We have just experienced the greatest percentage rise in ten year treasury yields in history -- 80% in 12 weeks.
In its wake, in a single summer, the rise has clobbered fixed-income investors and holders of REITs, and raised the long-term borrowing cost of buying a home in the U.S by one-third. There's been a mass exodus out of bonds into cash.
In addition to the rise in mortgage rates by a third, the shares of homebuilders have dropped by a third, and the 33% rise in house prices that has occurred in some desirable geographies has leveled off. Investors are now left wondering, what's next? There have even been dire predictions of 6% mortgage rates by the beginning of 2015.
I think that's highly unlikely, and the purpose of this article is to go through the historical themes that have successfully defined US interest rates for decades; and to remind everyone what brought the 2012 housing recovery here in the first place: the sub-4% mortgage rates that ran from October, 2011 to May, 2013.
As mortgage rates quickly backed-up again through the critical 4% level in June, 2013 - and they have since hovered around 4.5% - buyer traffic has cooled off like the flip of a switch.
As this article (Growth in Mortgage Purchasing Power) so aptly describes, the only justification for higher mortgage rates would be a strong economy and income growth, which we do not have (yet).
Instead, our economy has flat incomes, a shrinking labor participation rate, tight credit, and elevated unemployment. Think about it rationally, what kind of mortgage rates did the tepid US economic recovery justify after the Great Depression and WW II?
Secondly, what effect has the Federal Reserve's quantitative easing regimen - $4 trillion in mortgage-backed securities/treasuries and counting - had on our housing market and new home construction? After such an enormous stimulation, Single family sales of new construction have now risen to a level approximating the lowest points of ALL previous recessions.
Further, if we are into a new interest-rate cycle, what was it like the last time this cycle turned upward (in 1945); and what should we expect now?
The important thing to note is that rising personal incomes and rising interest rates grew hand-in-hand back then. And home prices slowly rose in conjunction with the gradual rise in mortgage rates.
But unlike now, the 1950s, 60s, and early 70s were a time when the labor participation rate was soaring, personal incomes were rising, and the baby boom generation was going through school and entering the job market.
The ten-year treasury yield remained below 3% from 1945 through 1955 supplying 10 years of 4% mortgage rates. And if/whenever the yield spiked up, it quickly sold-off again.
The rise in 10-year treasury rates during those boom years was very gradual. It was still only at 4% in 1963 and didn't rise above 5% til 1968. And during this time there were millions of new manufacturing jobs created, schools exploding with children, retail malls meeting the growing demands of families for homes, appliances, etc.
It was a boom economy - an economic explosion - by any measure. There was no manufacturing competition from Japan (yet); no China; no rise in labor competition from the emerging markets. We were the only game in town. Yet for 18 years from 1945 through 1963 the yield on the 10 Year Treasury remained below 4%.
And as rates rose, families bought smaller homes (less square footage) to take the bite out of the rise in interest rates. They bought what their monthly payment could afford.
Has anyone toured some of those homes from the 50s and 60s and wondered how people lived in them comfortably? They have one or two small bathrooms; modest-sized bedrooms; 2'x 6' closets, narrow hallways, low ceilings and galley kitchens. Compare that to today's must-have houses: bedroom and bath suites the size of a small playground; huge kitchens, cathedral ceilings, and walk-in closets you can get lost in.
The rising size of American homes since 1980 has been directly related to our reduced cost of borrowing. And with every passing year, it seems a family could buy more square footage with the same monthly payment. That is likely over now.
Do you see a boom economy like the 1950s and 60s around you now? That is why I think mortgage rates will be circumscribed in a band under 5% for the foreseeable future, or at least until the economy shows sustained income growth, and I mean a lot of growth, like 3 to 4% growth.
Chairman Bernanke has made the point many times in his academic papers and comments to the press that the premature raising of rates after a financial crisis could kill its recovery. So the recent market consternation is primarily about tapering, rather than a prelude to something more with interest rates in the short-term. Hasn't the Fed Chairman explained that repeatedly?
Has the 150 basis-point rise in the Ten Year Yield already "priced-in" the effect of tapering on the economy? This is a significant question, but I think the answer is probably yes, and in terms of the housing market, definitely so.
The real worry is the stock market and its risk premiums.
The Fed began QE1 at the bottom of the financial crisis and extended it for 17 months. Two months after it was completed (in April, 2010), the SPX cratered 15% that summer. Then there was QE2 for 7 months, and a month after QE2 was complete, the SPX had a second waterfall event, down 19% in the summer of 2011. Now we are into QE3. The Quantitative Easings (QE) have added (stimulus) of roughly $85BL/per month for 46 of the bull market's 54 months.
In May, 2013, Chairman Bernanke just "mentioned" tapering-off this stimulus - hasn't even done it yet - and the SPX dropped 5.6%; while interest rate-sensitive securities fell 30% or more. So it is obvious the stock market's rally since March 2009 is highly sensitive to the Fed's quantitative easing - what Chairman Bernanke refers to as the "accelerator".
In fact, during the QE3 time period (November, 2012 to August, 2013) we've had the longest buying-stampede on record - 10 months without 4 consecutive down days. Obviously, QE has been very good for the stock market.
But the experiment of removing it? Not so good.
However, there is a flip-side to this in 2013 that did not exist in 2012.
"If the budget deficit is now averaging $54 billion a month, down 40% from $90 billion monthly a year ago, Treasury may need to issue a significantly smaller amount of bonds to finance government operations.
