Landmark Links September 13th – Falling Behind

sanchez211.gif

Lead Story…. It’s incredible how quickly things change.  Just a few short years ago, conventional wisdom was that it would take an eternity to work through all of the excess inventory created by the housing bust and foreclosure crisis.  However, in reality banks were incredibly adept at managing their REO inventory, effectively preventing the massive  glut that so many expected.  In the meantime, very little in the way of new housing was built as financing dried up and builders pulled back in fear of competing with the looming bank REO inventory liquidation that never really materialized.  Fast forward to 2016 and the stark reality of a new sort of housing crisis: there simply aren’t enough residential units being built to satisfy household creation.  The pivot has been as pronounced as it has been swift and it doesn’t look like things are about to change anytime soon.  The Federal Government’s bi-annual report on housing inventory provides a rather bleak outlook, especially for entry level buyers and renters.  From ULI (emphasis mine):

Newly released data and analysis from several sources illustrate a major obstacle to a fully healthy housing market in the United States: the nation is not building nearly enough new residential units. The serious shortage of new supply is bottling up housing demand and pushing home prices and apartment rents well beyond what a growing number of households can afford.

A biennial report from the federal government titled The Components of Inventory Change found that the nation’s housing stock increased by a net 270,000 units between 2011 and 2013—the slowest growth measured by the survey over the past decade, which included the worst years of the Great Recession. The report concluded: “Despite the gradually improving economy, there were large declines in both new construction and net additions to the housing stock during the 2011–2013 period compared to the 2007–2009 period.”

A recent Freddie Mac market commentary noted that the total number of housing starts (single family plus multifamily) in 2015 was 30 percent below the historical average between 1970 and 2007. The National Association of Realtors estimates that the country’s supply of for-sale and rental units combined is 3 million units short of current demand.

The most substantial issue here isn’t even the massive shortfall in raw numbers, it’s the distribution of where what limited construction that we do have is occurring: at the high end.  Not only are we not producing enough units across the board but nearly nothing is being produced at the entry level in either for-sale or for-rent properties where units are most in need.  Again, from ULI (emphasis mine):

Not surprisingly, millions of Americans cannot find an affordable home to buy or an apartment to rent. A survey conducted by the National Association of Home Builders (NAHB) found that 59 percent of respondents said they could and would spend no more than $249,000 on a new home, but only 35 percent of new homes started in 2015 were at or below that limit. The online real estate service Trulia recently reported that the number of starter and trade-up homes available in the 100 largest U.S. metropolitan areas has plunged by more than 40 percent since 2012.

Yes, apartment development has experienced a historic boom: multifamily construction volume nearly doubled in 2012 compared with that seen in 2010, and increased another one-third from 2012 to 2014, according to a new study by the Research Institute for Housing America. New multifamily completions topped 310,000 units last year, the most in at least 25 years, according to the National Multifamily Housing Council. And 1 million more apartments could come on line in the United States in the next three years, according to projections by the market research firm Axiometrics.

But most new apartments and single-family homes are aimed at the top of the market. The median asking rent for a new apartment today exceeds $1,300, which is unaffordable for roughly half the renter households in the United States (based on a rent standard of affordability of 30 percent of income). The average price of new homes for sale in 2015 was $351,000—a 40 percent increase from 2009.

What is driving the trend towards builders constructing a smaller number of higher priced units versus a larger number of lower priced ones?  A few factors to consider:

