Residential housing is in trouble, according to Jeffrey Gundlach. It’s not heading for a repeat of the 2008 collapse, but it’s equally unlikely that housing growth will provide the needed push for a strong U.S. economic recovery.
“For all those people who are looking for a bump from housing,” Gundlach said, “I don’t think you’re going to get it.”
Gundlach spoke May 14 in San Diego at the Strategic Investment Conference, sponsored by John Mauldin and Altegris. He is the founder and chief investment officer of Los Angeles-based DoubleLine Capital.
A copy of Gundlach’s presentation is available here.
Too few buyers are chasing too many homes at today’s price level, according to Gundlach. Housing is like any other commodity ‑ its prices are governed by supply and demand. For residential home buyers, better times await.
I’ll review Gundlach’s assessment of the housing market and his predictions for the bond market.
Macro headwinds
At a macro level, Gundlach doesn’t expect sufficient credit growth to support a surge in home sales. He said deleveraging in the U.S. economy is a “myth.” Although private credit debt has fallen since the financial crisis, its decline has been more than offset by the growth in public-sector debt. The combination of private- and public-sector debt is now $63 trillion, which Gundlach said is a new high.
“It’s very unlikely, in my opinion, you’re going to see a sort of burst forward in borrowing that’s going to propel housing higher,” he said.
Consumers are still too highly levered, he said. Mortgage debt has declined, he said, but only because of write-downs due to defaults.
“That does not exactly set a great platform for future enthusiasm on housing,” he said. “These people have destroyed their credit, and they’re not likely to be able to run back into the housing market anytime soon.”
Second-lien mortgages have risen over the last several years, he said, to levels that resemble the pre-crisis era. According to Gundlach, that’s because household saving is limited and income growth (at least at the median-household level) has been non-existent.
Since the crisis, cash transactions have represented a larger share the residential market. They are up 50% since 2011. Gundlach said those were transactions by investment pools and by speculators in vacation homes, and they were responsible for a large proportion of housing price gains.
Investment pools bought single-family homes to turn them into rentals, but only for fixed time periods. When those terms expire, those homes will be sold, adding to supply. Now, those buyers are exiting the market, Gundlach said. Blackstone is no longer buying properties “anywhere near the pace they had been,” he said, and Oaktree Capital, a minority investor in Doubleline, closed its rent-to-own program last year because it “didn’t make any economic sense.”
Existing-home sales, he said, have risen since their low in 2010, but they have fallen rapidly in the past six or eight months. “It kind of looks like 2007,” Gundlach said, “and that’s with all that money coming in from investment pools.” One cause of that downturn, he said, was the rise in interest rates that began last summer.
New-home sales are falling too, he said, and those are unaffected by investment pools. The mortgage purchase index, which drives new-home sales, has been trending lower since 2013, according to Gundlach.
Housing starts have increased lately, he said, which is bad news for homebuilders and for housing prices.
Affordability
One of the things housing bulls love to talk about is how housing is now more affordable, based on a traditional 30-year mortgage. Gundlach dispelled that notion.
Those mortgages were uncommon in 2006 and 2007, he said, representing less than 30% of the mortgages in hot spots like California and Arizona. Back then, it was more common to finance homes with option-pay adjustable-rate mortgages (ARMs). Those mortgages don’t exist today, and Gundlach said it’s a mistake to compare them to 30-year mortgages.
Gundlach presented data showing that housing in California is less affordable now than it was in 2004 or 2006. Mortgage payments are greater now than they were then for similarly priced homes, using option-pay ARMs and 30-year mortgages, respectively.
When rates increased 125-150 basis points last summer, Gundlach said some people thought the housing market wouldn’t be susceptible to higher interest rates, since rates are still at historically low levels.
“I don’t believe that at all,” he said. “If you are thinking of buying a new home, it matters a lot that the payment and mortgage rate have gone up.” He presented data showing that housing sales decreased right after last summer’s rate spike. “It’s absolutely wrong to believe that higher interest rates do not affect housing,” he said. “You have to be almost heroically dismissive of this chart to believe that.”
One consolation, however, is that Gundlach believes Fed tapering will not lead to higher rates and a decline in affordability. He said last summer’s rate increases were due to the unwinding of levered positions. Anyone who believes tapering will eventually cause mortgage rates to normalize at their historical levels of 6%, he said, should also be prepared for a “really big drop in affordability.”
Affordability has already dropped 30% from its peak, Gundlach said.
Gundlach also spoke about the future status of government-sponsored entities (GSEs) Fannie Mae and Freddie Mac. More than 90% of mortgages have gone through the agencies, he said. In recent months, there have been talks of winding those GSEs down. If that were to happen, Gundlach said private-sector capital would fill the void and demand a higher rate of return than the GSEs, further diminishing affordability.
Gundlach said there is potential for a progressive real-estate tax, an increase in current real-estate taxes and a reduction in mortgage-interest deductibility. “Taxes on real estate are not going lower,” he said. “These things can only move in one direction, and that direction is one that becomes more negative for affordability.”
Demographics
“The home base for investing for the next 10 years in the developed world in particular is an awareness of how radically demographics are changing,” Gundlach said, “and how substantially the workforces are aging.”
