A once-in-a-generation opportunity to pick up prime US real estate
James Ferguson Apr 05, 2012
The slow-motion crash taking place in the UK housing market has been frustrating for bulls and bears alike. Official price falls have been in the 10% range, but with interest rates at record low levels, the market has been left in a zombified state, unable to find a ‘clearing’ price. Sellers aren’t desperate enough to sell at the prices buyers are willing or able to offer.
If you want to see a real crash, you have to look across the Atlantic, to the US. According to the US Federal Reserve, the value of American households’ real-estate assets peaked in 2006 at just over $25trn. Since then $7trn – equivalent to nearly 50% of the US’s annual GDP – has been wiped off the value of the US housing stock.
According to the Case-Shiller House Price Index of the country’s 20 major cities, the actual peak came in July 2006. Since then, the average house has fallen in value by more than 34%. Other studies suggest that forced sellers and foreclosure sales have averaged closer to 45% below peak prices.
But whereas the absence of a ‘proper’ crash means the risks to buyers in the UK market remain very high, the correction in the US market has thrown up a once-in-a-generation opportunity to buy prime US real estate cheaply. As Warren Buffett famously said about the value thrown up by falling markets: “In my family, we like hamburgers when they’re cheap.”
How the US bubble popped
The problem with credit cycles is that they fuel asset bubbles. This means that the dangers building up in the system aren’t immediately apparent. US mortgage lending more than doubled between the end of 2000 and the peak in the market. However, mortgage debt as a percentage of the value of the housing market – what’s known in the trade as loan-to-value (LTV) – hardly rose at all. That’s because prices rose every bit as fast as the mortgage lending that was driving the boom, so net debt levels never raised any red warning flags.
Then came the crash. From March 2006, when price growth started to sag, up until June 2009, the LTV rose from 37% of total housing assets to more than 56%. The trouble is, in a falling market, your house loses its value, but your mortgage debt doesn’t fall. For those with limited equity, such as first-time buyers (or sub-prime borrowers as they call them in the US), the risk is that the fall in house prices leaves you ‘under water’, or in negative equity – where the mortgage is worth more than the house – making it almost impossible to move.
In the UK, all mortgages are recourse loans. This means the bank can keep chasing you for any money you still owe them, even after they’ve repossessed your house. So you can’t simply abandon your house as a bad bet, and leave the debt behind.
However, many US states have non-recourse mortgages by law. This means that American borrowers in many states, including the so-called ‘sand states’ such as Florida and California, which saw some of the worst excesses of the housing bubble, can just walk away from underwater properties and post the keys back to the bank. This ‘jingle mail’ is a huge potential headache for US banks.
US banks have been unable to shrink their prime mortgage lending at all (that is, the mortgages used to buy the property in the first place). However, the Office of the Comptroller of the Currency did a study last summer that indicated that a fifth of all such residential mortgage loans held by US banks were behind on the monthly payments.
Meanwhile, the banks already have their work cut out with mounting losses from junior lien mortgages and home equity lines of credit (HELOCs) – effectively ‘equity withdrawal’ loans that enabled US homeowners to use their properties as cash machines during the boom.
Luckily for the banks, more than 80% of the US prime residential mortgage market is funded by the government-sponsored entities (GSEs) Fannie Mae, Freddie Mac and Ginnie Mae. These institutions needed to be nationalised once the crisis broke.
And it was because the US government was on the hook for potential losses at the GSEs, that Federal Reserve chairman Ben Bernanke directed US quantitative easing (QE) at buying GSE debt, rather than government debt, as the Bank of England did. In fact, the Fed bought up almost the entire GSE debt market with its first $1.75trn batch of QE and so had to switch to US Treasuries (government debt) for the second $600bn batch.
Affordability has surged
These purchases have combined to drive the typical 30-year fixed mortgage rate down to a new all-time low of less than 4%. New US home-buyers can lock their mortgage payments in at this level for three decades, never having to pay a higher rate but fully able to re-mortgage to a lower rate if rates do fall further. That’s the sort of deal that UK homebuyers can only dream of. It’s also the sort of exposure that made the GSEs very vulnerable if rates were ever to rise.
However, existing homeowners are not so fortunate. One of the key terms of a plain vanilla GSE mortgage is that the LTV be no higher than 75%. As at the end of last year, more than 11 million homes (approaching a quarter of all mortgagees) were worth less than the mortgage loan. This helps to explain why, even though US mortgage rates have fallen significantly (they were 6.5% in 2007), this hasn’t been enough on its own to stop the drop in prices.
What it has done, though – in combination with falling prices – is to give a massive boost to affordability. The National Association of Realtors compiles an affordability index, where a measure of 100 indicates that a family earning the median income has exactly the amount needed to purchase a median-price home using conventional financing.
The average score on this measure was between 130 and 145 throughout the late 1990s and early 2000s, but by 2005 it had dived to 110, and in 2006, it went below 103. In other words, median families buying median houses were leaving themselves with virtually nothing to live on. However, a one-third drop in house prices, combined with an almost 40% drop in the cost of conventional mortgage financing, has virtually doubled the affordability index, which now stands at 196, a post-war high.
