Real Estate's Next Crisis

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Summary

What are real estate's long-term trends?

How will demographics affect real estate's arc?

How will real estate stocks and ETFs be affected?

There are few topics that engender more debate than real estate ("RE") prices. There is no question RE has local components that affect supply and demand. I will not be discussing specific real estate, but rather the market at large.

Factors that drive housing

What made you purchase the first property in which you lived that was not for investment? My guess is that marriage and/or family were involved. That suggests that you were within a particular age range, and likely employed ("ninja" loans aside). So for the purposes of discussion, let's use the age range of 25 to 54 as encompassing most of those placing demands on the home ownership market. The other important factor driving the market is the availability of affordable credit. I like to use 1981 as starting period for any analysis involving a credit cycle.

Employment

If we presume you need to be gainfully employed to purchase a home, let's look at an important graph showing employment trends in the US.

Since peaking in 2000, the percentage of those employed relative to the population as a whole declined, and remarkably so after the 2007 stock market top. While it has recovered slightly, it remains well below the intermediate high of 2007.

The first graph relates to the market as a whole. What about the important 25-54 age group?

Since peaking in 2000, this important age group has also been declining in terms of their labor force participation rate. As I discussed in my book, the decline of the important 25-54 labor participation has been met by an increase in participation of those over 55. This increase is no doubt due to some of the points made below in the article section on Financial Considerations.

If we're looking for employment trends to bolster the market, we will be disappointed. Both the overall labor participation rate and those most likely to buy homes present headwinds for the market.

Demographic trends

According to the National Association of Realtors (NAR), 90%+ of all US home purchases are completed by those 20 to 69 years of age. The breakdown of buyers, using 2015 data is as follows:

  • 20-35 yrs old - 35%
  • 36-50 yrs old - 26%
  • 51-70 yrs old - 31%
  • 70+ yrs old - 9%

I would further posit that most of the buying is centered in the 25-54 age range earlier referenced. As long as that age range increases in numbers relative to the others, it should buoy the market. Except there is one problem. According to the Census Bureau, the number of adults over the age of 65 is expected to increase from 15% to over 21% in the period from 2015 to 2050. This growth is unprecedented in US history.

Much of the world's growth in the 65 and above category will come in Asia (think China, Japan, S. Korea, Taiwan, Hong Kong). China and Japan are both anticipated to have population declines. This is due to the fact that worldwide fertility rates will drop for all but the African continent. The chart below shows the decline in US birth rates.

The other important sub-category within demographic trends is the age range where peak spending occurs. In this short video from Bloomberg, you will note that peak spending tends to occur around the age of 46 and then declines into retirement. If we consider the aging population coupled with declining birth rates, it is not hard to conclude there will be fewer consumers in the peak spending years.

The demographic trends at both the front end and back end of the human lifespan do not bode well for real estate. I discussed the social impacts on the economy of the various generations in chapter 5 of Escaping Oz.

Financial considerations

Amplifying the above point on demographics, there have been numerous studies done that highlight the under-saving of the Boomer generation. Couple that with underperforming and underfunded pension plans, and you have a future where pensioners will not have the income they anticipated. The current low interest rate environment is only exacerbating the situation.

According to the NAR, housing affordability, considering the historically low interest rates, is worsening. The first table shows affordability nationwide over the last three years.

Less affordable
Year Affordability Index
2013 176.9
2014 165.8
2015 163.9
2016 (Jun) 153.3

The next table illustrates current affordability by region:

Move to the Midwest
Region Affordability Index
Northeast 154.9
Midwest 186.8
South 157.9
West 114.8

The country as a whole has experienced a sharp deterioration in 2016.

So not only do we anticipate that retiree finances will be strained in the future, they are likely strained right now.

Current trends

The last graphic I will offer falls in the category of current trends. This chart illustrates home ownership rates and the well-known Case-Shiller Composite Home Price Index.

Home ownership rates peaked just prior to the all-time high in the index and have fallen steadily since. The price index bottomed in 2012 and has continued up since then.

We can speculate regarding the divergence of price and ownership rates: foreign money, shrunken inventory, real estate purchased by hedge funds for investment purposes. I will add some thoughts on these points. Foreign money is highly susceptible to exchange rates, capital controls and government taxation policy. It would be risky to continue to rely on foreign ownership to bolster the market.

Futhermore, those owning real estate that is not also the roof over their head, represent owners with the easiest path to liquidation. That comment applies to both foreign and domestic owners.

I suspect the shrunken inventory is due to a couple of factors one of which is an owner who is still "effectively" under water and not wanting to take a loss. "Effectively" under water means someone who would still take a loss when considering real estate commissions and other associated expenses with a sale.

Conclusion

There are a number of factors providing considerable head winds to the real estate market. Unlike a bicyclist who can lower their profile with aero bars or ride in the relative comfort of a peloton, the real estate market has no such windbreakers. The next deleveraging in the real estate market will take a toll on the economy. It remains to be seen if the central bank wizards take another shot at reflating.

Readers should approach RE ETFs and homebuilder stocks with extreme caution, for the reasons stated in this article. In addition, the equity market's abject lack of volatility will diminish upside potential for these issues.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.