  1. Post financial crisis, there wasn’t much of any mortgage financing available at the lower end of the market.  It doesn’t make sense to build homes for people who can’t obtain financing so builders focused on more expensive price points where buyers were willing and able to obtain financing or buy with cash.  Combine this with the higher margins often achieved on luxury units and you have a recipe for builders gravitating towards more expensive units.  Availability of financing is improving but it has left certain markets 100% beholden to FHA limits.
  2. Regulatory burden is soaring.  A study that the NAHB released earlier this year found that regulatory fees for new construction jumped nearly 30% (80k per home) over the past 5 years.  It’s incredibly difficult to make any profit on lower priced product in that type of environment meaning that builders need more expensive product to absorb the regulatory burden.
  3. People are staying put longer in their entry level homes since less move up houses are being constructed.  The result is less infill inventory which drives up prices.  Yesterday’s entry level home becomes too expensive to be classified as entry level if supply does not materialize to meet demand.
  4. While the development financing market has shown some marginal signs of improvement, it still pretty much sucks for all but the most credit worthy of developers in the best locations.
  5. Land owners aren’t selling, at least not when it comes to their best lots.  One would think that rising home prices would make this a great time to be a land seller.  However, that isn’t currently the case as Bloomberg detailed last week.  When asked for investment advice, Mark Twain once said: “Buy land, they’re not making it anymore.”  Right now, owners of well-located property are taking a similar stance in expectation (or, in some cases hope) of higher prices: don’t sell your well located land because you can’t sell it a second time and it’s likely to be more valuable in the near future.  In other words, there is substantial gap between what builders are willing to pay and what landowners are willing to sell for, particularly in the best markets.  Landowners will sell today but only if builders are willing to pay them for possible future inflation that may or may not happen.  To complicate matters further, a lot of landowners bought during a brief run-up in 2013 thinking that the market was about to take off.  It didn’t and now they are holding out in hope of larger profits down the road.

At some point, the laws of economics pretty much dictate that this has to change.  We aren’t going to stop creating households and people can’t continue to pay an ever-larger percentage of their incomes towards housing costs without the result being major adverse economic consequences.  In reality, demographics are actually improving for household creation through at least 2024, meaning that the housing shortage will get worse as the deficit continues to widen unless we ramp up production in short order.  Unfortunately, as you can see it’s not a problem that’s easily solved.

Economy

Christmas is Cancelled: The bankruptcy of South Korea’s largest shipper has a lot of cargo stranded at sea just as retailers are stocking up for the holidays. See Also: The shipping industry has a major problem – there are simply far too many ships for current demand.

Tougher Road Ahead: Economists are predicting a tougher road ahead for the labor market. But See: Short term optimism as wages expected to rise amidst the scramble for seasonal holiday workers.

Commercial

Yogi Bear, Architect: Brokers are having a difficult time selling a seven story office building in Columbus, Ohio designed to exactly resemble a picnic basket. 

Back Up the Truck: investors are bidding up REIT shares prior to real estate getting its own sector in the S&P500.

Residential

Good Riddance: Gaudy Mediterranean style McMansions that were all the rage in the 1990s have fallen out of favor and are not rising as quickly in value as other types of houses.

Sound Familiar? Norway’s economy is historically based on oil, which has had a rough go of it lately.  Norwegian interest rates have plunged along with the price of oil, leading to soaring housing prices and housing sector investment.  This sounds eerily similar to the post-tech bust era in the US to me.

Don’t Call it a Comeback: Cities in California’s Central Valley that were largely left for dead in the wake of the housing crash are making a comeback.

Profiles

Those Who Fail to Learn From the 90’s Are Doomed to Repeat Them: People are buying minivans again and trying desperately to convince themselves that the soccer mom mobiles are somehow “cool.” Newsflash: minivans will NEVER be cool

Viva Socialism: Venezuelians are turning to black magic and animal sacrifices to heal their sick due to a lack of basic medical services.

You Should Already Know This: Cheese triggers the same parts of the brain as hard drugs.

Chart of the Day

Super Size Me, urban home edition.

Us home sizes_map_final

WTF

FAIL: There are still 4 months left in 2016.  However, I think that we can safely call this year’s Darwin Award for a Florida man (of course) who found an old bulletproof vest in his garage.  He wanted to know if it still worked so he put the vest on and had his cousin shoot him.  It didn’t work and now he’s dead and the cousin is in jail.

Cultural Literacy 101: Apple’s iPhone 7 launch slogan: “This is Seven” translates to something sort of vulgar in Cantonese.

