76report

January 13, 2025

Fix Housing to Fix the U.S. Economy

The Los Angeles wildfires have incinerated tens of thousands of homes. This tragedy is playing out at a time when homes nationwide are in increasingly short supply.

Just as public policy is largely to blame for the crisis in California, the U.S. needs drastic policy changes if it is going to solve the key problems now affecting the residential housing market.

The Fed has jacked up interest rates to snuff out inflation but, paradoxically, this has made housing unaffordable to many.

Housing-related stocks have suffered, yet we see long-term opportunity as new housing supply growth will be necessary to solve the overall inflation problem.

We discuss a number of specific investment ideas below.

Housing is arguably the most sensitive part of the economy when it comes to the Federal Reserve’s interest rate manipulations.

The vast majority of households take a mortgage when they buy a home.

Since the interest rate they need to pay represents one of the largest costs of home ownership, movements in rates have a major effect on behavior within the housing market.

The housing sector is also quite large. Residential construction and housing related services historically represent more than 15% of the total U.S. economy.

Housing has become the main reason the U.S. is facing a persistent inflation problem.

In the most recent Consumer Price Index (CPI) report from the Bureau of Labor Statistics, the rate of inflation over the past 12 months that was attributed to shelter was 4.7%.

The overall rate of inflation was reported at 2.9%.

If you remove shelter from the CPI equation (which the BLS does through a line item called all items less shelter), the inflation rate drops to 1.7%.

Inflation ex-shelter is now actually below the Fed’s 2% target.

Housing and the Fed

When we think of the Fed trying to stimulate or suppress economic activity, it is important to understand the key transmission mechanisms.

While interest rates have a broad-based effect on commercial and consumer activity, they impact housing in an especially powerful way.

In the early 2000s, the burst of the dotcom bubble and the 9/11 terror attacks sent the U.S. economy into a tailspin. Greenspan’s Fed proceeded to cut rates aggressively.

This set the stage for a housing bubble (and subsequent collapse) of unprecedented proportions.

U.S. Housing Starts - Past 25 Years

It took about a decade for the American population to absorb all the excess homes that were created between the 2000 tech crash and the 2008 Global Financial Crisis, which itself was caused by extreme distortions in the housing market.

Because of all the excess supply, home prices languished for years after the financial crisis despite extremely low interest rates.

It would not be until around Trump’s first term that the U.S. was back to a level of housing starts (typically assumed to be around 1.5 million per year) that is considered sustainable over the long-term.

A certain number of new homes need to be built every year just to replace the ones that are destroyed (by fire, for example, as headlines in recent days remind us).

Many additional homes must be built to meet the needs of a slowly but steadily growing population.

How money printing works

The U.S. economy is managed through a fractional reserve banking system. When the economy falters, the Fed cuts rates to promote loan growth.

When banks issue more loans, money is injected into the economy.

The process of money printing is to large extent the process of loan creation by banks. By cutting rates, the Fed stimulates bank lending, which expands the money supply.

Because it represents such a large portion of total bank debt, residential real estate tends to be the first stop on the money printing train.

To address the risk of a catastrophic recession after Covid arrived in 2020, the Fed did what it always does in an economic crisis. The Fed cut interest rates aggressively, essentially to zero, and flooded the U.S. economy with liquidity.

This liquidity went straight into the residential mortgage market.

In the five years prior to the start of 2020, total mortgage balances on single family homes grew by approximately 12%. In the five years after the start of 2020, they grew by approximately 28%.

Balance on Single Family Mortgages - Past 10 Years

Of course, the housing industry was not really the problem the economy faced during Covid. Travel, leisure and other parts of the consumer economy were the areas hardest hit by lockdown policies.

But driving up demand for housing became the solution—only because rate manipulation is the primary tool the U.S. government uses when it feels the need to stimulate economic activity.

Combined with stimulus checks and other forms of deficit spending, rate cuts led to a massive flow of money into the housing sector. House prices took off.

There was some uptick in new home creation in response to the pick-up in demand. But the generalized inflation that resulted from ultra-easy fiscal and monetary policy also dramatically increased the cost of labor and materials required for new construction.

Replacement costs consequently went way up. Existing homes became more valuable because new homes, with which they compete, became more expensive to build.

Rising construction costs have also fed back into other home ownership costs, such as property insurance, by making repair and remodeling more expensive.

Skyrocketing property insurance costs are in fact a major reason inflation remains so sticky today—a situation which will not be helped by the events in California.

Insurance costs tend to operate with a lag effect as insurance companies reset policies gradually. They began to surge in 2023.

Homeowner’s Insurance - Past 10 Years

In the aftermath of the Fed’s response to the pandemic, Americans were competing against one another for a relatively limited supply of homes.

In just two years following the arrival of the virus, median home prices in the U.S. jumped from a low of around $310,000 to a peak of $460,000—a nearly 50% increase.

U.S. Home Prices - Past 10 Years

From the perspective of existing homeowners, this policy-driven boost in home prices was to some extent good news. Increases in their net worth perhaps helped offset the much higher prices they confronted at the grocery store and elsewhere.

As a result of Biden-era inflationary policies, total home equity across American households has surged with rising house prices.

At the end of 2019, household equity in real estate was around $19.5 trillion. Today, it is about $35 trillion, an approximately 80% increase.

American households that were fortunate enough to own real estate and stocks going into the pandemic have done well.

This wealth effect really only benefits affluent households, however.

It also helps explain the apparent contradiction between reports of strong overall economic activity and the average wage earner’s perception of a very challenging economy.

Individuals who are not substantial asset owners, especially younger generations, increasingly find themselves shut out of the American Dream.

High interest rates are now the problem.

Conventional thinking on inflation holds that sticking with high interest rates will bring inflation down by hurting demand for goods and services.

