Click here to read our brief 4.25-pager letter to investors reviewing the past year as well…
Last week, we completely revamped our research and model on Altisource Residential, a stock we very much still like given the deep discount to peers and a business model that’s proving the skeptics wrong thus far in 2016. By this time next year, the company will have more than doubled its leased homes and will be supporting annual dividends of roughly of $1.00 per share, which should warrant at stock price closer to its NAV per share of $21.00.
The underlying asset of American single-family homes is also one that we’re attracted to, even with higher interest rates. And that’s what we’d like to focus on today, particularly because we’ve long been studying housing-related shorts in other international markets.
Most market participants talk about the house price to income ratio as if it were a price-earnings ratio of a stock. While this is a useful metric, it’s merely only one metric, and we don’t believe it incorporates all the relevant data each individual home buyer incorporates into their decision-making process.
Exhibit 1: Average House Price to Income Ratios in Selected Markets
A more useful home valuation metric would consider economic fundamentals, such as median household income, of course credit terms, such as required equity down payments, and most importantly, the cost of credit. Credit availability and interest rates are equally important considerations to the typical home-buyer as is the average income, as the monthly note is a far more relevant figure to nearly all home buyers than is the actual price.
While construction inflation has led to new home prices increasingly becoming less and less affordable, given lower interest rates, higher household incomes and average loan-to-values (LTVs) of mortgages, the monthly mortgage payment for the typical American home buyer has rarely been more affordable.
Exhibit 2: Average Mortgage Payment as Percentage of Household Income in the US
Because American homes are recovering from an unprecedented contraction while household income has continued to rise, the housing market can endure a period of rising rates while still remaining very affordable in a historical context. For the median monthly mortgage payment to merely equal the average of the last two decades (excluding the seventies and eighties), mortgage rates will need to rise over 200 bps from today’s levels (to 5.75%) all things being equal. Of course, if higher rates are coupled with higher inflation and higher nominal incomes, part of this worsening of affordability will be mitigated.
And that would only be bringing the median house price in line with historical averages, it would not be signaling any over-valuation from a historical context. Accordingly, we remain bullish on existing American homes, which is merely one tailwind Altisource Residential will be experiencing in the next couple of years.
Other international markets can’t say the same, particularly Canada and Australia. While the price-to-income ratios of the Vancouver or Sydney housing markets look like they’re indeed in bubble territory, applying the same affordability calculation to these markets show that they’re far away from reaching unprecedented territory from an affordability perspective.
Exhibit 3: Average Mortgage Payment as Percentage of Household Income in Australia
Sydney’s property market has been unable to withstand property prices so high that the financing burden rises north of 55% of median household income in New South Wales. Melbourne has been unable to withstand property prices that translate into mortgage payments higher than 45% of median Victoria household income. In the last couple of decades, when house prices rose to such high levels, the property market experienced subsequent contractions. Unfortunately for Australians in these key markets, interest rates only need to rise 50 bps for these affordability circuit breakers to be triggered, as house prices are entering the next monetary tightening cycle at unprecedented price-to-income ratios.
The environment in Canada is even more vulnerable to higher global interest rates. Because the average home buyer in Canada has been able to obtain a mortgage rate at a discounted rate under 3% per annum, the market affordability has been kept within historical boundaries only because of these ultra-low rates. Price-to-income ratios remain at unprecedented levels, particularly in Toronto and Vancouver (nearly two-thirds of the country’s residential exposure). Just like a long duration bond that has a very low yield, small changes in the prevailing yields in the marketplace leads to exaggerated price moves of the principal value.
Given the Canadian market has been enjoying sub-3% rates for the last few years, the property market, on which many highly intelligent investors have been ringing the bell for years, kept its momentum and prices continued to climb through the bearish sentiment.
Exhibit 4: Average Mortgage Payment as Percentage of Household Income in Australia
In the past, the Toronto housing market has experienced contraction in periods following levels which made the monthly mortgage payment higher than 30% of median household income, similar to levels on existing homes in the United States. Unfortunately for Toronto, the market is about 50 bps away from breaching this key ceiling of affordability, all other things being equal (house prices, credit terms and household income).
Vancouver, where prices have already started to decline thanks to new housing market regulations aimed at discouraging foreign purchases of homes, is in a similar position as Toronto. Across the country, the Canadian Mortgage and Housing Corporation, which provides mortgage insurance, has already tightened lending standards through new purchasing guidelines implemented in October and November. Thus, the Canadian housing market is facing a more restrictive financing environment at the same time its rates are dangerously close making most homes unaffordable at current price levels.
Existing American homes are half the price-to-income ratio as their counterparts in Sydney or Toronto, which reinforces the strength of the steady bull market in American housing prices. Canadians and Australians are precariously close to the canaries in the coal mine dropping dead. Coupled with tighter lending standards in Canada, the “boys crying wolf,” on these property markets may finally be proved right if higher rates last.
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