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Investing in Residential Housing

Written By Briton Ryle

Posted September 4, 2014

A funny thing happened on the way to bank… where once its vault was empty, it is now so full that bills are spilling out into the streets. Fine you say? To a certain extent, yes, it is fine to see cheap money circulating through the economy more easily, spurring growth everywhere it goes.

The only problem is that inflation is not falling back down like it used to. For the last two years or so, every time the inflation rate rose above the Federal Reserve’s target of 2%, it quickly fell back down below it, as noted in the table below.

Inflation rate and housing


This time, however, it isn’t falling back down, but is remaining up there on the 2% line. And its affects are taking a toll on the housing market.

Toll Brothers Inc. (NYSE: TOL), which designs, builds, sells, and finances luxury homes in the U.S., reported yesterday that new-home contracts declined in its fiscal third quarter, with signed contracts falling 6% from the year prior. Despite reporting an increase in net income for its fiscal Q3 thanks to completed sales rising by 36% from a year ago, Toll Brothers’ stock fell over 4.72% yesterday due to those lower orders going forward.

Is this it for the housing recovery? Rising inflation will soon be met by rising interest rates, as the Federal Reserve will be forced to raise rates to keep inflation hemmed in at its preferred 2% annual pace. Is housing about to slump?

Toll Brothers CEO Douglas Yearley believes not, expressing his firm conviction that “pent-up demand has yet to be unleashed”. And he appears to be correct.

The U.S. housing market is in what may be described as Phase 3 of its recovery from the devastation it suffered in 2008. Yet this third growth spurt will come with a few attachments that weren’t present during Phases 1 and 2. In this upcoming Phase 3 of the housing recovery we can expect to see rising inflation, rising interest rates, and even rising mortgage risk. What we won’t see is the end of the housing recovery.

To understand why the rising inflation and the upcoming rising interest rates won’t kill this third phase of the housing recovery, we need to note how it differs from Phases 1 and 2.

Housing Recovery – Phase 1

When the housing market imploded in 2008, banks lost a tremendous amount of money in failed mortgages, with many lenders falling into bankruptcy. Capital froze, markets were illiquid, and banks went on a foreclosure spree to salvage what they could.

As a result of the foreclosures, there suddenly appeared an over-supply of residential housing. As a result of this flood of supply, new housing starts plummeted, as noted in red in the graphs below.

Existing home sales also fell, since the banks were practically illiquid and had to tighten their lending requirements drastically.

With the banking system nearly out of capital and the housing market in shambles, the U.S. central bank came riding to the rescue.

residential housing starts and supply


In response to the crisis, the U.S. Federal Reserve began throwing money at the banks in an effort to recapitalize them for all the money they had lost. The Fed also lowered its inter-banking lending rate in an effort to force mortgage rates down, spur home buying, and thus trigger a reinflating of home values across the board.

With access to an abundance of cheap money, banks started lending again (albeit very cautiously, and only to those with immaculate credit scores), and home buyers started buying again, ushering in the first phase of the housing recovery. Fuelled by the glut of cheap homes on the market and falling mortgage rates, Phase 1 ran from about January of 2009 to around December of 2010, as noted in orange above.

However, this first phase of the recovery was not accompanied by a rise in housing starts, which remained flat. The oversupply of homes on the market had to be eaten up first before there could be any demand for additional homes. Phase 1 was something of a mopping-up after the housing catastrophe. As the foreclosed housing started running out, Phase 1 began running out of steam as indicated by the sharp drop in existing home sales in 2010.

Housing Recovery – Phase 2

The Fed, of course, knew that the task of saving the housing market was far from over, with property values still substantially lower than pre-crisis values. So the central bank stepped up its stimuli from 2011 to 2012, which kept the mortgage rate declining.

Thanks to the cheaper lending rates, the demand for homes continued to grow. After the glut of foreclosed homes was all eaten up, the only thing left to do was to build more houses. Thus began the second phase of the housing recovery, characterized by still falling mortgage rates, a rise in home sales, and a rise in fresh supply through new housing starts, as depicted in green above.

Phase 2 kept marching along very nicely until around the middle of 2012 when bonds had reached 30-year highs and, of course, their yields reached 30-year lows. That summer, bonds reversed sharply, with rising yields threatening to derail the housing recovery.

