Is the U.S. Housing Market a Conundrum or a Paradox (Part 2)?

In the first part of this deep dive into the variables that influence the housing market, we described a fundamental conundrum of the housing market over at least the past 20 years — affordability is decreasing and so is supply. In this part two, we will look more closely at the variables affecting affordability and supply to understand why the conundrum is so persistent.

Intractable Conundrum or Paradox

In the U.S., housing is entirely in the hands of private businesses, lenders, and investors. Housing is constructed for profit, not for altruistic reasons. Governmental attempts decades ago to provide publicly funded housing were inadequate and ultimately created urban blight because of poor security and maintenance. (Governments are moderately good at funding new construction and pervasively woeful at maintaining the structures they fund.)

Unless the federal government nationalizes the housing industry and suddenly learns how to operate efficiently (less likely than escaping from a black hole), solutions to the housing shortage and the diminishing affordability of housing must be consistent with capitalism and profit. The many participants in the complicated housing construction industry will not sufficiently, if at all, miraculously become fans of Karl Marx. We must assume, instead, that every link in the long chain from land-owners to builders and landlords will pursue the economic incentives that long have driven Americans to work, start businesses, and grow them.

Demand Will Not Decline

Although the rate of U.S. population growth has declined in recent decades, the effect of that decline will impact housing demand only gradually over many years. Even if the population of the country stopped increasing completely, inter-state migration particularly to the South and West would sustain new housing demand in those regions. Unless diminishing affordability drives Americans rapidly to adjust their expectations for how they live (e.g., in smaller homes on smaller lots or in apartments instead of single-family homes), the demand side of the housing shortage will not be part of the solution.

We note that other developed economies have diminished the influence of consumer demand by shrinking the average footprint of homes, particularly in urban areas. Young residents of Tokyo appear to be thriving in apartments measuring about 100 square feet. The adaptation may be culturally unique to Japan or may be a lifestyle change that started generations ago on a small island nation with a very high population density. No matter the reason, Americans do not seem to be primed for such a compromise, except perhaps in New York City.

Increasing Supply Is “Just” A Money Problem

Increasing the supply of housing is a money problem, but not a shortage of money problem. The money needed to close the housing supply gap abounds already in the U.S. economy. Investors hold trillions in cash, bonds, dividend-paying stocks, and other liquid assets that could fund the construction of more housing if the risk and return balanced appropriately.

Indeed, investors were a vital part of the solution to the rapid abundance of distressed single-family homes from 2008 to 2012. Without wealthy or well-funded and innovative investors from small, local investors to large REITs, tens of thousands of houses would have languished in foreclosure, bank portfolios of real estate, or disrepair. Even so, those investors absorbed only a very small portion (perhaps several hundred thousand) of the overall single-family housing extant in the United States during those five years.

The rise of investor participation in single-family housing did not damage the market, as so many housing advocates decry. Those investors simply captured an economic opportunity that also served to restore a modest number of homes to habitability while providing some families with an alternative to apartment living or buying a home.

Single-family investors also brought new money into a segment of the housing market that had been the nearly exclusive domain of small investors. The flow of institutional investor money into the single-family and townhome segments especially is a positive force behind the growth in and stability of housing supply for families that lack the financial resources to purchase a home or pay a mortgage at today’s rates. But for the entry of institutional investors into the single-family and townhome rental business, the supply of housing would be an even greater problem than the U.S. now faces. The build-to-rent variation gaining popularity rapidly in the U.S. serves to fill the demand sparked by incursion of institutional investors into single-family rental.

The overall impact of these institutional investment inflows has been too small and too slow, however, to impact meaningfully the availability or affordability of housing. The demand simply is too high. Other financial resources must be brought to bear either from investors, lenders, or the government.

Construction Financing Is Myopic

Much of the debt and equity that could fund an expansion of housing stock in the U.S. is constrained by myopia. Banks and private lenders especially, but also some equity capital, measure in months their participation in housing construction financing. Lenders and investment fund managers in particular measure the health and performance of their portfolios quarter-to-quarter and cannot tolerate even short periods of profit decline or loan payment shortfall.

Holding a development or construction loan for years does not comport with their investment thesis, the expectation of their shareholders and Wall Street analysts, or the demands of regulators. A borrower must pay interest on time every month. Interest cannot accrue or be deferred for very long, if at all. The loan term is compressed to the shortest timeframe reasonable for completion of construction if the project and the market all perform with near perfection.

If a loan becomes non-performing because of economic factors extrinsic to the specific property or borrower as occurred nationwide in 2007 to 2010, the loan is called, the property is repossessed, and the construction of housing stops. Under intense pressure from regulators from 2009 onward, many banks in possession of repossessed land and homes sold those properties at steep discounts to their long-term value. The institutional investors, such as American Homes for Rent (NYSE:AMH) and Invitation Homes (NYSE:INVH), recognized almost immediately the opportunity to capture enormous upside by purchasing from lender-sellers who were forced to sell by short-sighted regulators, shareholders, or boards of directors.

The profit originally expected by the owners of the foreclosed properties and the banks that made acquisition, development, and construction loans was not lost. The profit was redirected to the institutional investors who were not constrained by short-term measures of financial performance. The rapid rise in home values and rents that easily could have repaid foreclosing lenders and government guaranty agencies was and will continue to be realized by the longer-view investors.

Lenders Are Like Elephants

The lesson learned by lenders who endured the residential real estate calamity from 2007 onward can best be described as avoidance. Since 2007, financing land acquisition and development for residential use has been far more difficult than before 2007. Many lenders that once were active in the A&D arena now refuse even to consider such loans except to borrowers who could repay the loan entirely from assets other than the financed project. As a result, less land is purchased for development and fewer lots are developed.

These lenders have not and likely never will forget the 2007 experience nor should they. Staunch avoidance of A&D lending, however, is not a strategy helpful to housing supply. Until lenders are relieved of their fear of another 2007, lending practices will not change. The scarcity of financing (except for the largest builders who now dominate the industry) will restrain the availability of housing and keep prices high and rising.

Next Up

In Part 3 of this series, we will explore the variables in mortgage lending that keep home prices high and supply down.