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How To Play The Chronic U.S. Housing Shortage: Long-Term Stock Ideas

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Includes: ADSK, AVB, BRK.A, DASTY, EQR, ESS, EXPI, GOOGL, KB, LEN, LPX, MAA, NVR, RDFN, RMAX, SFTBY, SKY, Z
by: Quantitative Insights
Quantitative Insights
Long/short equity, long-term horizon
Summary

Rising home prices will benefit companies that own rental properties and companies that produce affordable housing.

Adoption of productivity technology and off-site construction methods will increase as a means of increasing industry output with a constrained labor force.

Decreased liquidity in the housing market will create new demand for liquidity providers that can quickly buy and re-sell existing housing stock.

Abstract

Labor scarcity is constraining the housing production capacity in the US to levels below what is required to keep pace with population growth. The resulting supply-demand imbalance is expected to be a long-term trend to which there is no quick fix. This article outlines the implications of this long-term trend and associated opportunities for investment in real estate, construction technology, and property technology.

Overview of US Housing Shortage

The United States is currently experiencing a housing shortage that is expected to persist for many years into the future (see 2019 Harvard University Joint Center for Housing Studies Report for much more detail). The root cause is a labor shortage linked to down-sizing during the 2008 recession, preferences among younger workers for less physically demanding jobs, and record low unemployment. This shortage of labor is constraining the construction industry's ability to increase housing supply and meet current demand.

Recent studies estimate that the housing industry will need to increase output by 30% just to keep up with demand from population growth. The problem is that the construction industry is large - more than 7.5 million people are currently employed in construction. Consequently, increasing production by 30% without being able to rely on expanding the labor force is simply not possible in a short time frame. Therefore, it is reasonable to expect the housing shortage to persist for many years into the future. In the remainder of this article, I highlight some of the implications of a sustained housing shortage and ideas for how to invest in this long-term theme.

Rising Home Prices & Demand for Affordable Housing

The direct result of a supply-demand imbalance for housing is rising home prices. Rising home prices will also be manifested as rising rents for rental properties. The obvious way to play this is to invest in companies that own existing housing stock such as Equity Residential (EQR), AvalonBay (AVB), Essex Property Trust (ESS), and Mid-America Apartment Communities (MAA). As housing prices increase, a significant fraction of prospective home buyers will be priced out of the market, which will create demand for affordable housing. Studies indicate that the housing shortage disproportionately affects affordable housing - current estimates indicate a current gap of 7 million units. This could potentially increase demand for manufactured home builders such as Skyline Champion (SKY) or Clayton Homes which is owned by Berkshire Hathaway (BRK.A) (NYSE:BRK.B).

There are some limits on how far home prices and rents can rise of which the reader should be aware of. The first is that housing already represents a large fraction of occupant income - at some point, the cost of housing simply will become unaffordable, which already appears to be the case across lower and moderate income brackets. The second is that there is policy risk - since housing is such a basic need, as housing affordability reaches a breaking point, it is likely that local governments will be pressured to step in and intervene. One example is California, which is seeking to cap the rate at which rents can rise. Finally, as prices rise, the home-building industry will be able to increase production by raising wages for laborers.

Adoption of Construction Technology & Off-site Construction

The chronic housing shortage will create long-term sustained demand for new housing production. On the surface, this is good for traditional builders such as Lennar (LEN), KB Home (NYSE:KBH), and NVR (NVR) whose earnings tend to ebb and flow with housing demand. However, it is not clear if this pent up demand will translate into sustainably increasing profits for home builders since the root cause of the housing shortage is an inability for the housing industry to increase production by hiring new labor. There are three potential scenarios for the future: (1) the home building industry will maintain current production levels, and rising home prices will lead to increased margins, (2) the home building industry will expand production by increasing construction wages, leading to higher volumes with no margin expansion, or (3) the industry will begin to adopt new technology to increase output with a fixed labor force. In reality, the industry will likely pursue some combination of all three scenarios.

In my opinion, scenario #3 (construction technology) is the only scenario that has the potential to create the large increase in output (i.e. +25% discussed earlier) necessary to match supply and demand. Hiring more workers simply is not a realistic option given current employment dynamics and the sheer size of the construction industry. The construction industry is considered one of the least digitized industries in the US, and thus the adoption of digital technology is one compelling route to increasing industry productivity. Autodesk (ADSK) is directly linked to the trend of digitization of the construction industry. Dassault Systemes (OTCPK:DASTY), while primarily used in other manufacturing industries, is also beginning to see some adoption by the construction industry.

Off-site construction/prefabricated construction is also another approach for increasing industry capacity. Again, the manufactured home giants Skyline Champion and Clayton Homes are incumbent leaders in off-site construction. There are also many emerging new players in this space, for example, Katerra which is backed by SoftBank (OTCPK:SFTBY) and Entekra which is backed by Louisiana Pacific (LPX).

Adoption of Real Estate Technology (Prop Tech)

Innovation in real estate (often referred to as "prop tech") will likely also gain traction in response to the housing shortage symptoms discussed above. Some companies are looking to innovate around how real estate is used and/or delivered in order to directly reduce their cost. This could be through shared co-living spaces, innovative financing models, or public-private partnerships structured around the goal of increasing housing affordability. A lot of these ideas are still in relatively early stages - two prominent examples are SoftBank backed The We Company and Alphabet (NASDAQ:GOOG) (GOOGL) backed Sidewalk Labs.

Another emerging need in real estate related to the housing shortage will be the need for increased liquidity. Historically, liquidity in the market was provided by excess supply - a vacancy rate between 12% and 13% is considered healthy (see discussion in 2018 Freddie Mac Report). This vacant supply allows for the housing stock to be renovated to bring that stock up to modern standards and to enable home buyers to easily move between houses. As vacancy rates decline, the resulting reduced liquidity could inhibit the growth of companies that rely on transaction volume for revenue, for example, traditional real estate brokerages such as RE/MAX (RMAX). If real estate agents start to see transaction volumes decrease, brokerages such as eXp Realty (EXPI) that are pursuing a cost-leader strategy for serving real estate agents may benefit. Reduced liquidity also directly creates a new opportunity for liquidity providers - Redfin (RDFN) and Zillow (Z) are both going after this opportunity by directly purchasing and re-selling houses.

Risks & Assumptions

It is prudent to conclude by acknowledging the assumptions underlying the housing shortage thesis and the risk factors that might cause the thesis to change. The first is the risk of a recession that affects most long positions. A recession would depress home prices and increasing unemployment could help alleviate some of the industry labor shortage. Ultimately, this is a temporary risk that does not alter in the long term the fundamental supply-demand imbalance in the housing industry. The next risk is that a market/technology disruption alters the labor dynamics in the construction industry. For example, aggressive adoption of automation in either manufacturing or general office work could produce the required labor force to support the construction industry. Finally, there is the potential for government/policy intervention since rising home prices and housing shortages will strongly impact voters.

Disclosure: I am/we are long Z. 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.