What Will Happen When Current Housing Dynamics Change?

NEWPORT BEACH, CA—We may be in the middle of the longest economic expansion in recorded history, with low supply and high demand for housing, but at some point, at least one of those dynamics will shift—and then what? Landmark Capital Advisors managing director Adam Deermount tells We spoke with Deermount about the factors that could shift the housing supply/demand scenario, and what could happen at that point. How do we look at home values today?

Deermount: Human beings are incredibly adept at explaining things by creating narratives to justify why something increases or decreases in value. During the housing boom, we rationalized away booming housing prices by pointing out the positive feedback loop created by increased housing production and expenditure. Houses were going up in price, so people bought more houses and tapped into their increased equity to consume more via HELOC, which in turn boosted the greater economy. Back in the Internet bubble of the late ’90s, we explained away absurd valuations and skyrocketing stock prices for unprofitable companies by rationalizing that “this time was different” and that companies could sustain high valuations so long as they continued to grow—profitability (or even revenue, for that matter) be damned. We even came up with new BS metrics. Suddenly, clicks mattered more than price-earning (P/E) ratios. In the teeth of the Great Recession, we were often told by pundits that home values would never recover because the bubble had burst, and demand would stay low forever since homeownership was almost always a bad investment. In hindsight, each of these economic narratives that justified excess of one form or another were proven wrong. Why is this a problem?

Deermount: The problem is that the chosen narrative du jour is often just a description of the symptoms of economic growth or contraction, as opposed to the cause. Daniel Gross of Strategy+Business explained this phenomenon in as straightforward and clear a manner as I’ve seen in a piece about procyclicality lengthening business cycles, titled “Economic Cycles Cut Both Ways” (emphasis mine):

“During uptrends, generally speaking, financial success begets more success. People earn wages and borrow money, which allows them to buy cars and homes. Because jobs are plentiful, they’re able to stay current on their debt, which boosts the profits and confidence of lenders—who then extend more credit, which allows more people to spend and invest. The longer the cycle, the greater the tolerance for risk. When everybody succeeds, everybody else succeeds. Between June 2004 and February 2007, for example, there were no bank failures in the United States, the longest such streak in history.”

By many accounts, we may be in the middle of the longest economic expansion in recorded history, as Goldman Sachs recently noted. Yes, it’s been a bit of a slog and uneven, to say the least. However, the above passage accurately reflects the current state of the economy in general and the housing market in particular, in my opinion. But there is a dark side. The above-noted feedback loop works on the downside as well, as Gross notes in the following post (emphasis mine):

“But procyclicality, as we learned in the mortgage and financial crisis, also moves in the other direction. And it can do so very quickly. When one party fails to keep up with an obligation—on a mortgage, lease, payment for services—it can push others to fail to keep up much larger obligations. And when there is a lot of leverage built into the system, the margin for error is smaller. For want of $5,000 in mortgage payments, somebody might lose their house, causing a bank to take a $300,000 loss on the mortgage, which leads instantly to larger losses in securities backed by those mortgages, which leads quickly to big losses for financial institutions that had borrowed money to invest in those securities, which leaves those financial institutions unable or unwilling to extend a mortgage to a homebuyer.” What else can our readers learn from this?

Deermount: Gross goes on to point out that recent negative trends in auto loans and credit card defaults could be pointing to the beginning of a downward swing in the economy. Housing has been going up in value in core markets for quite a while despite relatively low sale and start volume. The housing market (at least in terms of price) has tracked economic growth at the high end of the income spectrum, which has been where most of the gains have been in terms of wages and net worth.

The narrative has become that housing prices will continue to rise due to the supply/demand imbalance in desirable markets. The question that bears asking is what happens when this imbalance inevitably changes, either on the supply side (more units being built) or the demand side (a recession that impacts finances, out-migration from expensive markets, increased selling from Baby Boomers in expensive markets, etc.)? I don’t know when this will happen or if it will be soon, but it will happen at some point. No cycle lasts forever no matter how strong the narrative justification behind it is. This one won’t be an exception.