wife and I have always loved Scottsdale. Here's the fact of the matter. It's also grown at massive 30% per year home price appreciation. So in Phoenix and a market like that in certain Florida cities and so forth, you have great demand fundamentals. And you also have to figure out how prices recalibrate to what's already been big home price appreciation. I don't know how that plays out,

but I do know that Phoenix's dynamic is going to be different than other cities. And that's just the example I'm choosing to use. People say housing went national during the financial crisis, and it did go more national in the financial crisis than it generally does. But here's the thing. Houses were down 70% in Reno, Nevada. They were down 50% in the Inland Empire of Southern California. They were down 6% in Dallas, Texas. That's not that national. Where places had non-recourse financing, it was very different than places that had different underwriting culture. And then, of course, where there's a lot of job creation is different than places where there was a lot of job migration. And by the way, some of that was self-fulfilling prophecy. A lot of job migration that was affecting real estate was in the jobs of real estate. And so you got a negative feedback

loop that really hurt property development in Las Vegas or in Southern California, which was really real estate, mortgage driven, things like that. So right now, my belief is that the economy is going to benefit from a housing correction and that we are going to be inundated with doom and gloom talk about housing correcting. That the housing market will correct simply because it has to from an affordability standpoint. There are not enough people who can afford to buy the homes being built, ergo prices have to come down. I don't think that means a crash. The 50% drops of 2008 were specific to the credit environment.

There was very little equity in the system. I believe people should not buy a home without equity. And now I'm in a very different financial position than I was 20 years ago. We like to buy homes entirely home or grandkids want to buy a first home or maybe you're younger and we're trying to make those decisions. My point is it can't be timed perfectly. One's primary residence is a place to be a home, not a trading card. And to the degree one is price sensitive, I think prices will be lower. Inventory will be higher. And yet at the same time, the interest rates are higher than they were a couple of years ago. Interest rates don't have to keep going higher for prices to correct. That dynamic just has to get settled and cleared into the market. The cost of capital is basically about double what it was

a year ago. That's a big deal. And so I hope that we end up building more supply and that that helps prices come down. We need it. But the fact of the matter is that when we now speak about housing, you're going to hear people talk about, oh my gosh, house prices are coming lower. And I would say, why would you think of that as a negative if you're not looking to go sell, flip, trade homes? That you're going to maybe help your kid or grandkid get into a home, it's going to be a lower price. Maybe you're a young professional and you're going to buy a home, it's going to be a lower price. Maybe you're going to be able to have a house now that your cost of monthly servicing is going to be 10, 20% lower than it's been.

You have more money available for the really important things in life like dinner. You follow what I'm saying? This is a silly economic argument. What is more meaningful into the macroeconomic health of the economy? the mark to market fictitious asset on the balance sheet or the real life cash flows on somebody's P&L, someone's actual income statement. The latter is night and day more meaningful into the economy. So other than people's bragging rights or social strata or whatever else that I've never understood why people care about. It isn't material. There will be some price movements and it will be healthy. To think about this getting worse is

not to think about it going down 20. It's to think about it going up 20. That to me exacerbates even more social strain more divide more cultural tensions and ultimately will also end with some form of a bubble bursting so uh i hope this is helpful i could go on and on i have two different charts inend Cafe this week on the average monthly payment versus historical averages and where we are now and the bubble-like conditions of how much that average monthly servicing cost has blown out. And then another chart on the actual cost of capital and what kind of the basic reasoning is behind my belief that housing prices will start to moderate down. I hope this is helpful. Love sharing some of this with you and reach out if you have any questions at all. Let's get you back into your Memorial Day weekend. Enjoy your friends and family and barbecues and pools and warm weather and sports and whatever it is you're doing.

Enjoy those in your home. That's what the house is for. Thanks for listening to and watching it is you're doing. Enjoy those in your home. That's what the house is for. Thanks for listening to and watching The Dividend Cafe. IBC with Hightower Advisors LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC. This is not an offer to buy or sell securities. No investment process is free of risk. There is no guarantee that the investment process or investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors.

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