Official inflation numbers are becoming more and more laughable every day: the Bureau of Labor Statistics (BLS) reports CPI below 2%. We will address the causes of the mismeasurement in a separate piece, but in the meantime, you can rest assured, you’re not going crazy, and your eyes are not lying to you. Inflation is everywhere: in food, energy, healthcare, housing. The main goal for investors during the next decade will be to protect themselves from inflation and, ideally, to benefit from it.
For most Americans, housing represents the largest expense item in their budget. Cost of shelter is 30% of the CPI basket. BLS reported 1.6% increase in housing costs from January 2020 to January 2021. The much more credible Case-Shiller nationwide housing price index increased 10.4% in the most recently reported period, Dec. 2019-Dec. 2020. The US Federal Housing Finance Agency saw a 6% price increase from Q4 2019 to Q4 2020.
A popular way to get rich is to borrow money at a fixed low rate (currently 30-year mortgages are being offered at 3%) and buy a house, riding the rising housing prices with the benefit of leverage. But this only works if interest rates are falling. Housing prices are driven by the affordability of monthly payments. People decide how much they can pay for a house by looking at their paycheck and setting aside a monthly amount for the mortgage. The lower the interest rate, the lower the monthly payment, and the more expensive the house can be. As interest rates declined for 40 years, buyers kept bidding up housing prices. The housing bubble of the early 2000s turned out to be only a bump on the way up.
Interest rates probably reached a bottom in 2020, and they have started to rise. Nobody can tell how far they will go, but there is plenty of room for increase. When rates go up, they put pressure on prices of houses because monthly payments on mortgages balloon beyond the reach of overstretched buyers.
In the short term, we’re going to see a housebuilding boom for reasons outlined in the blog post of Aug. 3rd, 2020. There are housing shortages around the country due to low housing starts after the 2008 financial crisis. Compounding the problem, the flight of residents from high tax and high cost-of-living states to cheaper locations is putting pressure on the inadequate housing stock in their destinations. It would be tempting to borrow money and buy real estate where the demand is greatest, but it would be a mistake. Houses are illiquid investments that are expensive to buy and sell. If our goal is to benefit from the housebuilding boom but to avoid the crushing pressure of high-interest rates a few years down the road, we can do better than flipping houses. We can invest instead in commodities and equities that are direct beneficiaries of housebuilding. That would include lumber futures and stocks of sawmills and housebuilders. The beauty of modern financial markets is that they give us a wealth of instruments to choose from when we want to gain exposure to economic trends. Buying houses is for dilettantes; professionals prefer futures. They are much faster and cheaper to enter and exit.
S&P 500/Case-Shiller U.S. National Home Price Index – (1980-Present)
