Freddie Mac Details Housing Finance, Economic Trends
Recently appointed Freddie Mac Vice President & Chief Economist Sam Khater, along with the GSE’s Vice President of Multifamily Research and Modeling Steve Guggenmos, discuss the decline in housing affordability and their organization’s efforts to address it.
Sam Khater joined Freddie Mac as vice president and chief economist earlier this year, bringing more than 20 years’ experience in housing finance research and economic forecasting. Along with Steve Guggenmos, the GSE’s vice president of multifamily research and modeling, Khater detailed his plans to leverage Freddie Mac’s research capabilities to deliver insights on economic trends and policy issues impacting the housing market.
What are your primary objectives in your new role with Freddie Mac?
Khater: I’m really focused on trying to bind the research to be closer to the business. I’ve been speaking with the various business unit leaders, such as Steve, (with whom) I’ve talked about doing a research effort around multifamily rents. I’m more internally focused on making sure the business units are satisfied with what they’re getting from the research group. Then I want to take some of these new research initiatives and take it to the outside world. I’m looking for the overlap between research opportunities that are useful to the business and answer interesting questions.
On the vehicle side, I’m looking to develop at least one different distribution vehicle for our research center. What I’d like to develop is a middle ground between shorter outlook pieces and longer, academic-style insights. Like a rapid prototype, it kind of helps us tease out research ideas and see what the public’s reaction is. I’d like to do a bit more of a deep dive into individual markets and regions around the U.S.
We all hear that real estate is local, so what really matters is what’s happening in their neighborhood and their metro markets. I do want to focus a bit more regionally on the various metros than we have in the past, dependent on bandwidth.
What economic trends, risks and opportunities are top of mind for you?
Khater: The biggest issue for me is the lack of inventory—it’s what’s holding back sales and driving up prices. I’m worried about affordability. If you use mortgage rates in your affordability calculations, then the single-family market is still affordable. But if you take rates out of the equation, the market has become unaffordable.
The Fed has kept the posture that (it wants) the economy to run a little bit hot to make up for the issues that came out of the last recession. Due to all those factors, we could have a situation where all the home prices continue to increase for the next couple of years (at a rate) in the 5 percent range. It’s already, in my opinion, not affordable. It’s the hardest nut to crack because all federal policy is aimed at managing the demand side, but there is no federal lever for managing the supply side. It’s a state and local issue. It’s a coordination issue. It’s something that the local municipalities have to take up.
What resources can Freddie Mac provide to those state and local governments?
Guggenmos: It’s really hard from the debt side to affect supply. There are (low-income housing tax credit deals), but those are complex transactions that require certainty across all parts of the funding stack, whether it’s equity, debt or mezzanine. As Freddie Mac, we provide certainty in the transaction. I think the people who have been involved in developing (tax credit-eligible) properties know that if you have Freddie Mac on the debt side, you know exactly what that program is, with a certainty of funding, and that’s a big benefit. As we’re starting to get strategically involved on the equity side, that gives us another lever. I agree with Sam that there’s a lot that needs to be done on the local level to get housing built.
How do these trends trickle down to the broader U.S. housing market?
Khater: The end result, price, is the signal that all of these trends feed into, and that’s why we’re seeing home prices increase in the 5-6 percent range year over year. That’s higher than income (growth) on the single-family side. All of these issues that we’ve talked about end up driving up home prices faster than incomes, and that’s not sustainable in the long run. You can have short-term deviations, but at some point, incomes and home prices come back in line. I think that we have to keep our eye on what happens with home prices because that’s the signal that can tell us if there’s any kind of relief coming from a supply perspective. The dynamics of multifamily are a little bit different, but generally speaking, in the multifamily space you would look at rent growth as the main indicator.
The single-family housing market is very stable. We’re seeing very steady increases in home prices. Home sales have reached the speed limit in the sense that demand is there, but the inventory is not. I think sales would be modestly higher if the inventory was there. We are seeing some markets get a little bit overheated. They tend to be on the West Coast. Unlike the last boom-and-bust cycle of the mid-2000s, which was demand driven, this time the run-up in prices is driven by the restriction in supply. What’s nice about the current environment is that the rapid price appreciation is happening in markets that have very strong economies.