If the Fed does not taper back its bond-buying as fast as Treasury tapers its issuance of new bonds, the Fed will be buying an even larger percentage of Treasury bond sales, even though it tapers back its bond-buying.
So to the degree that the Fed's bond-buying creates low bond yields (higher bond prices), that effect is not likely to be impacted by the Fed's gradual taper plans." (paraphrased from: Being Street Smart, U.S. Treasury Bonds Are Oversold, by Sy Harding, August 23, 2013)
So the real question is whether the market can maintain or consolidate its gains - and the housing market continue its recovery - after the Fed's accelerator is gradually removed (with no change in the zero % Fed Funds Rate). That's the real issue. Not how "high" rates could rise. And this is why I think we have seen the meat of the rise in interest rates - and mortgage costs - for now.
It is my opinion that higher interest rates would need to accompany a structural change in the American economy (Vis-à-vis wage gains) towards the middle class (the ultimate consumer of goods) and away from the single-tier system we have now, which greatly enhances corporate profitability at the expense of wage-earners.1 Housing is integral to that re-alignment.
The Effect of Higher Mortgage Rates on New Construction
Although the rise in the last 3 months has been dramatic, there is a simple rule of thumb that both buyers and builders could apply to new construction in the future. At the most popular level of square footage per home, the size would need to drop approximately 11% to make up for the recent 100bps rise in interest rates.
So a smaller version of the 2,000 square foot home available in 2012 at 3.5%, could be bought in 2013 at 1775 sq. ft. for roughly the same monthly payment. Or buyers could opt to use 7 year or 10 year ARMs. Through some slight adjustments in scale, a careful architect can make the smaller home "feel" similar to the larger home.
Builders will dial down their construction sizes accordingly for the most popular homes in communities, and buyers will drop their expectations slightly. Meanwhile, the demographics of tight inventory, gradual job growth, and rising rents will continue to drive buyers to the market and feed builder profitability.
Thus I think the high growth will continue, just in smaller portion sizes. I don't foresee a losing quarter for any builder during the remainder of this decade. At its lows last week, MDC was already trading at 1.1x book, the standard valuation metric applied to builders.
Homebuilders with Lots of Lots
If now is the time to re-enter the homebuilder sector, which ones should you choose?
I think you begin with the builders most prepared and leveraged to the recovery through their land holdings (DHI, PHM, BRP, KBH, RYL, TOL, TPH). Remember - what works against a builder on the way down the real estate cycle, works for them on the way up.
DR Horton is easily the gorilla of the group, the King of Lots, the Lord of Leverage.
"In our third fiscal quarter, our investments in lots, land and development cost totaled $710 million. As we continue to find new communities and build our lot supply. Of the $710 million, $280 million was to purchase land, $263 million was to purchase finished lots and $167 million was for land development cost.
At June 30, 2013, we control approximately 190,000 lots, of which 124,000 are owned and 66,000 are option. 31,000 of our owned lots and 32,000 of our option lots are finished. The 63,000 total finished lots we control at quarter and are up 31% from a year ago." (Donald J. Tomnitz - Chief Executive Officer).
Pulte Homes has approximately 124,000 lots, of which 98,000 are owned and 26,000 are option. 26% of these are developed.
Then comes Brookfield Residential Properties with its 109,000 lots, divided evenly between the oil sands country of Calgary, Canada in the north, to California, Colorado, and DC in the south. The company's specialty is lot development and entitlement, so they are a go-to developer if another builder wants to acquire land. And they have enormous resources for such a small company, almost a billion dollars in liquidity.
KB Homes has a land inventory portfolio comprised of 52,725 lots owned or controlled, representing an increase of 18% from the 44,752 lots owned or controlled at November 30, 2012. They are the largest builder by volume in California.
Ryland increased its land holdings in the last year by 42.6 percent to 36,748 lots as of June 30, 2013, compared to 25,774 lots at June 30, 2012. Optioned lots are 44.2 percent of its total lots controlled.
Toll Brothers - the luxury builder with the "safest earnings" remains focused on growth. This quarter their land position grew to 47,200 lots from 39,200 one year ago.
Last but not least - although tiny - Tri-Pointe Homes is worth mentioning, because of its rapid growth in Silicon Valley. The Company purchased 591 lots valued at $61.3 million during the 2013 second quarter, all of which were located in Northern California. Furthermore, an additional 469 lots were contracted or controlled during the second quarter, 232 of which were located in Southern California, 32 in Northern California and 205 in Colorado. As of June 30, 2013, the Company owned or controlled 2,682 lots, of which 1,529 are owned and actively selling. Of the 2,682 lots owned and controlled, 1,087 are in Southern California, 1,086 in Northern California and 509 in Colorado.
1 Cycles of sustained-debt-to-GDP have grown under low-interest rates, and been paid back under higher interest rates (IRS revenues on expanding wage-gains). If the Interest cycle is undergoing a sea change at this moment, then a rise in incomes should be incumbent on the rise in rates.
For an admittedly ad hoc view of U.S. economic policy (1980-2013), read these articles: (The Reagan Theology in the Modern Age, by John Gilluly, Nov. 5, 2011; Debt, Taxes and Politics: A Perspective on Federal Tax History, by Doug Short, Nov. 13, 2012).
View America's Gilded Capital, a video review and interview with Mark Liebovich, author of the book This Town. Lastly, there's Jeffrey Sach's lecture before the Commonwealth Club of California on October 10, 2011, The Price of Civilization (begin at minute 10).