Four Horsemen of the Housing Apocalypse, Part 3: On a Black Horse – Recession
By
Rob Hahn
In part 1, we covered legal and regulatory challenges to the real estate industry. In part 2, we covered the insane money printing that has devalued the dollar, and stuck the Fed into a corner with no options. But, thanks to rising inflation that no amount of book-cooking can cover up, the Fed has been forced to “take action” by which we mean raise rates a tiny bit, then jawbone a whole lot about how tough they’re going to be on inflation.
We’ve already looked at why a number of very smart people think the Fed is just shoveling a lot of bull manure and that they won’t have a choice but to go back to quantitative easing and dovish policies, aka, money printer go brrrrr.
But in the meantime, even the modest Fed action has had real results in the real world. That brings us to the third horseman of the housing apocalypse: recession on the horizon, or the war against wages and those who depend on paychecks to pay their bills.
On a Black Horse: Recession
When He broke the third seal, I heard the third living creature saying, “Come.” I looked, and behold, a black horse; and he who sat on it had a pair of scales in his hand. And I heard something like a voice in the center of the four living creatures saying, “A quart of wheat for a denarius, and three quarts of barley for a denarius; but do not damage the oil and the wine.”
— Revelation 6:5–6 NASB
The third horseman of the Apocalypse is usually interpreted as Famine, as the figure is talking about overcharging for the necessities of life: food. It seems an apt metaphor for what the Fed has caused on purpose, and is bringing about, again on purpose: recession.
A recession is two quarters of negative GPD growth (contraction) in a row. Well, Q1 GDP in the US declined by 1.4%. If GDP declines in Q2, we have an official recession. Okay, let’s take a quick look-see on recent headlines, shall we?
Well, we already have announcements of massive layoffs, even from big names like Carvana, Netflix, and Paypal. Tesla is instituting a hiring freeze and cutting some 10,000 jobs.
After a month that saw nearly 16,000 tech workers lose their jobs, June is off to a similar tumultuous start. Startups across all sectors, from healthcare to enterprise SaaS to crypto, are laying off portions of staff and citing, seemingly, from the same notes: it’s a tough market, a time of uncertainty, and a correction toward sustainability is needed.
In real estate, we have beleaguered Better.com laying off thousands of people, Side eliminating 10% of the jobs, Rex basically going out of business, and Tomo laying off a third of its staff. Tech companies are cutting staff by the thousands. Mortgage companies are laying off thousands as the higher rates are killing the refi business, and the general slowdown in the economy means demand is sharply lower.
Target and Walmart reported terrible news, including “rapid slowdown in shopper spending.” And CNBC is reporting that even rich people are cutting back on spending:
With as much as 60% of U.S. consumers living paycheck to paycheck, it’s not a surprise to see that the spending cutbacks have started. Even with a strong job market and wage gains, as well as Covid stimulus savings, price spikes in core spending categories including food, gas and shelter are leading more Americans to mind their pocketbooks closely.
A new survey from CNBC and Momentive finds rising concerns about inflation and the risk of recession and Americans saying that not only have they started buying less but that they’ll buy less across more categories if inflation persists. But these financial stress points are not limited to lower-income consumers. The survey finds Americans with incomes of at least $100,000 saying they’ve cut back on spending or may soon do so in numbers that are not far off the decisions being made by lower-income groups.
Well, to be fair, making $100K in the post-money printing age makes you merely middle class, but still… consumers across the country are not looking to be on spending sprees anytime soon. Reports of layoffs aren’t going to make them any more willing to spend, but not spending means some other company isn’t making any money, which leads to layoffs, which then leads to even less willingness to spend, which means….
Deutsche Bank raised eyebrows earlier this month by becoming the first major bank to forecast a US recession, albeit a “mild” one.
Now, it’s warning of a deeper downturn caused by the Federal Reserve’s quest to knock down stubbornly high inflation.
“We will get a major recession,” Deutsche Bank economists wrote in a report to clients on Tuesday.
