An Englishman’s home is his castle

The problem is that it’s built in a highly financialized space.

As many of you who follow us on Twitter know, we are convinced that we are at a societal and macro inflection point; and its development has been accelerated by CV-19. For markets, the implications are potentially profound, with a myriad of highly complex scenarios.

In simple terms, we are rapidly transitioning from a decade marked by US exceptionalism, in which paper assets like stocks have dominated, to a world where persistent dollar weakness and ultimately inflation will make real assets the stars.

Real estate has long been viewed as the ‘ultimate’ tangible asset. However, a cornucopia of moving parts could see US real estate hit by a negative headwind as problems begin to surface.

US Real estate: what’s the big deal?

Real estate matters. We either own homes or rent them, but most people aspire to the former. Affordability has been a huge cross-generational bone of contention across much of the developed world. No more so than in the Anglo-Saxon sphere, where the US, UK and Australia jump out.

In the residential sector, real estate has become heterogeneous and local knowledge essential. There is the maze of mortgage availability, loan to value ratios and credit scores.

Then you look at the commercial sector; land and buildings are the collateral for lending to businesses, small and large alike. This debt is packaged and resold by financial intermediaries and forms an important subset of pension fund assets. Pension funds, endowments and life insurers also typically own commercial real estate for its rental yields and assumed long-term appreciation.

It is a statement of the obvious that real estate matters. It matters for its yield and valuation; for new home formation and construction; for landlords and renters in the domestic and commercial sectors. Real estate has its tentacles everywhere.

Covid means suburbs good, cities bad

At first glance brisk suburban activity might suggest residential real estate is in rude health, but finance is tightening, and urban activity is weak. The combination of home-schooling a six-year-old in a two-bedroom apartment, the closing of most urban amenities, and record low rates have driven many out of the city. Similarly, cashflow and debt are huge problems for commercial real estate and city office space could be impaired for years as firms embrace new work practices.

Higher unemployment will slow further suburban gains

The direct consequence of putting the economy into an artificial coma is that it triggered an unprecedented collapse in business revenues and wages resulting in an unemployment spike. This, in turn, undermines tenants’ abilities to pay rent and homeowners to pay their mortgages. Government has helped, but the issues are all very market specific.  

As a result, we are not alone in our belief that the current strength in housing will prove fleeting. As we have noted before, unemployment tends to trend for some time after reaching an inflection point. Given that a house is most consumer’s largest asset, the impact on broad confidence should not be underestimated. Last month, CoreLogic, a leading property data service, concluded that by May 2021, rising unemployment would drive a 6.6% decline in house price inflation.

Distressed credits don’t inspire confidence

While the market has decided to focus on metrics like mortgage applications for purchase, which have jumped sharply, the reality is credit availability is heading in the other direction. In an environment with widespread bankruptcy, rising unemployment and congressionally mandated forbearance, why would lenders want to increase their exposure to real estate?

We can expect all kinds of subsidy and support for the stricken property sector, including Federal Reserve monetary policy which will remain “lower for longer”. However, before the bailout there will be some significant write-downs, business restructurings, mandated change and so forth, which means how you choose to be exposed to the real estate market is mission critical. Perhaps now’s the time to nest, instead of invest?