Insights on U.S. Housing Market From Alex Pettee, President of Hoya Capital Real Estate

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Dividend.com: Tell us about yourself and Hoya Capital.

Alex Pettee (A.P): Hoya Capital Real Estate is a research-focused investment advisor that has been active publishing research on the real estate markets for the past four years. Our focus is on the publicly traded residential and commercial real estate sectors, as well as macroeconomic analysis and we publish primarily on Seeking Alpha. We’re best known for our sector reports on each of the major REIT sectors and on the major housing sectors. We publish all of our research free of charge and in doing so, we’ve built up a sizable following over the years, particularly with self-directed investors and advisors. From a macroeconomic perspective, our focus over the past several years has been on the lingering housing shortage across the United States and the considerable underinvestment in residential housing over the past decade. We think that this underinvestment is at the root of the trends of rising housing costs, seen most prominently through higher rents and home prices.

Interestingly, the firm was informally started during my master’s degree studies at Georgetown University. I took a course in Real Estate Investment Trusts with Professor Jonathan Morris, a former top executive at Boston Properties, one of the largest office REITs in the country. After the REIT course, Professor Morris advised my thesis and independent study in REIT portfolio management, where I started Hoya Capital with the mission of making real estate more accessible to all investors. I started publishing research back during my studies, and have been doing so ever since.

Together with the free research and ETF offering that is available and accessible to anyone with a brokerage account and about $25 dollars, we think we took a huge step towards achieving that goal. We know of at least a handful of investors that literally own a single share of HOMZ, and we take a lot of pride in being able to offer services to those investors as we do with investors of all sizes and backgrounds, which is only made possible through the ETF wrapper.

Over the long run, as HOMZ gets onto the wirehouse brokerage platforms, we think HOMZ will be an attractive institutional instrument as well, as we believe that it is the most representative proxy for the performance of the broader U.S. housing market at the ETF level.

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Dividend.com: Why should investors invest in real estate?

A.P: At the investment level, real estate has historically been a strong portfolio diversifier and source of both income and growth. Real estate is generally underallocated in a typical investor’s portfolio, as many homeowners believe that the investment in their own home is a substitute for real estate asset class within an investment portfolio.

While that may be true to some degree, a growing share of investors, particularly younger investors and renters, lack this comparable exposure to homeownership and are thus highly exposed to the effects of higher rents and housing costs. We think that HOMZ gives investors, not only millennials and renters, but anyone feeling the effects of rising housing costs, an opportunity to get their foot in the door by investing in the companies expected to benefit from rising rents and home values, including many of the companies actually collecting our rent or mortgage checks every month.

Dividend.com: Could you talk about your newly launched ETF HOMZ and what role can it play in the portfolios of income-focused investors?

A.P: A central focus of our research at Hoya Capital Real Estate has been on the macroeconomic trends affecting the U.S. housing markets. Specifically, we believe that, on aggregate, since the end of the recession the U.S. has been significantly underinvesting in residential housing on both new and existing homes. The effects of this underinvestment are far-reaching, but are most acutely visible through rising housing costs – specifically, higher rents and home values. As a percent of household spending, housing costs are now a third of spending for the average American according to the Consumer Price Index. This is up from around 15% back in the 1950s and, outside of a recession, there’s no clear end in sight or easy answer to quell the upward pressure in housing costs absent a sudden boom in new supply.

By tracking an index designed to capture total spending on housing and housing-related services across all housing categories – home building, rental operations, home improvement, and services and technology – we think that Hoya Capital Housing ETF (HOMZ) captures these trends affecting the housing market. At the household level, rising housing costs affect nearly every American in some way, but renter households are particularly exposed. Considering that housing costs represent such a significant percentage of total household spending, we think that the ability to capture or perhaps “hedge” rising costs represent a core investment need.
 
Dividend.com: What are some of the top holdings in your portfolio?

A.P: The Hoya Capital Housing 100 Index was the product of many years of research, first at the macroeconomic level to fundamentally define the “housing sector” and then at the company level to analyze the companies that could accurately represent this exposure. The index is designed to track total spending on housing and housing-related services, broken down into four major categories, each weighted based on that sector’s relative contribution to GDP. The index uses a tier-weighted system where companies are equal-weighted in each of their respective categories. Breaking free from the market cap weighted system allows the index to be significantly more diversified and not dominated by a handful of disproportionally large names.

There are 100 names in all and REITs represent close to 40% of the total weight, including twenty residential equity REITs, six residential mortgage REITs, and two timber REITs. Besides REITs, the index tracks the ten largest single-family homebuilders, the twenty largest homebuilding products and materials suppliers, and many of the largest home furnishings and home improvement retailers and manufacturers. Additionally, the index includes the real estate technology and services sectors including names like Zillow, Redfin, and CoreLogic that are rapidly changing the way that homes are being bought, rented and sold.

In general, we think that the U.S. housing industry is ripe for disruption and the ripples are just beginning to be felt. Forget the 5% brokerage fees and house tours with cookies on the counter. Homes are being bought, rented and sold with a mouse click. How about construction? Using modular fabrication techniques, homes are increasingly being built from foundation to completion in time-frames measured in days, not months or years. We believe that HOMZ effectively captures these underlying improvements in efficiency and innovation throughout the sector, but also feel that HOMZ is, itself, part of this innovation.

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Dividend.com: What are the key drivers and risks for the U.S. housing market?

A.P: While the recent pullback in mortgage rates is a clear short-term tailwind for the housing sector, we think that there are significant longer-term tailwinds lifting the housing sector into the next decade. First and perhaps most importantly is the significant underinvestment in new homes during the post-recession period and the effect that this has had – and will likely continue to have – on rising rents and home values.

