Real Estate Housing and its path forward

Innovation and investment opportunity

18 Apr 2024

Introduction

Housing is a basic need, a fundamental aspect of our lives, and an important component of economic growth. From the first mortgages, the advent of electricity and the urban industrial revolution, to the 20th century suburbia surge—housing is always evolving. A decade after the great financial crisis, the pandemic ushered in a new era. Remote work redefined the purpose of a home, introducing new migration patterns and adding to demand for home amenities. As retirement housing struggled in the pandemic’s wake, a new focus was placed on health and indoor air quality. Eventually, higher interest rates followed.

Today, as the world grapples with affordability near multi decade lows, energy security, aging, and extreme weather, what’s next? How will our homes adapt to the challenges we face? The next wave of housing innovation looks likely to center on resiliency, efficiency, and lower-cost solutions.

Housing markets are local in nature. Different regions face unique challenges and attempt to solve them with a range of policy approaches. This report does not attempt to draw one global conclusion, or predict a level of housing price appreciation over time. Instead, we address the state of the housing market, the forces shaping it for the future, and the investment opportunity across asset classes.

Current state of affairs

Existing home sales hit a 28-year low in 2023, an expected consequence of a dearth of for-sale inventory and multi-decade low affordability driven by elevated home prices and substantially higher mortgage rates as compared to several years ago. Higher mortgage rates resulting from tighter monetary policy, interest rate volatility, and a widening of the primary/secondary mortgage market spread increased financing costs and caused a “lock-in effect” across much of the existing home market, as homeowners with low mortgage rates became reluctant to sell and face higher mortgage rates (Fig. 1). We anticipate this dynamic will loosen, with headwinds to higher mortgage rates starting in the latter part of the year.

The slowdown in home sales hasn’t aided affordability though, arising from the lack of available for-sale inventory. Monthly principal and interest payments as a percent of disposable income are near 30-year highs (Fig. 2). 

Although falling mortgage rates would be an incremental positive in terms of increased affordability, buyers may not see much relief if falling interest rates draw a flood of potential buyers back to the market. A potential mitigant is that the increase in the supply of homes could reduce upward pressure on prices and eliminate bidding war situations.

Graph showing percent of mortgages outstanding is higher when contract rates at initiation are lower
Graph showing monthly principal and interest payments as a % of median household income, assuming a 10% down payment and 7.35% mortgage rate, are near 30-year highs.

Adapting for the future

Local market home prices and affordability levels will fluctuate over time as with any economic cycle. Looking ahead, we expect aging housing stock, supply challenges, and demographic tailwinds to power the next wave of housing innovation centered on resiliency, efficiency, and other solutions that can reduce costs throughout the lifecycle of a home. How these are prioritized will shift with the market. The current unaffordability backdrop should favor improved affordability in the near term, while over time resiliency is likely to gain in importance—it’s notable that oftentimes cost and resiliency are at odds.

Lower-cost solutions

In addition to the rise in material and labor costs that occurred in more recent years, housing-related spending has become a higher proportion of household consumption over time, but with significant variation between regions. While the average for the OECD has risen, housing consumption has been relatively stable in the United States, in contrast with Switzerland, for example, that’s seen a more clear upward trajectory (Fig. 3).

Graph showing housing expenditure as a percent of total consumption has risen for the OECD on average, but regional differences are significant (Housing, water, electricity, gas and other fuels, % of final household consumption expenditure, OECD 1995–2019)

Even if housing prices come down, lower-cost solutions can increase margins or reduce the ongoing cost of living for households. Construction labor is cyclical in nature, but the workforce is aging, and labor supply has been tight in recent years. If these trends continue, it will add to the appeal of solutions that can reduce reliance on labor (Fig. 4).

