As I sit down to write the September Insight, it is the afternoon of Thursday the 29th. With the Insight scheduled to be distributed tomorrow afternoon, this puts me well behind the normal distribution process. Frankly, I have been procrastinating. Not because there isn’t anything to write about, but because September was such a crazy month that it is difficult to choose what to write about. And regardless of the topic, none of it is particularly uplifting.
Students of history and readers over sixty may remember Gerald Ford’s efforts to combat inflation. Spoiler alert, it didn’t work. Just two months after becoming president in 1974, with great fanfare, and a WIN button on his lapel, he announced the Whip Inflation Now (WIN) program. In his speech to congress he called on the people and companies of America to do their part in the fight against inflation by spending less and using less energy. Of course, it included the obligatory temporary five percent “income surcharge” on corporations and high-income individuals. Jerry and Betty then publicly signed a pledge to do their part to personally fight inflation, specifically saying that they would “buy, when possible, only those products and services priced at or below present levels”. WIN was a huge flop. And while Ford didn’t have a direct hand in causing that bought of runaway inflation, he certainly didn’t have any success in resolving it. But hey, at least he didn’t try price controls like Nixon did only a few years previously (which also failed spectacularly).
Last month we pointed out how the Inflation Reduction Act (IRA) has nothing to do with inflation. Like the Ford’s WIN, it is now being mocked across the country for being more marketing than anti-inflation substance (and more likely inflation fuel). Unlike the WIN, regardless if you agree with the contents, there are true and actionable components of the IRA. It is just too bad that the use of such a misnomer is taking away attention from the contents. And it is not a good look for the President to be now using the same game plan as Ford by lecturing gas stations to cut prices and telling companies to cut prices to consumers. Whether a blatant lack of understanding of how the economy works, or maybe just playing political games, it just isn’t something that inspires confidence among the populace, or is the sort of thing that brings the country together. This is different than seeing the investment opportunities presented by the IRA. If you invest in Altus projects, we hope that you may start benefiting from the IRA in the coming months as we roll out solar and EV charging capabilities at several of our properties. Even if you don’t invest with Altus, this legislation created opportunity. Take advantage of it.
There is no question that inflation is biting into households’ ability to exist within the economy. According to a report by Bloomberg, as of late August, close to 20 million US households are behind on their utility bills. That is one out of six (16.7%) US households. As a reference, this is almost 3 X the number of households that are considered to be in poverty, and the highest amount on record. Since early 2020 Pacific Gas and Electric, operating in high cost of living California, has seen a 40% increase in delinquency. Other providers haven’t seen as much of an impact, but many are still seeing delinquency increases above 25%. With electricity pricing increasing 15% over 12 months from this past July, the utility costs themselves are making it harder to keep current on bills. But it isn’t just the utility costs. Increases in other necessities (food and fuel at minimum) are also squeezing budgets beyond their breaking point.
Most readers will be aware of the interest rate increases over the past month (piggybacking on the previous 6 month of increases). To call it a spike in interest rates would not strongly enough describe the situation. The ten-year treasury rate started the month at 3.19%. On the 26th the rate briefly broached 4% before falling back to consolidate. That is an absurd/astounding/asinine (and any other words you can think of) increase in the index borrowing cost of twenty five percent. In a single month. Or if you would prefer, 300% annualized. For context, the difference in a $20 Million loan with a ten-year loan term (as what is typically tied to the ten-year treasury), the borrowing expenses increased over $1.5 Million. In one month. If your closing got delayed from August 31 to December 26 while your lender dragged their feet, and poof, your income just dropped $1.5 million over the ten-year loan period.
On the ground in real life, the impact is more severe. Lenders lend based on an index plus a spread. The index has exploded. But spreads have also blown out. We are looking to refinance a small retail center we have in Oklahoma and the interest rate today is over 2% more than what it was when we started the process 45 days ago. Assuming you can find a lender to lend at all.
The situation in the housing market is similar. Mortgage rates have more than doubled since the beginning of the year, crushing affordability. Households now need to make over $100,000 to afford a median priced home (assuming no other debt). According to Bloomberg, it is the most severe decline in affordability in US history, all during a time there has been little price appreciation, meaning the decline is all tied to increased borrowing cost. Assuming 20% down, in January/February a $2,500 mortgage payment would have purchased a home worth more than $750,000. That same $2,500 mortgage payment would now only purchase a $475,000 home. Without a decline in borrowing cost home prices would have to drop 37% for affordability to return to levels seen earlier this year. And if you will remember, there were already affordability concerns at that time.
Does this mean we should expect a massive correction in the housing market? First let’s define what housing correction means. In April of 2021 I wrote that despite the rapid increases in home prices over the previous year, I didn’t think there was a danger of a popping bubble (which is different than thinking a market is overvalued). In the year that followed the 4/2021 Insight, median home prices increased another 22% (off the already inflated base) and have largely gone sideways in the six months since. This…this might be bubble territory? Especially with the fanaticism the Fed and the bond markets are pushing rates higher. And yet, I am less concerned with the possibility of price correction as I am of a volume correction. Prices will fall, but even if they fall 20%, the vast majority of homeowners still have more equity than they did 18 months ago. Even those that bought over the past 18 months (again assuming the standard 20% down) would have equity in their property with a 20% decrease in market prices.
