By: Stash Graham
Historically, American families have generated material portions of their estate’s net worth through the housing market. As we saw in the Great Recession, the levered investment can produce and lose significant returns. Supplementing this point is that we know about 40-45% of Americans do not own an investment account. For these estates, the equity in their home becomes magnified. Yet, since the Great Recession, home ownership is down (relative to adult population) as more adults are renting. As a part of the whole economy, residential investment has never accounted for more than 10% of the US Gross Domestic Product. Residential Investment is defined as the amount of money spent on the construction of new homes (single- and multi-family), production of manufactured homes, remodeling projects and fees generated by real estate brokers from these transactions. At the end of 2018, residential investment was only 3.8% of US GDP (per Federal Reserve Bank of St. Louis). You are probably asking yourself then why am I writing about it?
Housing, while small, is highly cyclical and encompasses movements, good or bad, in other larger sectors like banking, construction, consumer spending, manufacturing, durable goods and commodities. There have been 11 recessions in the United States since World War II, only 2 of the 11 recessions, did not see a material decline in residential investment leading up the ugly larger pullback. The real estate market is very much a confidence game (as such is most assets). If real estate prices are increasing, you, the American consumer, feels comfortable spending more money on discretionary (i.e. optional) goods and the economic cycle grows on itself. If real estate prices fall, the opposite effect happens, and you are less confident and want to save more and spend less. The economic cycle, in response, slows.
Fortunately for us, the process of building a home is structured in a way that allows us to project, with a degree of confidence, growth, positive or negative, within this forward-looking sector. Before you have a sale of a home (new or existing), you need to have the home built (supply, and, yes this includes homes made from scratch). Before the home is completed, you need to start the project as it takes a few months to complete a home (housing starts is a popular standalone metric). Before you can start the housing project, you need to have a permit from the local government body allowing for the project (housing permits). We can study each one of these metrics to project how healthy the real estate residential market is and will be in the intermediate future.
So, let’s look at some of the early indicators, first, we will start with permits. Since the process of building a home takes an extended period, observing permits is a great way to project home supply and, the result, sales. Since turn of the new year, building permits for residential homes has produced 7 consecutive negative year-over-year growth rates. This leading metric can be volatile month-to-month, but 7 consecutive months of negative prints is worth noticing and allows us to project that the construction pipeline is going to get quieter over the next few months. This is certainly not welcomed by the construction sector. Second, the monthly supply of homes has been below average over the last couple of years. The monthly supply is an important indicator to anticipate future behavior. It is commonly accepted that 6 months of supply is the market equilibrium, so when analysts see longer periods of time of increasing supply (i.e. more than 6 months of supply), it reflects that buyers are hesitant about the market. If the homebuilders are not confident in being able to sell homes, then they will not look to start the process of building homes (permits). In summation, this slowing process tends to grow on itself and can affect other, larger sectors of our economy. Let’s keep an eye on this relatively small but material sector as the year progresses, as housing will need to improve first to spur growth rates of our domestic economy, which have been slowing throughout the year.