Graph showing labor demand for construction workers in the US has been strong (Construction job openings, in thousands, seasonally adjusted)

The lack of affordable housing has resulted in numerous government policies to address it, but these policies commonly have unintended adverse consequences. The supply of housing is a major determining factor of affordability. In the US, at the single-family level, supply is running below long-term averages, while household size has declined at the same time. There isn’t enough housing supply to meet the demand. According to the National Association of Realtors, inventory for existing single-family homes sits slightly under 1 million, well below the historical average of 2 million. That equates to 2.8 months of inventory versus the longer-term average of 5.5-6.0 months.

Globally, the UN estimates that 3bn people will need access to housing by 2030, which indicates demand for 96,000 new accessible housing units every day. It’s not solely about new supply either, 49% of housing stock in the US was built before 1980.1 This adds to the case for retrofits and renovations.

Resiliency

Extreme weather, higher insurance premiums, and a strained electric grid all seem to point towards a growing need for home resiliency. According to a recent Bank Rate survey, over 57% US adults have incurred costs due to an extreme weather event over the last decade.2

Some of the world’s most valuable and sought-after real estate lies in regions with considerable weather risk. Extreme weather events like floods, hurricanes and wildfires not only threaten property values and cause loss of investment, they add to the cost of homeownership through higher insurance premiums and increase the risk of economically costly power outages.

Homeowners insurance is becoming harder to find at a reasonable price in the most impacted regions. Large insurers are pulling out of some markets altogether, evidenced by State Farm leaving California. The lack of options and increasing premiums have pushed consumers towards state insurers of last resort, but this threatens the economic viability of those insurers. As homeowners in the riskiest regions seek insurance from last-resort insurers, these last-resort insurers are forced to take on an increasing amount of high-risk properties—there’s also the chance that lower-risk homeowners unwilling to pay the overall higher premiums will drop out of the market entirely, leaving the insurers with only risky properties. This is a conundrum known as “the insurance death spiral,” or adverse selection. Last-resort insurance is not guaranteed to be affordable either. For example, the Louisiana Department of Insurance approved a 63% rate increase for the state’s property insurer of last resort in 2023.

For investors, publicly traded insurers have reduced their exposure to the highest-risk areas where regulated price increases have limited profitability. We don’t see immediate risk in the public market space, but higher insurance premiums add to affordability woes, and the difficulty of obtaining insurance paired with the high cost of damages should bode well for solutions that can make housing more resilient.

Natural disasters put more pressure on the electric grid, already strained by rising demand and higher capacity of variable energy sources. Data has only been collected by the Energy Information Agency since 2013, but the average customer duration and frequency of power interruptions appear to be trending higher, based on a two-year moving average of interruptions lasting longer than 5 minutes (Fig. 5).

Graph showing the average customer duration of power outages is starting to trend higher (Includes major event days)

In addition to the threat posed by extreme weather, the aging electric grid is facing higher demand for capacity driven by electrification trends and, more recently, the rapid development of artificial intelligence. Preparing the housing stock for emergency outages will require more backup power generation and battery storage.

Case study: After Superstorm Sandy in New York, 33 public housing developments were severely impacted, many losing power for three weeks. The city’s recovery and resiliency plan included building backup power sites with more than 300 natural gas powered generators, which the housing department found to be a reliable source, and easier to work with than diesel.

Efficiency

In the context of housing, we see “efficiency” as a two-sided coin—doing more with less to reduce cost throughout the home cycle, and as it pertains to home energy efficiency and reducing the ongoing cost of electricity and homeownership. In many developed countries, land-use regulation and permitting regulation has become more stringent, and in the US, residential buildings are taking longer to complete construction. US Census Data estimates the average time to completion of new residential buildings with two or more units has doubled since 1971. This supports the argument for tools that can speed up time to market.

1US Census, American Community Survey 2022

2Martin, S. (2023, October 23). Extreme weather’s financial burden on the U.S. South. Bankrate. Retrieved April 17, 2024, from https://www.bankrate.com/insurance/homeowners-insurance/extreme-weather-in-the-south/

The housing lifecycle

There is no single solution to these challenges, but if this backdrop persists over the longer term, it should favor solutions that can improve resiliency, increase efficiencies, or reduce costs anywhere within the lifecycle of a home—from design and construction to financing and homeownership. The graphic below shows what this could look like in practice, but ultimately, the right solution will depend on each home and individual. Consumer preferences and local regulation will help determine which aspects are prioritized.