An even larger majority of homeowners have interest rates on their home mortgages well below currently available rates. Unlike 2006 – 2008 when defaulting on a mortgage meant months (and even years) of mortgage free living and the possibility to move into a cheaper rental, few homeowners would now have that luxury without a large reduction in the quality of their living environment. For that to become a common necessity would mean large increases in unemployment.
Which leads us to the discussion of a housing correction that I am concerned about – volume and activity. Housing comprises ~30% of the US economic activity (at least we aren’t China, where it is 50%). When transaction volumes hit the skids, as they currently have, there are huge amounts of head of household jobs that are either eliminated (title/escrow/etc.) or dealing with massive reductions in income (real estate agents/loan brokers). That reduction in economic activity has a very real and painful impact if you are so employed; and has a carry-on impact on the goods and services previously normally purchased by those that lost their jobs or income. Further, new home construction is crashing to a halt. Not only does this also mean a loss of jobs (construction), it creates carry-on issues down the road when an already housing starved nation goes without new inventory coming on board for any extended amount of time. This in turn is likely to continue to boost rents. Where are people going to live? Where are they going to be able to afford to live?
There are two caveats that may reduce the impact of the housing shortage. I am not able to find it to source here, but I read an article that said the average apartment occupancy increased from 1.6 people per unit pre-COVID to 1.8 people per unit currently. That is a rather substantial increase in unit demand of ~10%. As economic times get more difficult this expansion will reverse, at least to some degree, and could reduce pressure on multifamily occupancies.
For single family homes, the last ten years have seen a spike in both 2nd home ownership and homes purchased as vacation rentals. Increased economic turbulence will force some owners of second homes to sell, and if accompanied by a decrease in vacation rental occupancy (which would be all but assured), many vacation rental investors would also have to liquidate. These factors may help relieve the housing shortage pressures, at least in the short run, but are highly unlikely to be enough to make a dent in the longer-term issue. Either interest rates need to drop (substantially), or incomes have to rise (substantially). The first means we have entered a severe recession. The second means inflation is remaining with us with a vengeance.
The Fed certainly thinks inflation is here to stay a while. Though not sure why anyone listens to them at this point. It was less than a year ago they were saying inflation wasn’t a big deal and not to worry about it. Over the last six months they have increased interest rates at a historically fast pace (though that word “historical” is severely overused in this day and age), and have said they will raise rates another 75 bps in November. If inflation is that hot, and the only way to fix it is to raise rates further, why didn’t they already raise rates further? Either the rate increases to date are working, in which case they shouldn’t need to raise rates further, or they aren’t, in which case the problem is getting worse while we wait on the future rate increase.
The Fed tells us they are data dependent, and I am sure they are. But the data they are using is backward looking. I wrote previously how inflation numbers were understated because of the way shelter (30% of the inflation calculation) is measured. I also wrote how it would be a problem for the Fed to deal with it in the future because of the same way it is measured having the reverse effect. Thirty percent of CPI measurement is based on a severely lagging indicator. This is one reason the Fed was so late to the game in increasing rates (you can read through the 2021 Insights to see that inflation was already a raging problem prior to Russia invading Ukraine). And it is why I think there is a strong possibility the Fed has already raised rates further than it needs to and will continue to raise them into a very hard landing. In the real world, using the massive amounts of real time data we have from real estate and management software companies, we know that thirty percent of the inflation calculation is now flat to slightly negative. But because of the way shelter is measured it is still adding fuel to the inflation numbers.
The debt markets are certainly expecting a hard landing and have been for the past several months; at least if you believe the inverted yield curve as an indicator. Many people wrote off the potential Q1/Q2 recession as the result of this (ongoing) inversion. What has been largely overlooked is that there was also an inversion last spring, though much less severe and shorter in state. The recent recession, or recession like thing (depending on your definition) that we experienced is tied to last year’s inversion. The recession associated with the current inversion is not here yet, and with this inversion maintaining over a much longer time frame and being much more deeply inverted, there is considerable historical precedence that the coming recession will be a doozy. Remember, the inverted yield curve precedes the recession by an average of 18 months. Don’t be surprised if we aren’t officially in a recession until sometime in the second half of next year.
And yet, I don’t have enough confidence in my analysis to go all in. There are many countervailing factors. The college debt forgiveness is inflationary (as an aside, the CBO estimates of taxpayer costs were higher than mine). Sorry Joe, but the Inflation Reduction Act is feeling more and more to me like an accelerant than a reducer. Energy levels are down, but still high – and likely to go higher over the winter. Food prices are high and likely moving higher as the world deals with current shortages and input shortages for future production. Labor shortages aren’t going away sans a major economic slowdown. Where I live unemployment is 2%. TWO PERCENT! That is so far below structural unemployment I wouldn’t have believed it to be possible were it not occurring in real time.
Last December I wrote:
“As crazy and unexpected as 2020 and 2021 were, I don’t think we have seen anything yet. This may not be a bad thing for wealth creation because volatility creates opportunity. With mid-term elections coming up, the federal government is going to have lots of motivation to be fiscally stimulative. As has been the case for many years and is increasingly so, those that know how to play the game will be given every benefit for doing so. Often at the expense of those that do not. As the game continues to change, I want to make sure I continue to learn and evolve along with it.”
How true that ended up being. And for those that can work through the noise (and there is a lot of noise), the opportunities are here, with more fast approaching.
Happy Investing!
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at fjinks@altusequity.com.