The Leaning Towers Of Metropolis

Submitted by Danielle DiMartino Booth by Quill Intelligence

  • From the trough of post-crisis valuation, apartment prices have been the key driver in overall CRE price increases as apartment prices have risen nearly three times the average across the broad sector
  • Luxury apartments have been a key driver in this cycle as nine in ten apartments were luxury in 2018 versus 52% in 2012; the luxury market is more susceptible to economic uncertainty as reflected by the decline in the Architectural Building Index
  • While new home starts have been declining and disappointing results from homebuilders are being reported, existing home sales have seen some modest improvements in response to declining mortgage rates; affordability and uncertainty may cap the upside housing

“Fix the problem, but don’t finish the job.” Can you imagine being a structural engineer and instructed as such? But that’s likely the sensation felt by the team of engineers tasked with stabilizing the Leaning Tower of Pisa in 1999. Constructed in 1173 on unstable subsurface soils, the bell tower sank further and further south until it tilted 5.5 degrees in 1990, defying simulations that suggested it would topple over at 5.44 degrees. In came the rescue squad who reversed the gravitational pull by placing weights on the structure’s north end while simultaneously removing soil from below causing it to gently sway north-ish resting at 3.99 degrees. In the engineers’ estimable estimations, barring an earthquake, the tower should stand for several hundred more years, safely continuing to draw marveling tourists.

Commercial real estate investors also have a deep faith in their towering monuments to the current business cycle being built on foundations that are just strong enough. And why should they harbor doubts? As per Morgan Stanley, “The recovery in commercial real estate (CRE) prices is driven in large part by multifamily, which has recovered 331%, while core commercial’s recovery is a more modest 126%.” Translated, from its trough post-crisis valuation, apartment prices have rebounded at nearly triple the rate of CRE as a whole.

The trend doesn’t look to be ebbing. In June, Industrials (read Amazon warehouses), which as detailed in last week’s Quill, look to be topping out as e-commerce hits its limits, prices grew by a blistering 13.3% over the prior year. In second place was the cycle leader, multifamily, which tacked on a 7.3% in year-on-year gains.

Why harp on apartments when single-family residential real estate is what moves the GDP needle? Let’s just say that the current cycle redefines multifamily’s contribution to GDP. The term “rentership nation” did not come about without a huge movement into apartment living. The catch is that a repressed interest rate environment challenges IRRs outside the construction of high rises to the sky. And that’s exactly what’s transpired: Nearly nine in ten apartments constructed in 2018 were luxury units. That compares to 52% in 2012 before QE priced anything rational out of the market.

The stutter-stop downward move in Architectural Billings for apartments you see above has unsurprisingly tracked down housing starts as a whole, which have been dominated by…apartments in the current cycle. While that’s still the case, the organization issued the following warning: “A growing number of architecture firms are reporting that the ongoing volatility in the trade situation, the stock market, and interest rates are causing some of their clients to proceed more cautiously on current projects.”

Where does single-family fit into this equation? In short, it’s been largely absent compared to its multifamily peer. Home sales have also weakened even as multifamily has hung in there. That, you may have noted, changed for the better yesterday morning. It took nearly a full percentage point decline in the 30-year fixed mortgage rate, but traction has finally been achieved. For the first time in 17 months, existing home sales rose a fraction over the prior 12 months in July.

What should Jay indicate in reaction to this finally encouraging housing data come 8 am EST Friday in Jackson Hole? Far be it from us to say, but a fractional move up in exchange for 100 basis points of easing defines “pushing on a string.”

Single-family housing has also been along for the luxury ride this cycle. The same math and economics apply. With that in mind, we’ve taken to following Toll Brothers to glean trends in the single-family market.

In its latest earnings report, the high-end homebuilder reported revenue had fallen 8% over the prior year, deliveries had sunk by 11% and backlogs by 10%. The only plus sign was cancellations, which were up 2.4% vs. 1.9% the prior quarter. Can you say ugly?

On a higher level, how surprised should we be when we read stories about real estate in the Hamptons and coastal markets on both sides of the country sliding into the abyss? This is, after all, how real estate cycles are supposed to end.

The sad thing for home buyers, keen on capitalizing on a capitulating housing market, is that it’s still God-awful expensive. All-cash buyers continue to muscle their way into markets out-bidding organic buyers as they’re price agnostic(it’s someone else’s money they’re playing with). As seen in yesterday morning’s home sales report, first-time buyers made up 32% of purchases, exactly in line with year ago levels.

Any way you slice the current cycle, we’ve built too many fancy pads and homes. Thanks to the Fed leaving rates too low for too long, we haven’t fixed the problems of the last cycle, nor can we finish that job.

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Author: Tyler Durden