The Fed then stepped in again with yet another stimulus measure. Beginning in the fall of 2012, the Fed began buying up the banks’ mortgage backed securities plus additional long-term bonds to the tune of $85 billion a month, or over $1 trillion per year. This gave Phase 2 of the housing recovery a second wind, which carried it into the spring of 2013. That’s when the trouble began.

Housing Recovery – Interlude

As the Federal Reserve’s balance sheet started filling up with over a trillion dollars’ worth of bonds and mortgage-backed securities to keep the banks lending and the housing market growing, the time finally arrived when the Federal Reserve would have to bring its QE3 monthly purchasing program to a close. After all, it was just an emergency measure, and could not possible go on forever.residential home construction building

When the Fed started getting the markets ready for stimulus tapering in May of 2013, all hell broke loose. Treasury bonds started falling, yields started rising, and mortgage rates started rising with them, as noted in blue in the graph above.

Tapering hadn’t even begun yet, but already rates were rising and home sales were falling. Housing starts took a little longer to respond, since contracts for new homes are signed months in advance. But after a while, even new home construction started dropping off.

But something funny happened on the way to the bank, as I noted at the outset. The banks seemed to have been fattened up pretty substantially over these past several years, to the point where they were now competing for mortgage borrowers and doing all they could to get their cash into borrowers’ hands.

Thus, even after the Fed began scaling back its QE3 in January of 2014, competition among the banks saw mortgage rates fall, home sales rise, and new housing starts pick-up. The housing recovery had thus entered its third growth spurt, which we are still in today.

Housing Recovery – Phase 3

So here we are with the third wave of home buying well underway since the start of this year. Only this one is proving itself to be quite different from the previous two. This one is being accompanied by rising inflation.

As shown in the first table above, inflation reached the Fed’s target rate of 2% in April of this year and has not fallen since. Five years of cheap money seem to have injected enough cash into the economy to satiate the demand for liquidity. Money is circulating more rapidly as 8 million new jobs over the past five years have increased consumer spending.

Of course, there is not an oversupply of money, so there is no risk of hyper-inflation. But the supply of cash has increased to the point of lifting inflation to 2% for some four months and counting. It looks like the economy is out of the ditch and is moving on the paved road again, hence the end of QE3 before this year is out.

Yet rising inflation means the Fed will soon need to raise interest rates to keep inflation hemmed-in at the 2% level, likely beginning in mid-2015. And rising rates mean rising mortgage rates as well. Won’t this kill the housing recovery? We saw what rising mortgage rates in late 2013 did to housing sales and starts, as they practically stalled the recovery all together.

Ah, but there is one important difference to Phase 3… the banks are no longer as starved for cash as they once were in the first two phases. Over the years, the Fed has fattened them up through bucket-loads of stimuli and mortgage purchases. Though the banks are not fully capitalized just yet, they are healthy enough to keep lending and fuelling the housing recovery on their own, without the Federal Reserve holding their hand anymore.

This is how Phase 3 of the housing recovery differs starkly from the first two phases – in that the banks have more lending capacity, and they are eager to put it to use.

Jim Huang, President and Portfolio Manager at Canada’s T.I.P. Wealth Management is looking forward to continued growth in the U.S. housing market as banks compete for growth.

“U.S. banks are really starting to look for growth,” Huang explained in a Business News Network interview yesterday. “How do they get more growth? Like Wells Fargo, they give more credit and loosen some requirements. That will drive the next leg of the housing cycle.”

The only problem with this, however, is that the banks will need to begin lowering their lending standards just a little. All the top-quality-credit home buyers have already purchased their homes by now. The only home buyers remaining are those with slightly lower scores.

The Housing Recovery is Far From Over

As such, this third phase of the housing recovery will be characterized by higher inflation (which is already here), higher interest rates (likely starting in 2015), and slightly higher mortgage rates too. Yet mortgage rates will likely not rise very much since the banks, in their quest for growth, will have be competing heavily for borrowers, and will keep their mortgage rates competitive.

Do not fear higher interest rates; they won’t kill housing. Look for slightly lower borrowing requirements and increasing competition among banks to keep the housing recovery alive throughout rate normalization by 2020.

Joseph Cafariello