The problem, according to the bank, is that while inflation may be peaking, it will take a “long time” before it gets back down to the Fed’s goal of 2%. That suggests the central bank will raise interest rates so aggressively that it hurts the economy.
“We regard it…as highly likely that the Fed will have to step on the brakes even more firmly, and a deep recession will be needed to bring inflation to heel,” Deutsche Bank economists wrote in its report with the ominous title, “Why the coming recession will be worse than expected.”
To be fair, everyone else disagrees with DB, so there’s that. Maybe those optimists are correct, and there may be a minor recession, and we’ll all bounce right back. I’ve also seen economists and analysts arguing that there is no recession in 2022, but maybe we’ll see it in 2023 or 2024.
And since I wrote the first draft of this, we got news that May CPI print came in at 8.6% nearly guaranteeing that Fed will continue to playact some more to control inflation until it can’t… which means a recession is all but certain.
But seriously, post a comment below if you think Q2 will come in with positive productivity growth numbers in light of what’s going on. Just diesel fuel prices alone are hammering productivity, but we’re somehow going to bounce back from a negative 1.4% in Q1 to positive territory in Q2? God I hope so, but prayers and hopes are just that: words and emotions.
Zombie Companies Die a Real Death
One of the effects of the Fed raising rates, even by the tiny bit that it has, is to threaten zombie companies with real death. What are those?
Here’s the Federal Reserve with a FEDS Notes from July of 2021:
Our main finding is that zombie firms are not a prominent feature of the U.S. economy. Among both private and publicly listed firms, zombie firms are few in number and generally small; they are mostly concentrated in the manufacturing and retail sectors and account for a small share of total credit to nonfinancial firms.
…
There is no formal definition of a zombie firm, but it is generally agreed that these firms are economically unviable and manage to survive by tapping banks and capital markets (Caballero, Hoshi, and Kashyap 2008). Accordingly, we identify zombie firms in U.S. data by requiring that they are highly leveraged and unprofitable.
Well, that’s coming from the Fed itself so… consider the source. Because here’s Nils Kuhlwein from the consultancy AT Kearney:
Nils Kuhlwein of Kearney discusses the surge in the number of “zombie” companies, or economically unviable firms, in capital markets across the world.
The number of zombie companies according to their study has tripled in the past 10 years. But how many companies is that?
Here’s NASDAQ reporting on zombie companies in May of 2022:
Roughly one-fifth of the 3,000 largest publicly traded companies in the US are failing to earn enough cash to cover interest expenses, according to Bloomberg, which gives them the unsavory zombie firm status. That can be a sustainable state of existence in normal times, when rates are low and companies can simply roll over their debts. And historic government efforts to boost private sector liquidity granted zombie companies months, if not years, worth of debt financing.
But soaring inflation coupled with rising interest rates may be enough to push a wave of companies from undead to dead dead:
US corporate profits dropped the most in roughly two years in Q12022, and about 620 companies saw earnings fall short of interest payments in the past year — well above pre-pandemic 2019 levels — according to Bloomberg.
Securing loans is now a tall task: Junk-rated companies, as denoted by S&P Global Ratings and Moody’s Investors Service, have only borrowed $56 billion in the bond market so far this year, down 75% year-over-year; May saw new loan starts of under $6 billion, a massive dropoff from January’s $80 billion, according to Bloomberg.
One-fifth of the 3,000 largest publicly traded companies??? That’s not a prominent feature of the economy? How many jobs are we talking about here if we’re talking about companies like American Airlines?
And here’s the same Nils Kuhlwein pointing out that the real estate industry has the highest number of zombie companies:
There’s a “big risk” of real estate companies filing for insolvency when interest rates rise, according to a partner at consulting firm Kearney.
Nils Kuhlwein pointed out that the global financial crisis of 2008 started with a real estate and housing price bubble and mortgage defaults in the United States.
“What we are now seeing again, 13 years later, is that again, the real estate sector has the highest share of ‘zombies,’” he told CNBC’s “Street Signs Asia” on Wednesday. According to OECD’s definition, “zombie” companies are those that are at least 10 years old and have persistent problems meeting their interest payments.
