The last housing downturn may have been driven by speculation and overbuilding, but certain lessons transfer to today’s exogenous shock to the industry resulting from COVID 19. Operators should keep a watchful eye for the three waves of risk before signaling all clear to their investors and operations.
The April 19, 2020 US Census Housing Start data signaled wave one. Even if your market was relatively unscathed and your operation continued delivering loads of lumber, you heard stories from other markets and saw the news reports indicating a softening in construction activity. Your order file may be full now, but how long will the backlog of housing starts under contract prior to COVID last? Wave one is not over yet and awareness of the fundamental factors impacting demand enables operators to proceed with appropriate caution.
What exactly is wave one? It’s defined by two primary factors. The first factor is market by market construction shutdown and subsequent re-opening, like in my home state of Washington. This is a transient factor that will disappear with the release of the restriction on construction. Factor two is the disappearance of marginal buyers as they step to the sidelines with their plans to move or build. The second factor is more difficult to quantify and likely has a greater and longer-lasting impact.
What exactly is a marginal buyer? Think of it as the buyer on the bubble. She may have been considering building a home this Spring, but uncertainty around COVID, election politics, or macroeconomic conditions make upgrading her living situation feel like the wrong choice, for now. This doesn’t just impact new builds, but also new rental upgrades or first-time renters. Should I sign this new lease right now? Or continue living with parents or roommates?
How big is wave one? Based on the April data it could be 30-40% of the market. Although there is no way to tell in the short term, if we assume the marginal buyer is half the impact, then sidelined buyers could keep the housing market depressed by 15-20% until they come off the sidelines. These numbers are national, but housing, like politics, is local. The market to market variance is likely great in both factors of wave one.
Wave two is starting now whether we can see it yet or not. Whereas, wave one takes the marginal buyer to the sidelines, wave two sidelines buyers due to instability in personal financial fundamentals. Those who lost their jobs (near term indications show spiking unemployment), no longer have the opportunity to be buyers. Again, this applies to renters as well. We often forget that a new renter ultimately creates the need for a new housing unit. Without jobs, both buyers and renters are sidelined and can’t create new starts.
How big is wave two? It’s too early to tell until we identify how quickly jobs and income recover. The key here will be the speed of job loss, recovery and new job creation by an expanding economy.
Wave two may be unpredictable, but at least the cause is understandable - no job, no money, no new housing. Wave three, on the other hand, is all about financial market dynamics that can be complicated even to the financially literate. Maybe a reread of Michael Lewis’s The Big Short is in order here. Wave three will come when those who underwrite and insure the housing economy can no longer create liquidity. Whether this shows up as inflation and higher interest rates, bank imposed lower loan-to-value ratios and tighter lending standards, or lack of secondary market liquidity is yet to be seen. Either way, outside forces may be the third wave that keeps previously eligible buyers from creating new demand for housing starts.
A personal story from 2008 illustrates how wave three could unfold again in the coming months or years. I was under contract to sell my home, under contract to buy a lot, and finalizing a construction loan to build a house. My mortgage banker called the night before the close, “Matt, don’t sell your home. I can give you the lot loan, and technically you're still approved for a construction loan, but AIG will no longer insure it.” I had heard the news that day of AIG’s financial trouble. I just had no idea that their trouble would mean three years in a rental and fire-sale price of an empty lot for a financial loss.
We don’t know exactly how or even if wave three will unfold, but until our financial system is on solid footing again it will remain a risk. For wave three I’ll be watching commercial real estate, the financial institutions that underpin it, and their connection to residential single and multi-family construction. Why commercial real estate? Maybe you, like me, are you working from home, shopping online, and avoiding public interactions in commercial facilities.
Watch for all three waves of this market as they roll by. We have contactless pizza delivery, contactless car buying, and foot bumps instead of handshakes, so it's apropos that we wave and not shake hands. Just make sure to wave three times before signaling the all-clear to your operations and investors.