1. Design (thermal cooling, insulation, and circular systems); 2. Construction (resilient materials, modular homes, and roofing and window protection); 3. Financing (mortgage technology); 4. Homeownership (home energy and backup power systems, land ownership credits, and shared space)

Design

How homes are designed can result in dramatic differences in resiliency and the ongoing cost of living. Future homes will be designed for efficient heating and cooling, disaster mitigation, and accessibility. A focus on efficiency and sustainability could favor design choices like thermal heating and cooling, or low-lying buildings that can be good for both temperature control and accessibility. Designing a home to be energy efficient and well insulated can save costs in the long run.

Construction

Land, lumber, and labor are three of the most significant cost components of the construction process. Factory built panelized and modular homes offer a cost-effective solution that can reduce labor intensity and speed up time to market by avoiding weather delays and automating processes. Modular homes are often significantly cheaper than site-built homes and are subject to the same zoning laws. The industry’s challenge will be overcoming the stigma that a pre-fabricated home sacrifices quality, or is associated with the traditional idea of a mobile home. Panelized homes are similar to modular homes but can offer more customization.

3D-printed homes have also come to market in recent years, but the industry hasn’t yet matured.

Why don’t we see more 3D printed homes?

  • 3D printed homes can be constructed faster than with traditional methods, require less labor, and some of the largest publicly traded homebuilders are partnering with startups in the space.
  • Cost savings on labor and time to market haven’t translated to cheaper consumer prices yet—the upfront equipment costs are still high. The industry would benefit from greater economies of scale and lower interest rates.
  • Homes in one of the world’s largest 3D printed communities are priced near half a million, which is no less than the broader average for Georgetown, TX.

Outside of lower cost solutions like modular homes, we view construction materials from two different lenses: materials for resilience, and the adoption of circular materials to lower cost.

Materials that save costs don’t need to be groundbreaking—according to the Department of Energy, insulation can save an estimated 15% on heating and cooling bills, and some types of insulation already use recycled materials. However, looking farther ahead, we could see greater utilization of circular systems both for materials and within the home’s design—refurbished materials can often save costs, and circular technologies like water reuse systems can reduce the ongoing cost of living in the home. We’ve already seen some creative solutions in this regard, for instance the rise of the “container home” in the US, built with repurposed shipping containers.

Construction and demolition are one of the five priority sectors in the EU’s Circular Economy Action Plan. Reclaimed products from construction and demolition waste have a replacement rate of 50-85% when reintroduced into the production cycles for concrete and timber.3 Prefabricated products have also been touted for their circular properties, with standardized components easier to replace and reuse. With time, we could also see circularity more commonly applied to home water systems, particularly in areas facing water stress. Concrete and cement look like low hanging fruit considering their energy-intensive production process. Concrete waste can be recycled and reused to replace clinker as an aggregate in the production cycle. Steel and aluminum have already adopted circular processes, but there’s room left for improvement. There is a plethora of potential options to implement circularity in home design and construction. This report will not attempt to discuss them all, but we discuss the broader opportunity in circularity in our report Circular economy.

In a similar sense, there are a number of ways to use building materials to make a home more resilient, but the best solution typically depends on location and the unique resiliency challenges that region faces. Broadly, precast and reinforced concrete, structural steel and rebar are examples of construction materials that have been shown to improve home resiliency. Home insurance rates vary due to a variety of factors, but buildings made with resilient material can help reduce premium costs. In regions that have suffered severe natural disasters in the past, homes that were built up to the most recent codes and with resiliency in mind have managed to survive extreme weather with little damage.