Kuhlwein is likely talking more about homebuilders and perhaps REITS who have to use leverage (i.e., borrow a lot of money) to do things like build homes or buy enormous apartment complexes and such. But that’s not really reassuring news, as we’ll see.
These zombie companies have to “roll over their debts” to stay in business. That means they have to borrow new money to pay back the old debt; sometimes, you do that with the same lender. Other times, you have to find a new sucker lender to give you the money. Well, rising rates means rolling over is more expensive, and lenders are going to be taking a harder look at your free cash flow numbers to see if you can even make those higher interest payments. Maybe they all decide to pass because the risk isn’t worth the returns.
Now, said zombie company is really dead and enters bankruptcy proceedings. Layoffs are all but inevitable.
Of course, the Fed will reverse itself after a few months of this and go back to easy money printing days as we discussed in part 2… but for a lot of these companies, it will be too late. They’ll already have gone under, and they’ll already have laid off thousands of people. “Hey, mortgage rates are back down to 2.5%!” is hardly an encouragement when you’ve been unemployed for six months.
Impact of Recession on Wages
If you believe, as I do, that what we have seen and are seeing is not “inflation” per se but dollar devaluation… then the serious Big Kahuna problem isn’t that gasoline is up 101%, mortgage rates up 89%, and food is up 58% but that wages haven’t gone up by 101%. In fact, real wages have actually gone down:
As I have mentioned before, REAL hourly wage growth is negative since March 2021, just after Biden signed his executive orders canceling drilling on Federal lands and cancelling the Keystone Pipeline. Later, he canceled off-shore drilling permits and Alaska drilling. Now we have REAL average hourly wages declining at -2.8% YoY as The Fed has been reducing M2 Money supply YoY.
That is Prof. Anthony Sanders of George Mason writing on Confounded Interest, one of the best real estate finance blogs out there, and that was posted on June 3, 2022. As the chart shows, real wages have been shrinking since late in 2020.
So if we’re either already in a recession or heading into a recession after Q2 numbers come out, what does that do to wages?
The short answer is, recessions depress wages even more. Even I can understand that.
When companies are laying off thousands of people, and consumer spending is way down, and there are dozens of job applicants with more experience than you have applying for your job… that’s not a great time to go to your boss and ask for a raise.
If you do get a job offer, but it’s at a disappointing salary so you pass… it might be a while before you get another job offer and there are no guarantees that that job will pay more.
If you are the boss, and you really value your employees and would like to pay them more, except that the bank isn’t lending anymore, the capital markets have dried up, your suppliers have doubled their prices, the cost of transporting your goods to the store has doubled, and consumers aren’t spending like they used to, what choice do you have? Socialists and children (but I repeat myself) who think that money just sorta exists and greedy company owners want to feast on caviar and champagne while laying off people have no idea as to how business works.
Wage growth cannot happen in a recession. Period, end of story. Add in inflation, and we’ll have negative wage growth for the foreseeable future. That’s the wonderful world of stagflation. That 70s Show will not be just a rerun on basic cable.
Can We Avoid a Depression?
The real question to be asked in the summer of 2022 is not whether we’ll have a recession or not, or how severe or mild the recession will be. The question to be asked is whether we can avoid an economic depression.
A depression is negative GDP over years, not months, or a drop of 10% in GDP in one year. Investopedia lists these factors as characteristic of a depression:
Substantial increases in unemployment – depends on what you consider substantial…
A drop in available credit – check!
Diminishing output and productivity – check!
Consistent negative GDP growth – Q1 check, we’ll see going forward
President Reagan once quipped, “Recession is when your neighbor loses his job. Depression is when you lose yours.” I fear that for many Americans, it will be a depression no matter what the talking heads on CNBC and Bloomberg say.
But let’s hope that we can avoid an actual depression, at least for the next few years, and settle for a severe recession before the Fed starts up the printing presses again.
