Recalculating Risk: The Californiafication Of US Housing
TBD Dream Teamer Scott Cox unpacks how to grapple with where housing's at, where it's heading, and what builders, developers, and investors need to do to factor for disrupted supply and demand forces.
I think we’re all thinking the same thing. How long does this last and how does it end? For all of our angst over costs, we’re making a lot of money (not as much as the public thinks, but a lot). Yet there is a palpable sense of concern in conversations around the country.
Part of what we are feeling is the benchmarks for market health we used in the past don’t seem as helpful as they did previously:
- Home price-to-income. This looks troubling, but home payments to income are more or less at historical norms. We intuitively feel we’re at risk on this metric given record low mortgage rates. But we’ve been worried about that for a number of years, and you can find as many economists who think rates will stay like this for the foreseeable future as you can who think rates will go up significantly sooner rather than later.
- Employment-to-permit ratios. This used to be a key benchmark for us and in the last year it’s been beyond useless, it’s laughable. Maybe we can replace it with some kind of nuanced specific employment sectors to permits ratio? Or is that just looking to justify the unjustifiable?
- Months of supply of finished lots. When we could reasonably respond to demand with more supply, a critical metric to keep an eye on. Now? It looks like this will be such a lagging indicator as to not be helpful until it’s too late. More on that later.
- Permits-to-population. A favorite of some analysts to demonstrate massive undersupply. But really, we should be focused on permits to population growth. Growth is slowing dramatically, now down to a 0.5% annual rate. Furthermore, the composition/size of household formations is changing, making it hard to look at past relationships of population growth to housing units and draw precise conclusions.
- National statistics in general. We’ve always known housing is a local business, but with much of the growth in the US taking place in a modest number of very successful metros, the combined national numbers are even less useful than they once were.
- Past history in general. I’m certainly not suggesting the past is not useful, but we now find ourselves with a changed situation from much of our industry’s history. With the exception of a few markets, notably California, we could reasonably meet supply – and even oversupply -- through the early 2000’s. Then the great financial crisis and a long slow recovery. Now most of the successful metros in the country are struggling to produce sufficient supply to meet demand, supercharged by recent events. So, we can and should know our history and be cautious of saying “this time is different”. But there are material differences -especially the entitlement process.
So, we feel uncertain as to how analyze this. I know I have less confidence in future forecasts than I ever have (some of that may be, being old enough to know how wrong I can be). What can we learn from history?
California, having been in this position much longer than most of the rest of the country, gives some clues. First, traditional demand measurements (discussed above) are of limited practical use other than, at best, to flash weak and very forward-warning signals. The truth is, no one has a good metric for how far prices will move beyond fair value (however you define that) before it’s too much. Sometimes you get an exogenous event that changes markets. However, sometimes it’s as simple as, one day, fewer people show up, and pretty soon fewer people will buy at the new price.
There is an old saying that the cure for high prices is high prices. It certainly holds true here. Prices rise because demand cannot keep up with supply. Long drawn-out project approval processes mean there is a long lag to bring on new projects, during which demand tends to grow (buyers fear missing out). This impacts supply in several ways. Higher prices:
- Create a sufficient price differential from further out to more desirable locations to increase demand for lots/homes on the periphery.
- Make previously approved projects that would not pencil, whether due to locational demand issues or conditions of approval, financially feasible.
- Increase land residuals, inducing land owners who would not sell before and were holding out for a target rice, to finally sell.
But all of these factors take a great deal of time to play out. During which time, prices continue to rise. Supply finally reaches the market ... about the time that buyers are played out. So, we have an oversupply at the price-points we targeted. Not in the classic sense, using historical guideposts, but in the true sense of supply and demand meeting at a price.
So, are we all becoming California?
I hope not. But I fear so. If that is true, what might it mean:
- More volatile pricing/activity levels
- Longer entitlement processes mean it’s harder to have an even flow of production as project deliveries are “lumpy”.
- A balance sheet that will survive corrections/recessions will have to be less leveraged with more liquidity than many might be used to.
- In tension with the previous point, more capital is needed for more expensive projects.
- Managing house costs, while it will always be important, is a less important when direct costs are 25% of house price, not 50%. Maximizing land value through product design increases in impact.
- The value of velocity goes up as the price of lots goes up. Which drives product and presentation spending.
Perhaps most importantly, being very detailed in analyzing your market’s pipeline of future projects (beyond those delivered, or close to delivering) will be critical. What price points will they likely need to succeed? When taken in total, what does that mean for necessary volume at various price points? Essentially, you’re projecting a different price/volume graph than you are seeing today. This may be more art than science, but it’s an art that will be necessary to prosper and maintain an acceptable risk profile.