Lead indicators for Britain's economy
Banks are lending again
Affordability alone, even after six years of declining prices, is not enough to build a hard floor under US house prices. For things to properly bottom out, lenders need to lend and new borrowers need to feel comfortable about taking on the commitment of a 20- or 30-year mortgage.
Gradually, that seems to be happening. US banks have finally started to increase lending to corporate borrowers again, while their attitudes to mortgage lending have stopped deteriorating: they are no longer tightening lending standards for ‘non-traditional’ mortgages – and for prime mortgages, they’re even easing a touch. Banks are also finally reporting stronger demand for mortgage loans too.
What the banks have to say about prime residential mortgage lending is immaterial, given the dominance of the GSEs, but it does indicate the underlying trend. Houses have become cheap enough and mortgage rates low enough that we are finally seeing shell-shocked home buyers cautiously creeping back out of the rubble.
The National Association of Homebuilders monthly survey reports the largest and most sustained improvement in the traffic of prospective buyers since the US economic recovery began. With prospective buyers back at an almost six-year high, they’re also finally above the worst days of the 1990 housing downturn.
One of the main factors behind this improved confidence is the nascent recovery in the US economy. The US banks are showing important signs of having put the worst behind them. In 2007, the banking sector could marshal just $560bn in the most conservative form of capital, known as tangible common equity.
Today, capital totals almost $1trn. Considering the sector has realised losses of $275bn on securities and more than $550bn on loans during the interim, this is no mean feat. Even although as-yet unrealised future losses appear to be in the $500bn range, this is clearly no longer enough to sink the sector – a very different proposition to the one facing it in mid-2007, when the crisis began.
This is why US banks have felt able to start lending again. They are still being very picky about it (only large corporates need apply), but this is a far healthier situation than exists in Europe. Companies that are able to borrow from the banks again feel confident enough to start hiring again too.
The US created 227,000 new jobs in February, bringing the 12-month total of net new jobs to 2.02 million. Even more promising was the shift apparent in the figures, away from the unproductive sectors (such as construction, government and retail) and back towards the sectors that America’s prosperity has been built on, including professional, business and health services, leisure, hospitality and even manufacturing.
All of this on its own might be enough in more normal times to underpin rising house prices. But these are not normal times and so the market is probably in need of record high-affordability readings to help inject some fresh energy into the proceedings.
However, house price recoveries always start slowly. The evidence from leading indicators, such as prospective buyer traffic, along with clear signs that the decline in actual house prices has slowed dramatically, are enough to give us a lot of confidence that the worst is well behind us and that soon we can expect prices to start rising again.
What about the inventory?
That is certainly the logical conclusion from looking at the demand side of the US housing market. However, there are many concerns about the supply side, and especially the huge inventory overhang of unsold homes – let alone the ‘shadow’ inventory of potential foreclosures that the banks and even the GSEs are sitting on.
This was certainly a very visible problem at the peak of the crisis. The number of unsold new and existing single-family homes had fallen from a peak in the mid-1980s of about 1.4% of total population, to a low of 0.66% in 2001. The ensuing housing bubble and building boom however, drove the ratio all the way back to the old peak and beyond by 2008. Since then, an illiquid and falling market has discouraged most sellers from listing their homes, and the ratio of homes for sale to the population has returned all the way back to 30-year lows.
Any signs of life in the housing market will bring these frustrated sellers back into the open. But there are two reasons why we shouldn’t be too worried about any recovery getting swamped before it can start. The first is that recoveries are likely to occur in different locations to the inventory overhang.
One problem with America’s housing bubble was that so many houses were built where people didn’t really want them and jobs weren’t readily available (think the outer suburbs of cities like Phoenix and Las Vegas, as well as much of Florida and some parts of California).
But there are some locations in the US where housing supply didn’t take off, and where a recovery in demand is unlikely to be met with supply from the shadow inventory. And even where supply did rocket, in some cities, prices have fallen so far compared to incomes, that this perhaps doesn’t matter too much.
Houses in Atlanta cost an average of 1.4 times incomes, lower even than the famously derelict Detroit on 1.5 times. To put that into some perspective, London prices are around 5.5 times, compared to a long-run average of just over three, and at the far extreme, Vancouver house prices are reportedly 12.5 times local incomes due to Chinese demand.
The other reason to expect that supply won’t be as much of a concern as some believe, is the dramatic, sustained fall in new home construction that came with the slump. Back near the beginning of the US crisis, I wrote here in MoneyWeek that one of the big problems for the US housing market was the lag in slowing down new house building. Even once it was clear that demand was on the wane and that prices were vulnerable, home builders who had bought land saw no better way to work off their inventory than to build it out and add some value.
So although numbers of new one-family houses for sale peaked in July 2006 at more than 570,000, and fell back to 537,000 by the end of the year, they rose again for several months in early 2007, back up to almost 550,000. Today it’s a very different story. Since 1971, the lowest inventory of new homes for sale had been 246,000 in October 1982. Today the same figure, for a far larger economy, stands at a record low of 150,000.
