Concerns About The Real Estate Market And Stock Market As A Whole

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Includes: MORT, NLY, VNQ, XHB
by: A Capitalist At Heart
Summary

Real estate has grown too quickly and has priced non-investment buyers out.

Home values will only appreciate at around 2% this year as opposed to the 7.6% average.

New home construction is slowing down.

Chinese housing could have an effect on American markets.

Other macro factors indicators are showing a slowdown is near.

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Since the real-estate bottom in 2010, investors have been piling on. House prices have risen steadily, rents as well. But, as data shows, that growth is stopping. Non-investment buyers have been priced out and are not able to sustain the price of the housing supply. Housing inventory is increasing, listings with price cuts are increasing, and housing permits are decreasing. With most REITs reaching all-time highs, these risks have not been realized by the majority of investors. I believe they will become realized in the next few months and could be the catalyst for a larger economic slowdown.

REITs and Their Excessive Leverage

In the aftermath of 2008, real-estate-investment-trusts (REITs) became very popular. This is a type of fund to aggregate investors to purchase property. Here is more information on REITs.

Total assets owned by REITs, yearly returns on REITs, and total liabilities owned by REITs have ballooned since the financial crisis.

Accruing liabilities for purchasing property is not a bad thing, as property is a capital-heavy market. However, the property value must increase at a rate higher than the interest rate on a loan. For example, you can buy a property on a 5% loan that increases 8% in value every year; you make 3% in profit every year. This happens the majority of the time, especially during periods of low federal funds rates. We are coming out of one of those periods, with the federal funds rate climbing from 0.25% in 2015 to 2.5% at the time of writing. Because of abnormally low interest rates, property developers like REITs have done extremely well. Many development trusts which purchase MBS mortgages (called Mortgage REITs or mREITs) have done so well that their dividend yields exceed 10%, leading many people to add them to their stock portfolios for a high ROE. The only way they can achieve these kinds of profits is by using incredibly high amounts of leverage. These dividends are only sustainable with markets that appreciate in value at a high rate, and that has been true for around the last 10 years. As I will cover below, the market is no longer going to appreciate at such a rate. Depending on other factors, the housing market might actually depreciate slightly in the next few years.

Because of the end of quantitative easing (higher federal interest rates), combined with lower overall housing demand, many of the mREITs will become unprofitable and not be able to sustain their 10% dividends. At the current rate of leverage, they risk sacrificing their earnings for loan payments.

This, combined with other macroeconomic factors, brews trouble for the economy and stock markets as a whole.

Housing Data

Over the last 10 years, the housing market has been expanding rapidly, quickly recovering from the 2008 crisis. When looking for a recession, this is usually the first place to check. Housing is a cyclical market, and there are some very specific things to look at when gauging the state of the national economy. Before a recession begins, there is a slowdown of growth in home sales. The following examples reveal that this slowdown of growth is upon us.

Cut-and-dry, realtor.com is expecting housing prices to rise at 2% instead of 7%. This means that the appreciation of houses will be much smaller in 2019 than it was in the previous 5-10 years. The average appreciation rate per year is 7%. At the same time, there is lots of data from Zillow saying the same thing.

Source: Zillow Housing Market Overview

It is clearly indicating that the amount of homes sold in 2018 has decreased by a significant amount. This could be an indicator of a further slowdown in growth, but alone, it is not enough to form a conclusion. Here's another graph showing the amount of listings which had to have their price cut to reach a sale.

Source: Zillow Housing Market Overview

This graph is harder to read, but two things are obvious: The peak in October was 18.1%, much higher than the previous year's peak of 15.88%. And that the low, which occurs in December, was 10.35%, much higher than the previous year's low of 8.67%. This shows an upward trend in price cuts, which is bearish for the housing market in the long term.

This is because non-investment buyers have been priced out of the market. With house prices rising upwards of 7% each year, many people can no longer afford to purchase houses.

Here's a graph showing the annual home appreciation, annual rent appreciation, and current median value of a home.

Source: Zillow Housing Market Overview

The median real wage has been relatively stagnant and has clearly not kept up with the value of homes rising so quickly. The antithesis of this is that the market has been able to rise this way for so long, and that's true. However, at the end of a cycle, this growth starts slowing down.

Here's a graph showing the change in housing starts (beginning of construction) of large apartment units from year to year. The black lines have been added to show trends between each recession. I encourage you to check this graph monthly if you believe any part of this theory.

Additionally, here's a graph of new housing permits. These are permits requested during the planning phase before construction starts on a building. Keep in mind this data is not up-to-date due to the government shutdown. I urge you to visit it at the end of February when it is updated.

It does not indicate anything for the near term, but if it begins to drop quickly, that means the economy is nearly in a recession. This has been the case for 6/7 of the recessions, which this graph effectively covers. If the data (covering 2 months) comes out at the end of February that the permits have dropped significantly, I will update you, and my time-frame for this will also shorten.

Additional Data

Heavyweight Truck Sales

This indicator is important because of how much the number moves before a bear market. If retailers and manufacturers believe there is economic strain coming, they will stop ordering heavyweight trucks (semi trucks) because they anticipate a drop in demand and thus will not need additional logistics to ship their goods.

Yield Curve

Another graph which many people look at is the Yield Curve. It is a combination of long-term bond yields minus short-term ones. When the short-term yields are higher than the long-term yields, it's known as an inverted yield curve. This phenomenon usually happens shortly before a recession. A popular curve to view is the 10-year minus the 2-year treasury yields. Here is a graph of that curve.

On this graph, the yield curve passes zero at different times relative to recessions.

It dropped below zero on January 31, 2006. The stock market peaked on October 11, 2007; One year and 9 months after the yield curve passed zero. However, it went above zero quickly afterwards. The second crossing occurred on June 7th, 2006, still much before the peak of the stock market.

It dropped below zero on June 12th, 1998. The stock market peaked on March 24th, 2000; One year and 9 months after the yield curve passed zero. However, the real estate market peaked in 1998 for that period. It also went above zero quickly afterwards.

It dropped below zero on December 13, 1988. The stock market peaked on October 29th, 1989, and again on July 13th, 1990. It should be noted, however, that the stock market had just witnessed the largest 1-day crash in history a few years prior in 1987. The circumstances here make it more difficult to extrapolate data about the yield curve's ability to foresee recessions.

It dropped below zero on August 17, 1978. The stock market peaked on November 26th, 1980, two years and three months later. However, it should be noted there was a 21% crash beginning in February of 1980.

All of this data, combined with the fact that the yield curve is positive, does not help my theory. However, there is always the exception to the rule. Using one graph does not make a theory. I believe we are much closer to a recession than the yield curve indicates due to the other graphs shown in this report, but that will only become apparent as more data comes out.

Conclusion

There are significant risks in the real estate market right now, as growth is beginning to slow. Too much money has made its way into investment properties, pricing out non-investment buyers. Housing prices have risen at too high a rate, and appreciation is clearly slowing down. These risks will become realized in the next 6 months as REIT earnings reports come out and more data is released. That, combined with other macro trends, is evidence we are at the end of the business cycle.

If correct, this means that the real estate market has already peaked. It also means that REITs will begin to see their earnings decline, similar to what was seen in early 2007 (though, circumstances are not the same). Pay close attention to housing data in the next few months, for that will paint a clearer picture of the direction of the housing market.

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.

Additional disclosure: I will be entering a short position on real estate ETFs within the next 3 months. I do not currently have any positions open which pertain to this article or subject matter.