This logic may be relevant for many parts of the economy, but current circumstances within the housing sector complicate the cause-and-effect relationship.

Home prices have softened somewhat from peak levels but are generally holding up despite the fact that 30 year mortgage rates, close to 7%, are now at levels we have not seen for nearly 20 years.

30 Year Fixed Rate Mortgages - Past 20 Years

Many current homeowners have mortgages that are locked in at low interest rates from years past.

They are reluctant to move in this environment because buying a new home would involve getting a new higher rate mortgage. This tends to reduce available supply.

Meanwhile, much higher mortgage rates are deterring renters from buying new homes, simply because they cannot afford the payments. This lack of demand is in turn depressing new supply creation.

Residential real estate developers are themselves hurt by high interest rates. They tend to finance their projects with borrowed money. The cost of debt is high for them as well.

Developers cannot profitably create housing at prices that buyers can afford. The housing sector is essentially broken. High interest rates are now just making matters worse.

The only practical solution is to create more supply.

From the standpoint of the current housing crisis, the good news is that a real estate developer will shortly be inaugurated as President of the United States.

Despite its central importance to the key challenges facing the economy, housing policy seems to have taken a backseat to many other crucial economic topics, like AI, crypto, energy, trade and tax cuts.

Housing has perhaps not been commanding the spotlight, but it has been a clear priority for the incoming administration.

Because housing has become so intertwined with the all important inflation problem, we do expect meaningful and aggressive action.

Deregulation will be critical to expanding the supply of new homes. Residential construction around the country is stymied by convoluted zoning laws and environmental requirements.

Trump has indicated a desire to make an aggressive push to remove red tape and deregulate the housing market.

He has also floated the idea of building freedom cities on federal land, which could alleviate supply shortages in many metropolitan areas.  

We’ll actually build new cities in our country again…. These freedom cities will reopen the frontier, reignite American imagination, and give hundreds of thousands of young people and other people, all hardworking families, a new shot at home ownership and in fact, the American dream. - Donald Trump

How to play it

Rising interest rates and faltering demand for homes have led to recent weakness in housing-related stocks.

The current interest rate environment is quite difficult for many companies in the housing space. Share prices across the sector have been under pressure.

We see long-term opportunity, however, as the incoming administration recognizes that the supply-side is the only real solution.

Below, we highlight three long-term investment ideas that we find particularly interesting at the moment.

S&P 500 vs. ITB, VMC and FND - 9 Months

(1) Buy the whole sector

Investors seeking to build a passive position in the U.S. housing sector have a few options among Exchange Traded Funds (ETFs).

The iShares U.S. Home Construction ETF (ITB) provides substantial exposure to the leading homebuilding stocks as well as retailers and other suppliers to the housing industry.

Shares of ITB have significantly underperformed the S&P 500 over the past three months. While the S&P 500 has delivered a slightly positive total return of 0.5%, shares of ITB have returned -18.5% (10/11/2024 through 1/10/2025).

(2) Vulcan Materials

Vulcan Materials (VMC) is a Model Portfolio holding that we have previously discussed. VMC is one of the leading suppliers of construction aggregates in the United States with a dominant footprint across the sunbelt.

With a long track record of pricing power, VMC owns a network of quarries that produce the raw materials needed to make concrete and asphalt.

While the business is not entirely geared to residential construction, homebuilding is an important pillar of demand for VMC. Recent weakness in the shares reflect concerns about the state of the housing market.

VMC also supplies to infrastructure and commercial end markets. As Trump takes office, we see demand for construction aggregates coming from many areas that are targeted for growth through deregulation, including data centers, electric grids, fossil fuels as well as housing.

The potential creation of “freedom cities” from scratch would require enormous basic infrastructure work, which is when construction aggregates are needed most. If these cities are built, we suspect they are most likely to be located in red sunbelt states where VMC has exposure.

Any source of increased construction demand within VMC’s markets could lead to both volume and pricing growth and significant incremental earnings growth.

(3) Floor & Decor  

Another interesting play on a longer term recovery in housing is home improvement retailer Floor & Decor (FND), a Model Portfolio position we have not previously discussed in the 76report.

The primary reason to own FND is that it is an early stage “category killer” retailer with a significant long-term expansion opportunity.

A relatively frozen market for existing home sales has dampened remodeling demand. Homeowners typically engage in remodeling activity when they are preparing to sell their home or buy a new one.

Uncertainty around the near-term outlook has put pressure on FND shares, which have significantly underperformed the S&P 500 Index over the past year. But the company is managing the cyclical downturn well, preserving capital by slowing down the pace of new store openings.

With a reduced valuation, any signs of a turnaround in housing demand could lead to significant upside for FND.

With only a $10 billion market cap, FND is a relatively small stock and tends to be quite volatile. But investors with a longer time horizon should view the current weakness in FND opportunistically.

A lot at stake

The housing affordability crisis in the United States is a crucial economic issue.

High interest rates have perhaps helped bring prices down in a lot of areas of the economy—but for various reasons are proving to be ineffective when it comes to housing related inflation.

Perhaps the key risk to the success of the MAGA economy is high interest rates, which threaten economic growth and hurt stock market valuations.

Subduing housing related inflation therefore needs to be one of the incoming administrations top priorities. Given the obviousness of the impact on overall inflation, it likely will.

Housing affordability is connected to an even broader priority of the MAGA movement, which is to create the conditions for family formation.

Trump’s victory was to a large extent a function of gains among younger votes, who saw little benefit from inflation-driven wealth effects of the Biden years.

If Trump can make real progress on the housing affordability issue by supporting meaningful supply growth, there will be a wide range of economic and social benefits.    

Vulcan Materials (VMC)

Floor & Decor (FND)

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