This crisis started with US residential property and especially sub-prime, so it makes sense that the route back out towards recovery will require an end to the US house price slump. That now looks to be happening. US banks are looking for new lending opportunities, the currency looks to be on the verge of a multi-year turnaround (as I noted last week), the economy is winning the ugly contest with the rest of the developed world and housing has never been more affordable.
This is the sort of background you’d normally only dream of before committing yourself to something as illiquid as US residential property. In short, US property could now, on a risk-adjusted basis, be one of the most attractive asset classes in the world today. You can, of course, invest in US housing directly, by buying yourself a holiday home or rental property and we’ll be looking at how to do that in more detail in an issue of MoneyWeek in the near future.
For now, below we’ve looked at some stocks that should benefit from the US housing market recovery.
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What to buy to profit from the recovery
By John Stepek
We’ll be looking in more detail at how to buy physical property in the US in a forthcoming issue of MoneyWeek, writes John Stepek. But what can you do if you like the idea of getting exposure to a recovering US housing market, without going to the effort of heading out there to research and buy a holiday home or rental apartment?
One option is to invest in an apartment real-estate investment trust (Reit). Like any landlord, these companies buy large portfolios of apartments and rent them out. To qualify as a Reit, they must pass 90% of their net income on to shareholders.
The benefits of buying a Reit over your own rental property are pretty clear – you get exposure to a broad range of properties (so you’re not exposed to the risk of buying a ‘dud’ property), and of course, someone else manages all the hassle of being a landlord for you.
Meanwhile, with job creation picking up, but appetite for buying houses still weak, demand for rental property is likely to continue to improve, particularly as the majority of the jobs are going to younger workers in the 20 to 34 age bracket, who are less likely to be in a position to buy.
Also, George Skoufis of credit-rating agency Standard & Poor’s reckons that, with construction finance still in the doldrums, the supply of apartment buildings will continue to lag behind demand – construction of new ‘multi-family’ dwellings is at a 20-year low, according to Reit trade association NAREIT.
There are 15 such Reits out there – Martin Hutchinson, writing in Money Morning US, likes the look of UDR (NYSE: UDR). The Reit – which maintained its dividend yield even during the depths of the housing crash – trades on a prospective yield of 3.3%, and is “among the best-positioned multi-family apartment Reits in the US”, according to Zacks Equity Research, “with the majority of its portfolio located in California, Florida and on the Atlantic Coast”.
Another, higher-yielding option is Home Properties (NYSE: HME). The Reit offers a yield of 4.3% and analyst Tom Mitchell at Miller, Tabak and Co rates it a “strong buy”. He believes it could be a potential takeover target.
Of course, you just need to look at their charts to see that residential Reits have already done well over the last couple of years. However, other housing-related stocks have made less of a comeback. Housebuilders is one sector that has rallied strongly in recent months, but it seems to have paused for breath for now. But housebuilders are still well below their boom-era highs. If you’re feeling adventurous, names to keep an eye on include Meritage Homes (NYSE: MTH) and Lennar (NYSE: LEN), according to John Burns Real Estate Consulting.
These builders have the most exposure to areas where the economic fundamentals – measures such as jobs growth, and local sales prices achieved – seem to be improving most rapidly. For example, nearly half of all the communities in which MTH builds are located in Texas, which has seen “stronger job growth and relatively better sales activity”.
Lennar, meanwhile, “stands to benefit most from the continuing recovery in Southern Florida”. Credit Suisse is also a fan of Lennar – the investment bank saw record buyer traffic levels in its Survey of Real Estate Agents for February, leading it to upgrade its sales expectations for the year ahead. And if stronger traffic continues, there could be an even better rally in sales, given that they are starting from such a low base – “sales per community are approximately 33% below average historical levels (including the depressed recent years)”.
Particularly bold investors might want to take a look at another group of stocks that has been hammered since the US housing collapse. With demand for home building picking up in some areas, builders are going to need more materials. One stock that has already seen some benefit to its share price is Builders FirstSource (Nasdaq: BLDR), one of the five largest suppliers of building materials to professional builders in the US. The catch is that the company is loss-making.
However, its fourth-quarter sales for 2011 trounced analysts’ expectations, while insiders have bought up nearly 375,000 shares in the stock worth more than $1.1m in recent months. As Tyler McKee notes in Forbes, the group has heavy exposure “to some of what are now considered the better segments of the housing market: the Carolinas, the DC area and growth cities in Texas”. BB&T Capital Markets rates the stock a ‘buy’ with a 12-month price target of $5 per share.
A safer bet might be Stanley Black & Decker (NYSE: SWK). The construction and industrial tools provider is trading near its highs for the year. However, as US financial paper Barron’s points out, on a p/e of just under 13, it is still trading at a discount to the S&P 500, although earnings look set to grow more rapidly than the average stock in the index this year.
A solid recovery in the US property market could drive the stock even higher. And even the overhang of poor-quality, formerly repossessed homes might benefit the group, as Barron’s notes: “Distressed property needs repair work – accomplished with power tools – and security improvements before it can generate rental income or a sale.”