The Housing Puzzle: Putting the Pieces Together

By Fred Matera, CIO, Redwood Trust

A lack of affordability will lead to near-term weakness, but a severe shortage provides a strong foundation for investors.

More new households will choose to rent as the market is creating an increasing array of living alternatives, and more renters will stay renters for longer.

In the bigger picture, the housing affordability crisis exposes societal issues that need to be solved.

It is estimated that 40% of homeless people have jobs, meaning over 200,000 working people are not able to afford their own shelter and are living on the streets. It is difficult to assess exactly how much housing we are short, but most estimate that America is undersupplied by between 4mm and 6mm units, inclusive of both single family and multifamily.

The lack of supply has fed the affordability crisis, where housing has reached record levels of unaffordability, even before the Fed threw gasoline on the problem by raising interest rates by 400bps in less than a year. This crisis is wreaking havoc demographically, as the National Association of Realtors (NAR) reports that the average age of first-time home buyers has climbed to 36yrs old, from 33yrs old last year, and is as high as 56 years of age for repeat home buyers. Also according to NAR, and this is not a typo: 88% of first-time home buyers were white and only 3% were black. (1)

Since the start of the pandemic, home prices have risen some 40%. This has driven down the average loan-to-value (LTV) on residential housing to approximately 30%, about the same level it was in 1960. This morning, Bloomberg reported that 48.5% of homeowners have an LTV of 50% or less, this is up from 39.5% a year ago. (2) In spite of expanded credit lending programs, underwriting on home loans remains conservative.

This is also true in the single-family rental space, where loans are generally underwritten to existing, “in-place” rents, while expenses are assumed to ramp up. LTVs on new loans are as low as they have ever been. Housing credit by most measures is as strong as it’s ever been. Existing homeowners have locked in 30yr funding at rates lower now than where the US Treasury can borrow money. Housing is in strong fundamental shape.

Affordability Shock

But this strength is a double-edged sword. Housing has come really far, really fast -and it just ran into a wall of monetary policy. Let’s look at some numbers: A year ago, the monthly payment on a $350k loan for a home purchased for $500k would be approximately $1,475, assuming a 3% 30yr mortgage rate. Today that same mortgage payment, with a new 30yr rate of say 7% as I type (better type fast!) is now $2,328 per month. The home price would have to fall from $500k to roughly $370k, or down 26% for the monthly payment to be back down to where it was before rates went up from 3% to 7% in this example.

Should home prices therefore adjust lower to the “down 26%” or so implied by the above example? It really depends upon the extent of distressed selling. The fact that existing homeowners have locked in low rates and have substantial equity built up suggests that we will not see the distressed selling necessary to drive housing down to those theoretical breakeven levels, certainly not on a widespread or national level. The situation today is vastly different than it was leading up to the Great Financial Crisis, when homeowners had little to no equity, were largely paying floating rate mortgages, and the housing market was oversupplied.

Now, if home prices do gap lower to those theoretical “break even” levels, they would likely do so on low transaction volume and are unlikely to stay down that low for long. For example, in some markets where short term holders like I-buyers predominate, we might see opportunities for distressed purchases, but I think that would be fleeting due to the fundamental supply imbalance and underlying pent-up demand. The inverted yield curve which by definition implies lower forward interest rates (and therefore lower mortgage rates) supports this argument for a temporary hit to home prices.

Right now, according to data from the St Louis Fed, falling transaction volume is driving up the ratio of new houses for sale vs existing monthly home sales to 8 months, from below 6 months earlier in the year. Generally, markets with more than 6 months of inventory are no longer considered “tight”. The bottom line: its all about the Fed. The planet is trading like its massively long duration, and home prices like most asset classes are going to continue to be highly correlated to the direction of interest rates.

Renting

A likely result of the affordability crisis, with lower existing home turnover will be that household formation will fall and that more people will become renters. The affordability crisis lends support to the single-family rental and multifamily markets. Rents have been strong post pandemic but have lagged home price increases and have certainly lagged the monthly mortgage increase during 2022.

In the above example, mortgage “rent” is up 57% this year, while actual rents are up 24% since the pandemic according to Zillow, and up high single digits in the last year.
In the example above, a year ago putting $150k down on a $500k home left you with a $1,475 monthly payment.

Considering you could earn zero on your cash, putting that money down for a house was a great idea. Today, not only has that payment gone up substantially, but by putting that money down on the house, you are foregoing 4% interest you could earn by investing it in Treasuries. Your payment is up by $853 per month, but you also are foregoing another $500 a month you could be earning on your cash. That money could help offset part of a rental payment. A year ago, with short rates close to zero, that was not the case. Renting has become so much more attractive and less expensive on a monthly carry basis for new households.

