Jerome Powell just created an Investor Housing Crash
New data from Redfin confirms that Investors are running scared from the US Housing Market. In particular, they are running scared from Jerome Powell.
Redfin's report revealed a massive 30% Decline in Investor Home Purchases in Q3 2022 compared to the previous year. Excluding the initial stages of the pandemic, that was the largest decline in Investor buying since the last Housing Crash started in 2006.
In especially hard-hit metros such as Phoenix, Portland, and Las Vegas, Investor Purchases declined by more than 45% YoY. Marking a definitive end to the pandemic era of Investor Housing Market Domination.
What's amazing is how quickly this transition took place. Only six to nine months ago, the prevailing narrative across the US Housing Market was that Investors, particularly big Wall Street Landlords, were going to continue to gobble up homes forever. But then suddenly, they stopped. What happened?
Jerome Powell's Rate Hikes
Jerome Powell is what happened. Starting in March 2022, the Powell-led Federal Reserve began increasing short-term Interest Rates. First by a little. Then by a lot. By October 2022 the Federal Funds Rate (the rate set by Powell and the Fed) was up to 3.1%.
This rapid escalation in Fed Funds Rate caused long-term interest rates to spike, pushing the 30-Year Fixed Mortgage Rate up to 6.9%. The highest level in over two decades.
These higher Mortgage Rates have become a big problem for Real Estate Investors because they can no longer make money on rental property acquisitions. The cost of their debt to purchase these properties is now way above the Cap Rate (aka Profit %), meaning that they are breaking even or losing money after paying their lenders.
Remember - even though Investors typically buy in cash, the source of that cash is almost always debt. Typically either a Mortgage Backed Security offering or a Lending Facility with a big bank. The Interest Rate that Investors pay on this debt tracks the 30-Year Fixed Mortgage Rate closely. So now that their cost of debt is above 6%, and their profit on rental properties is only 4.5%, there's no money to be made. And the Investors are dropping like flies.
"Housing Reset" in Phoenix, Charlotte, and Atlanta
Back in the summer Jerome Powell said that the US Housing Market needed a "Reset". Some were confused by what he meant by that at first. But now it's becoming clear - Powell was referring to a purge that would kick Investors out of the market and return leverage to regular Homebuyers.
This Housing Market Reset is happening fastest in Sun Belt Housing Markets like Phoenix, Atlanta, and Charlotte, where Investor Purchases have dropped by more than 40% YoY.
But the real test of Powell's Housing Reset is not just a decline in Investor Purchases. It's when Investor Purchases decline by more than Regular Homebuyer Purchases. Take Phoenix, AZ for instance. In Phoenix the Investor Sales dropped by -49%, which was substantially more than the -32% decline in Regular Buyer Sales. A sign that leverage is returning to the regular Homebuyer in Phoenix.
The market with the biggest "Reset" is Charlotte, NC. In Charlotte Investors purchased 42% fewer homes in Q3 2022 compared to 2021, while regular buyers only purchased 17% fewer. A dramatic 25% differential. Great news for Homebuyers in Charlotte.
Of course - not all Housing Markets are seeing a reset that favors Homebuyers. For instance, in Anaheim, CA, Regular Sales declined by -38% YoY, a sharper decline than the -27% YoY for Investor Sales. A similar story played out in Seattle, WA, where Regular Sales fell by -35% and Investor Sales by only -24%.
These differences signal an interesting trend about Investor Purchases. The big decline is coming mostly in relatively affordable Housing Markets (Charlotte, Atlanta) that had a big presence of Wall Street Homebuyers. Meanwhile, more expensive Housing Markets like Anaheim and Seattle, where the Investor presence is more mom and pop, didn't see as big of a drop off.
Big Home Price Crash Coming?
My suspicion is that the exodus of Wall Street from the Housing Market is a prelude to something much bigger. Where not only do Investors stop buying, they start selling. Resulting in a much bigger crash in home prices than expected.
How much will Home Prices crash? Well, in a market like Phoenix I think the decline could be as much -35%. How do I arrive at a 35% Decline? And how can you calculate how much prices will go down in your market?
Well, it all comes down to Cap Rates.
For example, a Wall Street Investor purchased the property below in Phoenix for $420k in December 2021. And currently has it listed for rent at $2,200/month.
If the Wall Street Investor achieves this rent, they will receive around $16,700 in annual income from the property after paying basic expenses. When Cap Rates in Phoenix were 4.0% back in late 2021, this property was worth around 418k. Which is why the Investor purchased it for around that amount.
However, Cap Rates are no longer 4.0%. Today are likely closer to 6.0% or 7.0% given the increase in Interest/Mortgage Rates. Assuming the Cap Rate is 6.0%, that would result in a value of $278k for this property, a massive 33% decline from what the Investor paid for it last year.
Say the Cap Rate is higher, around 7.0%? Well that would necessitate a 43% decline in value.
The Problem with Investors buying Real Estate
And this is ultimately the problem with so many cash flow-driven Investors buying real estate. They will inevitably cause the local Housing Market to trade more and more like the Stock Market. Where Home Values are a simple function of Cash Flow divided by prevailing interest rates. When Rates go down, Values go up. When Rates go up, Values go down.
It's with this realization that the purpose of Jerome Powell's Housing "Reset" becomes even clearer. He believes that a shock treatment of higher interest rates can kick investors out of the market, cause cap rates to go higher, and push home prices back down to more normal levels.
It's apparent that many Investors also believe this to be the case. I'm hearing lots of comments from Investors like "We're sitting out the rest of 2022. We'll start buying again in 2023 when prices go down. We have billions in capital to deploy."
And perhaps there will be some good deals in early 2023. However, it's likely going to take time for prices to decline by the 30% Investors need to start buying again. Moreover, the collapsing rental market introduces a new phenomenon that complicates matters further. If rents continue going down, then values should decline by even more as a result.
Powell and the future of Interest Rates
Some final thoughts on Jerome Powell and the future of Interest/Cap Rates.
First - while Powell is making progress in slaying this Housing Bubble, we need to remember it's a Bubble that he helped create. Powell's overly accommodative Fed Policy during the pandemic enabled many of these Investors to buy into the Housing Market in the first place.
Second - we should recognize that Powell has an extended history of flip-flopping on his monetary policy stance. In 2018 he was a moderate Inflation Hawk. In 2019 he was a dove. In 2020 and 2021 he became a reckless money printer. And in 2022 he's the biggest inflation Hawk since Paul Volcker.
It's likely that Powell will pivot at some point. Because he always does. But also because events in the Economy will force a pivot. The Recession Storm is building and deflation in the Housing Market suggests overall Inflation will be going down soon. The bond market clearly sees this, which is why the 2/10-Year Treasury curve is 70bps inverted.
As a result, my projection for 2023 is lower interest rates and mortgage rates. It's difficult to say how much lower. A return to the 2020-21 pandemic era of a 3.0% fixed rate mortgage is unlikely. However, I could see a march down in mortgage rates back down below 5.0% as 2023 progresses.
That will of course lower cap rates, and entice Investors (and Homebuyers) back into the market. However, I suspect a declining rental market will keep many Investors on the sidelines. While a recession will lower the appetite for regular homebuying. Resulting in the Housing Crash worsening throughout the entirety of 2023.