When You Gotta Go: How NFL players hide it when they have to pee during a game. Spoiler: there’s often more going on in the huddle than you think.

Sort of Impressive: A man was arrested for stealing $3,000….. in pennies.

Landmark Links – A candid look at the economy, real estate, and other things sometimes related.

Visit us at Landmarkcapitaladvisors.com

Landmark Links September 13th – Falling Behind

Landmark Links April 26th – Disconnect

Disconect

Lead Story… Goldman Sachs published a research note last week that CNBC posted some excerpts of, making the case that the construction labor shortage isn’t to blame for the sluggish home builder performance:

“Our analysis of payroll growth and wage inflation data suggests that labor shortages may not be to blame for the mediocre level of housing activity,” Goldman Sachs analysts wrote in a report this week. “We find that, on the one hand, the construction sector has experienced the largest job growth over the past year.”

Construction growth has led all other sectors at 5 percent, according to the Bureau of Labor Statistics, but average hourly earnings in construction gained only 2.2 percent over the past year, which is about the national average.

“Economics 101 would suggest that, if labor shortages did in fact exist, upward pressure on wages would be more pronounced and payroll growth would be anemic,” the report said. “Therefore, the evidence from the industry-level employment and wage data does not support the existence of labor shortages in the construction sector.”

Goldman instead pointed to permitting delays and land scarcity as the culprits, citing a report from JBREC’s Jody Kahn that we posted earlier this month:

A survey of 100 builders nationwide by John Burns Real Estate Consulting backs that thesis. They asked about costs that didn’t exist 10 years ago, and found high levels of builder frustration, not just from labor, but from cost overruns stemming from new regulations for house erosion control, energy codes and fire sprinklers. They also cited understaffed planning and permit offices as well as utility company delays.

“New regulations to protect the environment and to shore up local city finances have made it extremely difficult for home builders to build affordable homes,” the Burns analysts wrote. “Now, more than ever, the demand for affordable entry-level housing will need to be met by the resale market, since new homes have become permanently more expensive to build. We were overwhelmed by the reply as well as the builders’ level of frustration.”

I agree with what they are saying to an extent as the construction labor shortage Isnt the sole culprit, but first we have to put things in context.  Yes, we are rebounding but it’s from a very low level when it comes to construction employment:

The CNBC story made two important clarifications: 1) The labor shortage is a much bigger deal on the west coast (most of our clients would agree); and 2) The construction industry has failed miserably when it comes to to attracting younger workers and is stuck with an aging workforce (again, our clients have verified this):

There is a labor crunch, though, in some parts of the country, more so in the West, as a considerable number of the construction workers who left during the recession still have yet to return.

The average age of a construction worker today is far higher than it was during the housing boom, Michelle Meyer, deputy head of U.S. economics at Bank of America Merrill Lynch Global Research, said Tuesday on CNBC’s “Squawk Box.” Builders need to attract younger workers, but they seem, so far at least, unwilling or unable to pay them more.

IMHO, there are a number of issues conspiring to make this a very difficult environment for builders and developers.  Permitting delays, a lack of developable lots, low affordability, more stringent mortgage underwriting, people forming households later in life, labor shortages, high costs, lack of development financing, almost no new entry level product, etc.  Builders could probably overcome a couple of these but add them up together and you have the perfect storm for a relatively moribund home building recovery.  This sluggishness is leading to capital market pessimism.  Meyers Research noted last week that their investor round table is expecting a downturn in land in the not-too-distant future which is causing them to proceed cautiously:

  • The train may arrive early: While a national economic recession is still on the horizon, the recession is now expected within the next two years, which makes investing in a residential land opportunity more interesting.

  • Possible repricing ahead: In fact, some groups are suggesting that land will be “on sale” within the next 6-18 months. Widespread distress is not expected, but neither are decreasing home prices. It’s simply an expectation that some return-based land owners may be experiencing deal fatigue and be willing to accept a modest return rather than endure another cycle.