Other countries are aging more rapidly than the U.S. Gundlach said Italy’s workforce will fall by 39% in 15 years. But those changes that are occurring in the U.S. will have a negative impact on housing.
Our population will grow in the next 15 to 25 years, and the size of our labor force will grow along with it.
Despite that growth, Gundlach doesn’t expect a surge in new-home buyers. First-time buyers, as a percentage of existing-home sales, have decreased steadily since the beginning of 2013. Gundlach dismissed those who say this represents pent-up demand. Instead, he cited structural changes in demographics.
Household formation is “incredibly depressed,” he said, because “millennials are not the same as boomers.”
Millennials grew up in an era where parents placed many more restrictions on them than boomer’s parents did. Unlike boomers, who could walk to school on their own and stay out at night – often without their parents knowing where they were – millennials are parented much more closely and spend less time away from home.
Millennials want to be physically together, even if they are in a mall or a café and sending one another text messages, Gundlach said. The implication: They are more likely to rent or share a multi-family house than to purchase one on their own.
Boomers couldn’t wait to move out of their parent's’ houses, be on their own and adopt the anti-establishment life style of the 1960s and 1970s, Gundlach said. Millennials, on the other hand, happily live with their parents, “watching the same reality TV, buying the same designer brands and waiting in line with each other at the Apple Store,” he said.
Those societal changes, combined with high student debt and youth unemployment – 40% of college graduates are unemployed or have a job that doesn’t require a college degree – are driving down home-ownership rates, according to Gundlach. He predicted an increase in multi-generational households.
Homebuilders, he said, are acknowledging those societal and demographic shifts. Basements in new homes now have nine-foot ceilings and windows to accommodate live-in children. He is extremely bullish on micro-apartments – living spaces that are compressed into a few hundred square feet, “not much more than a maximum-security prison cell.” He said that supply is constrained by zoning and tenement laws, even though those units would increase the tax base of the communities where they are located.
Home-ownership rates have declined to their 1995 levels, and Gundlach doesn’t expect them to increase. Indeed, he said, ownership among those under 25 is at its 1995 level – and it was the increase between 2005 and 2007 that was aberrant. Gundlach cited a survey by the MacArthur Foundation that showed a heavily skewed preference among Americans to rent rather than buy.
Rental income is increasing, which Gundlach said is bullish for multi-family housing, but his presentation was focused on residential housing. That increase in rents is making it harder for people to save for a home purchase.
Homeowners are unlikely to trade up to larger houses, he said, because nearly 20% of them are still “underwater” with negative equity, and many more lack sufficient equity to buy a bigger home. Nor are transactions likely to arise from moving. Gundlach said there has been a “nonstop monotonically declining propensity to move.”
Supply is still coming from houses financed prior to the financial crisis, Gundlach said. Among subprime loans, 35% are delinquent, as are 20% of Alt-A mortgage borrowers and 9% of prime borrowers. Only 5% of homes are being liquidated, he said, which is at least temporarily boosting prices. Boomers have under-saved for their retirement, on average, Gundlach said, and many will need to sell their homes to finance their retirement.
“This is the future of supply – homes to be liquidated into the market eventually,” he said.
Future homeownership
Homeownership in the U.S. peaked at 69.2% in 2004 and has steadily declined to its current rate of 64.8%.
It’s going lower, Gundlach said. He was recently on a panel with Sam Zell, the largest multi-family owner in the U.S., who said it would go to 55%. Gundlach said he wasn’t sure if it would go that low.
Gundlach discredited those who are bullish on real estate and expect a return to the “good old days” of 70%. “With what we know of wealth polarization, indebtedness and the structural unemployment problem,” he said, “that seems really hard to believe.”
His outlook for new-home starts was equally grim. “I’m going to make a bold prediction that for the rest of my career: We never see a year of 1.5 million housing starts in the United States,” he said.
“Housing won’t be the tailwind to the economy that many people expect,” he said, “although multi-family growth might soften the blow.”
The bond market
Gundlach’s glum forecast for housing doesn’t translate to poor returns on mortgage-backed securities (MBS), the core investment in his funds. MBS are a “little overvalued,” he said. But lending money to homeowners can be successful even without strong housing demand, according to Gundlach. His fund, and many others, did exceptionally well when the housing market collapsed during the financial crisis.
A number of sectors of the fixed-income market are significantly overvalued relative to Treasury bonds, according to Gundlach: corporate bonds, junk bonds, most European sovereign debt and municipal bonds.
Flows to bank-loan funds have been steadily increasing, he said. He warned that those funds can have significant liquidity constraints, however, as trades can often take up to a month to settle.
The cheapest sector is long-term U.S. Treasury bonds, according to Gundlach. Prices have held steady despite the Fed’s tapering, because pension plans have “picked up the slack in bond purchases,” he said.
He warned, as he has in the in the past, that another move downward in Treasury yields could cause an “incredible short scramble,” as funds that are short bonds are forced to cover their positions. Gundlach said there is a 30% chance that the low yields of 2012 could be taken out. He said that if the 10-year yield drops below 2.47%, “the melting could begin.”
On the day he spoke, the 10-year rate closed at 2.54% – and it closed at 2.50% the next day.
“The risk market is quite a bit different than people think,” Gundlach said.
Read more articles by Robert Huebscher
