Real Estate

When Times are Good, Investors Overlook Certain Market Conditions: How Real Estate Keeps Tricking (And Treating) Investors

By Benjamin Richard Truitt, Spire Fund Advisory

In good markets, investors may not always take precaution about underlying factors that are brewing up a storm. Over the course of the last 50 years, perhaps even longer, the real estate market has been the epicenter of the last few market events, both good and bad.

Throughout the COVID-19 pandemic, housing became the “it” commodity, with droves of people fleeing cities and flocking to the suburbs to find more space and a way to live comfortably through quarantine. Hedge funds noticed this trend, and as of late, they too have been bullish on the burbs as some of the biggest buyers of single-family properties across the United States. It’s estimated that hedge funds have purchased somewhere between $60B and $100B of single-family homes to hold for appreciation and rental income. It seems they have quite a bit of confidence in this market. Should you?

What is a Home Worth?

In sales, there is a famous line that states, “Something is worth what someone is willing to pay for it.” With that, what is a house worth? Is it all comps, schools, walkability, location, number of bedrooms, size of yard, etc.? These are all obviously important motivators for a homeowner or a tenant, but as significant is the cost associated with living in a home.

Historically, a financial comparison between renting versus owning would show that all-in-all the financial impacts of renting versus owning are typically close, but in the long-term you are better off owning. Paying a mortgage should typically be slightly less than paying rent for the same home, since a homeowner is on the hook for other expenses like maintenance.

We have been in this historically low interest rate environment since the financial crisis and it has significantly reduced the cost of owning a home. The average interest rate for a conventional 30-year mortgage in 2006 was 6.41%, according to Freddie Mac. At 6.41% the payment on a 30-year $500,000 mortgage would be $3,130.80. Through September 2021, the average conventional 30-year interest rate for 2021 is 2.92%. At this interest rate the same payment would cover a mortgage of $750,249.52. This represents a 50% increase in buying power for a homeowner.

The rise in buying power has effectively increased the supply of capital for single-family homes from homeowners by 50%. In 2006, there was $13.53 trillion in outstanding single-family mortgage debt. A 50% increase in this amount would be $20.3 trillion; however, at the end of Q1 2021 there was only $16.96 trillion of outstanding single-family mortgage debt. The difference between these two numbers represents excess buying power and excess capital demand for single-family real estate that has not been met due to lack of available supply. Of course, this excess capital or buying power could evaporate quickly with a recession or increases in interest rates. An opposite increase in interest rates would just as quickly, or even more quickly, wipe out this capital.

It is important to also be aware of the other portion of capital that is invested in single family real estate: the down payment. All else unchanged, if you increase your debt by 50% you will also need to increase your equity investment by 50% to maintain the same leverage ratio. This means that investors or homeowners purchasing single family homes need to have this down payment available, which is dependent on savings and income.

Savings has largely been buoyed by an amazing bull run in the stock market along with government stimulus during the pandemic and post pandemic. Incomes have also been increasing, driven by the extended strong economy and government stimulus as of late.

All these factors are very vulnerable to a dramatic shift in economic conditions, driven by activity within the U.S. economy or macro events outside of our boarders. Significant geopolitical impacts are often underpriced in the capital markets but can have a staggering impact on global economies and often so quickly that the real estate investors have no time to adjust due to the illiquidity of real estate assets.

Beyond interest rates there are other measurable metrics that can highlight how thinly the market may be or not be stretched. The index of U.S. House Price-to-Rent Ratio has exceeded 100, which it has not reached since 2006. Home prices relative to rents have not been this high since just prior to the Great Financial Crisis. This strongly supports the argument that home prices are stretched very thinly relative to the affordability of covering the monthly costs of owning the home or renting a comparable home.

Price to rent ratio

Another key measure to consider is household incomes relative to household debt. This gives an idea of excess disposable income that could be used for something like moving up into a larger home, financing a car, or carrying additional credit card debt. The below chart of Household Debt Service Payments as a Percent of Disposable Personal Income ( actually shows that the U.S. has reached a significant low since at least the 1970s.

FRED chart

It appears that consumers have plenty of excess income, at least relative to household monthly debt costs. In addition to the increase in capital available to the single-family home industry, from decreased borrowing costs, hedge funds and private equity, there appears to be a significant increase in capital available from household income. This household income can be accumulated for down payments or used to cover an even larger mortgage payment, which would also expand the debt capital that is available to single-family real estate even further.

Benjamin Richard Truitt, throughout his career, has endeavored to bring the technical fields of engineering and computer science to the real estate investment and banking industries through the development of innovative applications designed to streamline complex valuation models and better forecast outcomes using artificial intelligence (AI) and Machine Learning. Currently, he is the VP of Products for Lending Standard, where he has been for almost five years. In addition, he is the Founder and Chief Executive Manager of Spire Fund Advisory LLC and President & Chief Investment Officer of BYTZ Fund, LP, an algorithmic-based hedge fund he founded in 2019.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.