The Third Horseman and Housing
The impact on housing from the third horseman is relatively simple and straightforward: consumer demand disappears, and is replaced by investor demand. The reason is simple, as I’ve written in part 2: housing is not a discretionary purchase. It is a necessity for life.
Consumer demand for buying houses has been, is, and will be crushed. But since having a roof over your head is a fundamental need, consumer demand for housing cannot be crushed. Investors know this, just like they know that the Fed will continue to crush the life out of the stock market, the bond market, and any financial market until it is forced to relent.
To be fair, home price growth might come in far lower in 2022 because it is clear that the American consumer is near the end of his rope. He can’t afford anymore, because his wages haven’t been going up 20% YOY, and it wasn’t like he was doing great before the government shut down the economy because of COVID. Rate increases means greater likelihood of recession, meaning layoffs, meaning banks being more skittish about lending. So buyer demand (or at least buyer capability) will be impacted.
I think that gap from consumer demand gets filled by institutional investors. Yeah, those hedge funds and pension funds and insurance companies and sovereign wealth funds who used to buy RMBS… a lot of them are going to just buy the underlying asset: the house itself. If the dollar is losing 15% a year in purchasing power (aka, inflation), then you have to park it someplace that can offset that loss. US residential housing makes perfect sense, especially with rents on the rise again. And those guys couldn’t care less what the mortgage interest rate was; they’re paying cash, then levering up afterwards with high-yield corporate debt.
The part of that where I was definitely wrong was the high-yield corporate debt part; that’s dead as a parrot now. But so far, 2022 looks to be living up to my predictions.
What’s more, since the first draft of this post, we got word from a 44-year veteran of the mortgage market, Louis Barnes, who wrote that MBS went “no-bid.” No buyers for MBS. Where then will the pension funds and insurance companies and sovereign wealth funds put their money? They can’t just sit on it and watch the money lose 8.6% of the purchasing power, when they have pensioners to pay and insurance claims to pay. Where indeed….
When local and first-time homebuyers hesitate, real estate investors rush in. And apparently, those investors are cashing in. Attom, a curator of land and property data, estimated in a first-quarter report that the typical return on investment was 47.2%, higher than the 37.5% return in the first quarter of 2021, and nearly 20 percentage points above the 29.4% return in the first quarter of 2019.
Still, profit margins are tightening, down from 51.6% in the fourth quarter of 2021. Similarly, gross profits on home sales in the first quarter hit $103,000, down from $107,187 in the fourth quarter. Still, first quarter profit exceeded the profit of $75,001 recorded a year earlier.
Oh noes! Whatever will those poor private equity funds do with a mere 47.2% in return on investment! How will they afford to keep the lights on? A bond fund looking at negative bond yields are looking over at these poor saps making only 47.2% ROI and shaking its head.
And Seeking Alpha points out the other obvious thing which I mentioned, saying “With mortgage rates rising, though, competition for homes may be cooling. But with that, demand for rentals may increase.” Right on schedule, as of June 6th we get this:
As anticipated, rent growth did NOT slow down in May — even as inflationary concerns cast doubt on housing demand. New renters signing leases in May paid 19.5% more (a new record) than the previous residents of the same units…
New renters are paying 20% more in rent YOY, a new record. Since many of them can no longer afford to buy (Thanks, Jay Powell!) what else are they gonna do? Live in a van down by the river?
Investors face less competition from family buyers, compete against one another to see who can do better than 47.2% ROI, and since they’re the ones with cash (because, you know, they’re closer to the money printer) they don’t give a hoot about mortgage rates shooting up through the roof. This article from Slate from June of 2021 lays out the issue pretty clearly:
The truth is between the two: We can panic and acknowledge Wall Street’s small role at the same time. Although the number of houses being purchased by mega-investors is currently not enough to move the market in most parts of the country, these firms’ underlying structural advantage is profound and growing.