  • “Multiple” Opportunities: Some of the larger, more patient capital sources are expecting this to be an attractive buy opportunity where they can “play for the multiple”. The challenge is that few of these investors are looking to develop land. The heavy capital requirements of land development are not justifiable today and banks remain tepid toward land development. It is not a stretch to expect the for-sale market to remain under-supplied, or at least not oversupplied, for a protracted period. This condition surely will reduce the risk of capital loss for patient investors but make things challenging for home builders who need land as their most basic raw material.

At some point this becomes a self-fulfilling prophecy where lots fall in value due to a dearth of capital availability where investors pull back to wait for a better entry point.  This couldn’t be more different than the 2007-2008 scenario where there was plenty of lot and home supply that weighed on the market heavily once subprime lending (and demand from marginal buyers) vaporized.  No, in this case homes could actually keep going up in value, getting less affordable while new construction continues to slow and land development grinds to a halt.  Why?  Because people are still forming households and there is still demand that will likely continue to outstrip supply of development slows further.

Private equity investors made large investments in land coming out of the downturn, banking on a strong rebound when home values began to rise.  Many of them have been disappointed with the results and many portfolios haven’t hit expected returns despite home prices and lot prices generally rising.  This has mainly been due to the various headwinds facing development and home building that I mentioned above.  The prevailing view on Wall Street appears to be that land is overvalued but home prices may not be which is why Meyers sees the potential for land to go on sale while low supply keeps home prices elevated. Ironically, developers and their capital partners could have been spot on underwriting finished lot values and still under-performed due to permitting delays and cost inflation.  Developers and their equity partners are also struggling since home builders are now demanding finished lots whereas they were previously buying unimproved but mapped land and did their own improvements.  Improving lots is very capital intensive as mentioned in the Meyers report above and your average developer has a substantially higher cost of capital than a public home builder does.

I’m of the opinion that the correction has been underway since 2014 when builders essentially stopped buying paper lots in all but the most infill locations since underwritten returns on land improvement and horizontal construction are now higher (ask a west coast based land broker and they will likely confirm this). All told, we could be setting up for a somewhat bizarre scenario where land prices languish as development risk gets repriced while home prices stay firm or go higher.

Economy

Look at the Bright Side: As lucrative oil jobs dry up,  some workers are jumping ship to the growing solar energy sector.

Commercial

Just Speculating: Spec construction is on the rise as tenant demand continues to fuel the industrial sector.

Residential

There’s a Freeway Running Through the Yard: Buyers in high priced markets like Los Angeles will put up with a lot, including a home adjacent to the freeway to find something even moderately affordable. See Also: Home price surge stymies first time buyers.

Profiles

Keeping Up With the Googles: Traditional businesses are making their offices look like startups in a bid to appear “cool” to millennials.  However, what many of these traditional businesses run by 50 year old execs don’t grasp is that the appeal of the startup lies in the excitement of the concept, the culture and the idea that you are getting in on the ground floor….oh yeah, I almost forgot about the ability to participate in the upside if the company makes it big.  These are things that your typical advertising agency will never offer and nap pods, ping pong tables and hip office design in an old-school business are superficial and come off as pandering.

Better Off Just Dripping: The Dyson Airblade jet dryer is really bad for hygene. A new study shows that using one is akin to setting off a viral bomb in an already-disgusting public restroom.

Chart of the Day

The latest update of Bill McBride’s “Distressing Gap” doesn’t look to be closing anytime soon.

WTF

Makes Sense to Me: A woman in South Carolina crashed a car into a Walmart.  She claims that God told her to do it.

Video of the Day Twofer: Watching disgruntled construction workers battle it out on the street with heavy machinery is my new favorite pastime. (h/t Ian Sinderhoff)

The Law of Unintended Consequences: An animal rights activist group “freed” an ostrich from the circus.  It was promptly hit by a car and killed.  Turns out that ostriches aren’t well equipped to handle an urban environment in Germany.  Who would have though?

Landmark Links – A candid look at the economy, real estate, and other things sometimes related.

Visit us at Landmarkcapitaladvisors.com

Landmark Links April 26th – Disconnect