While politicians will likely try to address this with politically popular short-term fixes, ultimately the only way that a supply shortage gets resolved – absent a demand recession – is by adding more supply. This is far easier said than done, considering the significant challenges that developers face in the zoning and permitting process and the increased costs associated with stringent building codes and other regulations which have been a key constraint on supply growth in recent years.

The need for housing doesn’t seem to be going away or getting disrupted anytime soon, so we’re generally bullish on the rental operators during this period of undersupply, but also believe that the supply shortages will eventually be equalized by slow but steady growth in new home construction well into the next decade.

The other effect of the underinvestment in new home construction is that the average age of existing homes keep getting older and older, and when you consider that households significantly deferred home improvement spending in the post-recession period, you’re seeing a substantial tailwind lifting the home improvement and home furnishings categories. We think that the remarkable run of same-store sales growth at Home Depot (HD ) and Lowe’s (LOW ) is the best indicator of these trends, but think that we may still be in the early innings of those trends
 
Dividend.com: The U.S. housing bubble crash in the 2006-2008 period affected several states at the same time. Do you think the housing sector is much stronger today and the risks of a nationwide slowdown or crash have subsided?

A.P: The financial crisis ushered in a new era where households, particularly younger millennials, now have a far different view of homeownership than past generations. The desire and the need to own real estate remains, but the manner in which households and investors are doing it is changing rather dramatically both because of need and because of innovation.

Households continue to feel the impact of a lingering housing shortage across the nation. The effect of this shortage has been felt by all Americans over the last several decades – housing costs have significantly outpaced average wage growth. For many, it’s simply that the “rent is too damn high” but for others, this shortage amounts to a real crisis, pushing not only homeownership but any form of affordable housing out of reach for millions of households.

The housing crisis highlighted just how important and integral the residential housing sector is to not only the U.S. but also the global economy. The housing markets of 2019 bear little resemblance to the markets of 2004-2006 after a decade of limited supply growth and tight credit conditions. If anything, our research indicates that the response to the crisis in terms of mortgage availability and housing supply has swung too far to the opposite extreme. Sub-prime and adjustable rate mortgage issuance has been almost nonexistent in the post-crisis period relative to the early 2000s and leverage has been continually drained out of the housing markets.

While U.S. homeownership has historically produced significant value appreciation, that paradigm came to a crashing end during the Great Recession and the effects continue to linger today. Households are increasingly less likely to look at buying a home as an investment vehicle any longer but rather an affordable place to live within a budget. With lenders sticking to a 30% equity requirement before granting a mortgage, many people are shut out of purchasing a home and instead prefer to rent. Also, many people who previously owned homes have decided to rent and avoid the high carry and maintenance costs associated with homeownership. This is the huge “Renter by Choice” paradigm that was a direct result of the Great Recession.

We think that HOMZ captures the macroeconomic effects of these trends, and in doing so, gives those investors and households most exposed to the negative implications of rising housing costs a way to “hedge” or benefit from those trends.
 
Dividend.com: The Federal Reserve signaled a pause in rate hikes and ending balance sheet unwinding soon. How will those factors affect the housing market?

A.P: While we do think that HOMZ will be less interest-rate-sensitive than other real estate ETFs due to its wide diversification across multiple equity sectors, it’s impossible to completely avoid the effects of interest rates on real estate equity performance. We saw last year how rising mortgage rates quickly and completely changed the dynamic in the single-family housing market, and how the pullback in rates since late last year seems to have potentially reignited the sector based on recent forward-looking data.

So far, 2018 and 2019 looks a lot like 2014 and 2015, respectively, when rising mortgage rates slowed the single-family housing markets to a near-standstill in the aftermath of the taper tantrum, only to reaccelerate once rates moderated. New home sales grew 17% in 2013, but skidded to just 2% growth in 2014 after the 30-year mortgage rate spiked 120 basis points between May 2013 and September 2013. It was doom and gloom across much of the sector, a similar sentiment as we saw towards the end of 2018. When rates pulled back by the end of 2014, however, new home sales resumed their gains, rising 14% in 2015.

We’ve pointed out in our recent research that the forward-looking metrics in the housing market – including mortgage demand and permits – look quite strong and indicate that there doesn’t appear to be any lasting damage from the spike in mortgage rates in the second half of 2018. While it may take some time for these trends to show up in the traditional housing market metrics like new home sales and home prices, which tend to be lagged by several months or more, we think mortgage rates remaining in this range are quite favorable to all segments of the housing market.

Total household formations is the key metric that we think drives HOMZ, and formations are driven largely by demographic trends and job growth. Outside of a spike in mortgage rates, a slowdown or reversal in household formations, as we saw during the recession, would probably be the factor that has the most potential to drag on the performance of a majority of the sectors represented in the index.

That said, we think that HOMZ is relatively agnostic to the distribution of households between renting and owning, something that certainly can’t be said about a REIT-exclusive or homebuilder-exclusive ETF where investors are effectively making a call on homeownership trends, which is essentially impossible to predict because of the impact of policy changes and other non-fundamental factors, as we saw with changes from the 2017 tax act. Demographics appear highly favorable well into the next decade with the largest mini-generation in the U.S. being 25-30 years old. Moreover, most metrics indicate that there are significant deferred household formations from the lingering aftermath of the recession.

Alex Pettee, President of Hoya Capital Real Estate, believes that investors who are feeling the pinch of rising housing costs in the U.S. should consider ways to hedge it. HOMZ provides an opportunity to achieve this by providing a unique way to gain exposure to the broad housing sector.

At the same time, Mr. Pettee expects to see a gradual increase in home supply in the coming years as homebuilders try to bridge the supply-demand gap created by the aftermath of the Great Depression. This along with housing innovation initiatives should set the tone for the overall sector going forward.

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