Financing

The US mortgage market is large and inefficient. More than USD 2 trillion of annual mortgages are still mainly originated and processed over legacy analogue systems operated by banks and other financial institutions. The entire mortgage workflow from application to underwriting to closing to fulfillment is slow, cumbersome, error ridden and costly. We believe the application of technology-based solutions to the mortgage workflow should enhance speed, accuracy and efficiency for originators, servicers and borrowers alike. Recent efforts by technology-driven platforms to digitize certain aspects of the mortgage food chain have gained acceptance and end-to-end tech-based solutions are steadily expanding market share. While incumbent players including the largest banks have historically employed internally developed systems for mortgage origination and servicing, newly developed digital capabilities are increasingly embraced by the industry, helping drive high-single-digit revenue growth.

Homeownership

In theory, the steps taken in the design and construction process should lead to lower costs for the resident through savings on things like heating and cooling. Not only can home energy efficiency solutions save on operating costs, homeowners may be able to take advantage of tax credits for retrofits and energy-efficient upgrades. Solutions like heat pumps are efficient and have gotten a boost from government spending initiatives, but homeowners should investigate which models are appropriate for their location, as older models may be less effective in extreme cold. Homeowners interested in more ways to improve the efficiency of their homes can read more in our blog series, Greening your home. We also discuss the related investment opportunity further in the full report, Energy efficiency.

There are some additional ways for homeowners to earn income. The shared economy offers one avenue for homeowners to utilize their asset as a source of income when not in use, but the growing popularity of short-term rentals has caused cities short on housing to push back, and the industry is likely to face regulatory hurdles in the years ahead. Landowners can also tap into the value of their property through carbon credit markets, but earnings potential varies by location.

It’s not just about efficiency either, entire home energy systems are evolving with the energy transition. Rooftop solar and battery systems have become more common, but the economics vary dramatically by location. Traditional backup power systems like generators have also grown in popularity since the pandemic, with more workers relying on having power at home to do their job. This is still a largely underpenetrated market, offering room for further growth in the years ahead.

3https://www.circularhomes.eu/circular-measures-and-products-materials

Investment conclusion

What does all of this mean for our investment views? Below we detail our cross-asset class views.

Equities

  • In the near term, we expect the peak and eventual fall of mortgage rates to spur a recovery in home-related consumption and mortgage activity, benefiting companies with exposure to home improvement, building tools, and mortgage financing.
  • Over time, we expect the longer-term themes, Energy efficiency and Circular economy, to become more embedded in housing. Energy efficiency initiatives are already well underway, while circularity will become more viable if and when resource scarcities become more acute. We also see implications for our Aging in comfort theme, which discusses the aging population and what that means for housing.

US fixed income

  • Agency MBS is one of our top recommendations in the coming year. The interest rate volatility experienced in 1Q24 has pushed spreads for agency MBS to 153bp (a risk-free credit asset class), which is a pick-up of 40bps versus a BBB IG. As 30-year mortgage rates fell from 8.01% to the mid-6% level at the end of 2023, home purchase applications have risen. While affordability will remain an issue in 2024, it should be less of a headwind if rates decline and supply increases. With slower economic growth ahead, the enhanced quality and liquidity of agency MBS will drive returns.
  • Municipal housing bonds: Municipal housing is a relatively small corner of the municipal market, accounting for roughly 3% of the Bloomberg municipal bond index. There is a wide variety of municipal housing bonds, and we tend to focus more on higher-quality State Housing Finance Agencies (HFA). Median S&P Issuer and Mortgage revenue bond credit ratings are AA and AA+, respectively. Despite some weakness in net interest margins, state HFA credit quality remains strong, supported by strong capital adequacy metrics. This was driven primarily by a resilient macro economy. The role of HFAs has become more critical as housing affordability remains very stretched amid high home prices and mortgage rates. We expect greater state HFA mortgage revenue bond issuance in 2024 and perhaps some increase in leverage. Notwithstanding that, we expect state HFA bonds to deliver attractive risk-adjusted returns, as credit quality remains on a solid foundation and interest rates decline from current levels.

Alternative investments

  • Investors can tap into opportunities in the housing market through alternative investments too. These can include a variety of strategies in private markets, such as opportunity zones, multifamily development, and affordable housing.