New Sources of Capital

The Single-Family Rental (SFR) business was created out of the Great Financial Crisis, when there was a void of capital for housing, when home ownership had dropped to all-time lows and household formation was plummeting. While the industry has been since criticized by some for helping to push housing prices up, the SFR industry is now poised to provide important stability, and help provide badly needed rental units and a wider array of choices for families. Note that in the past, the housing choice mostly came down to buying a home or renting an apartment.

Multifamily vs single family. This industry now provides rental choice for families who want more space, more privacy-the feeling of a home. People who want to live in houses but can’t afford to buy, don’t want to buy, or want to delay purchase represent a big market, and the Build-for-Rent-Business (BFR) is emerging to address this need. More rental alternatives like BFR provide consumers more choices and will lead to increased market share for renting vs owning.

Workforce Housing

Workforce housing can be considered broadly as housing for middle income professionals located within or near the communities in which they work -can be rented or owned, and often in the $100k to $400k price range.(3) This is the type of housing in which there is the greatest need, and the type of homes the market has had trouble supplying. In addition to supply chain issues and labor costs, fixed costs as a % of total are often higher for smaller homes as expenses like permits, appliances, kitchens and HVAC are quasi fixed costs that push up price/sqft. Zoning is also often an obstacle for bringing workforce housing closer to infill areas.

The result is that smaller, workforce homes often cost more per square foot than more medium to larger homes (putting custom, luxury homes aside). We believe that the SFR and BFR businesses are in the early stages of their growth as they are largely focused on these markets, creating rental and housing supply in a price segment that is underserved.

Volatility and Investment Opportunities

The period of 2010 through December of 2021 was one in which policy makers by design suppressed interest rate volatility to encourage risk taking. Global markets obliged by selling volatility through pretty much every means possible: from UK pensions funds getting long futures and swaps to lever their returns, to high yield bonds, to crypto, to watches, to mortgages, to real estate. Going from historic monetary easing to historic monetary tightening, from a policy of forward guidance (“dont worry, we’ll telegraph what we are doing..”) to data dependency (“we might do anything, it all depends on the latest data..”) is by definition volatility inducing, and exposed the world to being “short vol”.

One area where this abrupt transition will create opportunities for investors in real estate and housing will be in maturing investor loans for SFR and multifamily projects. Loans have to generate enough operating income from rents to cover interest and expense obligations (debt service coverage or DSCR). With rates so high, the amount you can lend to refinance a maturing loan is limited by DSCR coverage requirements.

Affordability prevents you from increasing rents enough to offset a 400bp to 500bp increase in funding costs over a 10-month period. If current market conditions persist over the next 2 to 4 years, refinance shortfalls will present opportunities for new equity to come in and help re-equitize projects that serve an important need but are being squeezed in short term by the liquidity provided by the lending/capital markets.

Takeaways

The housing market today is unlike the one leading up to the GFC, perhaps different from any housing market we have seen, at least in the last 30years. Fundamental strength for the intermediate and longer term, with affordability headwinds in the near term are going to change how we look at housing, and create generational opportunities for investors, lenders and operators.

As rental markets offer more and more alternatives for households, we are cautiously optimistic that some of the solutions to our housing crisis will come from these newer emerging housing sectors.

When you consider the aging demographic of homeowners and the lack of representation within homeownership of people of color, it is imperative that we as lenders, operators and investors come together with policy makers to solve a societal crisis that is growing with every basis point higher in interest rates.

ABOUT: FRED J. MATERA
Fred Matera is Chief Investment Officer at Redwood Trust. Prior to being named Chief Investment Officer in September 2022, Fred held the role of Head of Redwood Residential. Fred also previously served as a Redwood board member from March 2019 to December 2020. Prior to that, Fred was co-founder of MoVi Partners, an advisory firm focused on promoting innovation through diversity in the fintech industry. During 2008-2016, Fred held several leadership positions with Redwood, including Chief Investment Officer and Head of Commercial. He has more than 30 years’ experience at top financial and mortgage banking firms, serving in senior-level positions. Fred has a bachelor’s degree in Economics from Tufts University, and an M.B.A. in finance from The Wharton School of the University of Pennsylvania.

1) https://www.nar.realtor/research-and-statistics/research-reports/highlights-from-the-profile-of-home-buyers-and-sellers#homebuyers
2) https://www.bloomberg.com/news/articles/2022-11-03/us-homeowners-have-a-fat-equity-cushion-for-real-estate-downturn?srnd=premium
3) https://ced.sog.unc.edu/2018/07/what-exactly-is-workforce-housing-and-why-is-it-important/ According to the Urban Land Institute (ULI), Workforce Housing is defined as housing affordable to households earning between 60 and 120 percent of area median income (AMI). Workforce housing targets middle-income workers which includes professions such as police officers, firefighters, teachers, health care workers, retail clerks, and the like (Parlow, 2015).