Worrying about rates won’t solve the housing crisis
Shelter is a prerequisite to life, liberty and the pursuit of happiness. Today, there is simply not enough to go around. With the explosion of real estate prices and rents during the COVID pandemic, a crisis bubbling beneath the surface came into stark relief. Still, new home construction severely lags the needs of an aging population, and a chilled venture market along with a shocking rise in the 30-year mortgage rate is scaring investors away from funding businesses that solve this generational crisis.
At Gutter Capital we invest in companies that advance the American Experiment. Our mission reflects our conviction that the great companies of our time will be built in response to humanity’s greatest challenges. We have spent considerable time seeking to understand the housing crisis, as there is no more pressing issue facing our country.
While the lack of housing is common knowledge, the extent of the shortage remains greatly underestimated. Publications like the NYT and WSJ often cite a Freddie Mac study that reports a 3.8 million unit nationwide shortage as of 2020. Unfortunately, after two years of building homes at the fastest pace since the global financial crisis, we estimate a far more dire shortfall of over 6.5 million units. We believe the crisis is much bigger than commonly understood, and presents significant opportunities to teams who bring solutions to the table.
How did we get here?
The seeds of the shortage were planted during the housing market crash of 2007. Homebuilders fueled by what were historically low interest rates, and high gross margins, for a brief period in the mid 2000s built new construction faster than family formation demanded. The resulting housing surplus kicked off a nearly 30% decline in real home prices that precipitated the global financial crisis.
Homebuilders touched the stove, and they got burned. Nearly half of them failed. The survivors were the most well capitalized and risk-averse of the group. Unfortunately, they learned the wrong lessons from the crisis: to prioritize margin of safety, over construction volume. The result was a decade of chronic underbuilding.
Homebuilder’s departure from the market could not have come at a worse time, as an aging population began to require more housing than in previous generations. The rise of single-person households, led by baby-boomers aging-in-place, pushed down average household size and increased the number of housing units required per adult. That trend will only get worse over the next decade as the share of the population over 65 increases from 16.5% to over 20%. We will need to build more homes just to keep up with changing demographics and we are so far behind the curve.
Housing has reached the point of a national emergency. Yet still, on earnings calls for the major homebuilders, the executives tout their prudence. When they have everything to gain from ramping production, they still choose to prioritize margin over growth.
Before taking any position, it’s important to consider the ways that we may be wrong. The most prevalent opposing view is that we are in the midst of a housing bubble, spurred on by emergency fiscal and monetary policy during the COVID pandemic. So it goes that if the Fed created the boom, the Fed will surely create the bust as rising mortgage rates tank the housing market. To assess the validity of this view, we ask ourselves “why did rates rise so much?” and “what do higher rates mean for the housing market?”
Why did mortgage rates rise so much?
Many people blame the Federal Reserve for the jump in mortgage rates. After a surprisingly high inflation report in June, the Fed started aggressively raising short term rates, putting upward pressure on the interest rates for longer dated bonds and mortgage backed securities. This view is mostly true, however, underestimates the equally important psychological effects of the Fed’s asset purchase program. In 2021, the Fed accounted for over 20% of the total mortgage backed security market. When such a large buyer suddenly walks away, it makes sense for other participants to wait-and-see how the rates adjust. Accordingly, the spread between the 30-year mortgage and the 30-year treasury blew out from about 1% at the beginning of 2022, to over 3% in October.
Spreads this high have only occurred three times in recent memory, 2000, 2008 and March 2020, all periods of distress in credit markets. We believe this is evidence of a market distortion that will correct over time to the historic average. If all other factors remain the same, the result would be over a 1.5% drop in the 30-year mortgage rate. There’s reason to believe that rates above 7% will be temporary, and it doesn’t require the Fed to start lowering the overnight rate for things to cool down.
What do higher mortgage rates mean for the housing market?
Most people believe there’s a direct link between mortgage rates and home prices, simply put: higher rates means people can afford less, therefore as rates rise, prices must drop. While intuitive, the evidence of that relationship is not clear cut. Historically, changes in the mortgage rate have had only a modest (0.1) correlation with real home prices. A recent counterfactual occurred during the global financial crisis, when a steep drop in interest rates did little to support the housing market as it declined from 2008–2012. For that period it appears like the supply imbalance was the dominant economic force.
We believe the same may be true today–that lack of housing supply will outweigh the effects of rising interest rates to buoy home prices. Because mortgage rates are locked in for 30–60 days, and home sellers gradually drop prices as homes don’t sell, real estate prices reflect a snapshot of what dynamics were a few months in the past. The 30-year mortgage rate first rose above 5% in the beginning of April. After 7-months, so far we’ve only seen modest declines in prices (Redfin’s nation-wide median sale price data shows a 6% drop from a peak in March 2022, Zillow’s data hardly shows any decline at all). Transaction volume has dropped, but remains historically high, and for-sale inventory matches the number from 2021, which was a multi-decade low.
What is our view?
We believe that there is a historic opportunity today to invest in businesses that accelerate the development of housing in the United States.
It took us a decade to create the housing crisis, and at the current pace of construction, it will take more than a decade to build ourselves out. While we believe the anticipated drop in real estate is exaggerated, or may not come at all, we aren’t making a directional market bet. Even without higher prices, the housing supply must expand. It is a national imperative. We believe that in any environment generous margins can be achieved by companies that find novel ways to accelerate the pace of housing development, and we aim to fund them.
Given the scale and scope of the crisis, we don’t expect one company to solve it alone. In the past few months we’ve led three investments in the category. We are looking to back mission driven founders who are showing up to this moment of crisis with solutions in hand, ready to build. If you’re interested in joining us, please don’t hesitate to reach out.
Sincerely,
James Gettinger & Dan Teran