Let’s focus on Invitation Homes, a $21 billion publicly traded company that was spun off from Blackstone, the world’s largest private equity company, in 2017. Invitation Homes operates in 16 cities, with the biggest concentration in Atlanta, where it owns 12,556 houses. (Though that’s not much compared with the 80,000 homes sold in Atlanta each year, Invitation Homes bought 90 percent of the homes for sale in some ZIP codes in Atlanta in the early 2010s.) While normal people typically pay a mortgage interest rate between 2 percent and 4 percent these days, Invitation Homes can borrow money for far less: It’s getting billion-dollar loans at interest rates around 1.4 percent. In practice, this means that Invitation Homes can afford to tack on an extra $5,000 to $20,000 to the purchase price of every home, while getting the house at the same actual cost as a typical homeowner. While Invitation Homes uses a mixture of debt and cash from renters to buy houses, its offers are almost always all cash, which is a big leg up in a competitive market. [Emphasis added]
Maybe Invitation homes can’t get 1.4% rates for borrowing anymore when Treasuries are paying 3%. But I’ll bet my annual income that Invitation Homes can get better rates from its bankers than you and I can from ours.
Homebuilder Weakness, Perfect Opportunity for Investors
We’ve already established that real estate has the highest share of zombie companies, as per Nils Kuhlwein above. We’ve already established that the Fed raised rates, causing a massive spike in mortgage rates. It doesn’t matter that the Fed is playacting and will need to reverse course soon; the damage is done. The sector that is feeling that pain the most might be homebuilders.
If you’re not following Rick Palacios of John Burns Real Estate Consulting on Twitter, and you’re interested in this topic, you really should. Here’s one of his latest tweets:
May homebuilder survey results published last week. Top themes: 1) Builder metrics quickly deteriorating across the board. 2) Price cuts on standing ‘speculative’ inventory accelerating. 3) Buyer incentives are back. Market commentary to follow…
I’ve already written on and discussed the growing Build To Rent trend, where private equity and large family offices partner with builders to buy out entire communities to turn them into rentals. What I wonder now is whether homebuilders getting into trouble means easy pickings for deep pocketed investors. I have to think so.
If you’re a homebuilder, and you’ve borrowed $50 million from the bank to build a bunch of houses, and all of your spec homes are sitting there, buyer demand is plummeting, even those buyers who want to buy can’t actually qualify for the mortgage needed… and you’re facing debt payments… wouldn’t an offer from some bigass hedge fund even at a big discount be compelling? It might be one of those offers you can’t refuse.
Given the turmoil in the financial markets, I have to think (in fact, I know from speaking to hedge fund friends) that quite a few investment firms are rotating out of bonds and equities and crypto into real estate. It’s a physical asset that is a necessary requirement for life. Consumers will cut a lot of spending out of their budgets before they cut “roof over my kids’ heads.”
#RenterNation is probably not just a hashtag in 2022 and beyond.
Don’t Party On Just Yet
Based on this reading of the signs, you would be forgiven for thinking that housing and real estate are going up forever. I mean, why put your money anywhere else, right? Residential real estate is a fundamental good, with limited supply, with real value as dollar devaluation continues, and the returns are kind of recession-proof. REALTORS across the land would be justified in thinking the party won’t stop, can’t stop.
There are a few reasons why the real estate industry should not be thrilled. I’ll cover many of them in Part 5, where I wrap everything up, but let me point out one.
I cannot imagine a scenario where the combination of inflation, war on wages, and unaffordable housing (not just home buying, but living under a roof) do not lead to major political turmoil. That is our fourth horseman of the apocalypse, usually thought of as Death, riding on a pale horse, which we’ll tackle in the next part.
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Managing Partner of 7DS Associates, and the grand poobah of this here blog. Once called "a revolutionary in a really nice suit", people often wonder what I do for a living because I have the temerity to not talk about my clients and my work for clients. Suffice to say that I do strategy work for some of the largest organizations and companies in real estate, as well as some of the smallest startups and agent teams, but usually only on projects that interest me with big implications for reforming this wonderful, crazy, lovable yet frustrating real estate industry of ours.