It’s not unhealthy like during the last (cycle), where we had a very rapid run-up in markets that didn’t necessarily have strong economies. This time we’re seeing steady increases for the market overall. But, the really outsize home price increases are in markets with very strong job growth. It’s happening in markets like Seattle, Austin, Nashville, Denver, San Jose and San Francisco. You’ll notice that a lot of these are tech markets, but some of them are not, like Nashville and Denver, which have very strong in-migration. The largest price increases tend to be in the West Coast and Rocky Mountain states in the current cycle.
What trends have you observed in multifamily fundamentals?
Guggenmos: When we look at how tight markets are right now, vacancy rates are very low, and occupancy is very high. This tends to produce rent growth, which gives owners some confidence that they can make their returns, and thus, they make an informed bid on a property. Multifamily property prices have been going up by double digits since 2012, even faster than on the single-family side. Certainly, I think people have to look very carefully at their property values. The good thing is, they can turn to their cash flows and make decisions based on that.
Multifamily rents, which have been continuing to go up, are certainly correlated with single-family home prices. Rent growth is moderating, though, given the supply that’s coming on in multifamily now. We’ll probably see multifamily supply peak this year, at somewhere around an annualized rate of 360,000 units. It’s a pretty good story that rent overall is growing faster than inflation, and that’s all coming back to vacancy rates continuing to be tight. I think that the overall housing market is tight, too. The market is delivering in the range of 1.2 million households per year, whether single-family or multifamily. From my perspective, the housing market is undersupplied, so you’d expect to see prices go up. Do we see single-family house prices going up? Yes. Do we see multifamily prices going up? Yes. Do we see multifamily rents going up? Yes. And to the extent that we can measure it, single-family rents are going up as well. Everything is going up a little bit, and that’s all pointing to the imbalance of supply and demand.
That said, multifamily is a bit further along in the cycle. While rents are going up, they’re not going up as much as they were one or two years ago. So in markets that have taken on a lot of supply—like Austin, which Sam mentioned—rents are slowing. They’re basically flat year over year right now. Certainly in some boroughs of New York City, there has been a ton of supply and some softening of rents there. San Francisco is interesting, too: There was a ton of building not that long ago and a fair amount of concern about that market. Looking back six months, rents were falling a little bit year over year. They actually have turned a corner, and if that continues, they’ll be back to positive ground. When we point to these high-supply markets and see a little bit of a turn, that’s good, and we’ll see if it continues.
In San Francisco, oversupply compressed rent growth over the past 1-2 years?
Guggenmos: Yes, there was actually a lot of supply that came online in San Francisco in the second half of 2017. By some vendors’ estimates, there was some contraction of rents during that period. It was pretty brief, but I think people were concerned with how many units were coming onto the market so quickly.
What trends have you observed in household formation, and how do those relate to supply?
Khater: Household formations are still running below trend for two reasons. One is the economic scars of the recession are really still impacting the lower end of the market. We’ve got an elevated percentage of young people that have moved back in with their parents or relatives, and we haven’t seen them begin to move out yet. There’s this question around when these Millennials will begin to move out on their own.
Here we are, about to hit the 9-year anniversary of the economic expansion, which is fairly old. It’s the second-longest economic expansion we’ve ever had. That tells me that the scars of the recession are still impacting certain households, but it’s also driven by the (bifurcation of) supply. Because when we look at prices and rents, there’s a difference between what’s happening at the low end and what’s happening at the high end. On the low end, price and rent growth is rising at a faster rate than what’s happening in the middle. That’s a potential headwind that new households are going to (encounter) because there just aren’t enough vacancies for them to occupy, either on the single-family or multifamily side in the affordable space. The lack of affordable vacancy is also a headwind for household formation.
And when I talk about affordable, I’m talking about middle-income and below, because the lack of construction is really beginning to impact the middle and even into the 60-65th percentile of the income distribution. That there hasn’t been enough housing for low-income families has been an issue for a long time. Now it’s crept up into the middle-income (segment).
Guggenmos: Most of the supply we’ve been talking about is in the Class A space, unless it’s supported by low-income housing tax credits. According to Yardi Matrix data, from 2012-2017, the number of units in the discretionary Class A and A+ segment increased by 78 percent from 800,000 to 1.4 million. But then we go down to everything that’s C+ and below, it’s completely flat, zero percent change, which isn’t a surprise because those may just be a handful of low-income housing tax credits probably. The Class B/B- space grew only 2 percent, and Class A-/B+ grew by 26 percent.
Khater: All that supply is coming in on the upper end of the market. As we talk about more and more households forming, they’ll likely rent, not own, first in something that’s not Class A. You look at how tight those markets are, and none of the new supply is feeding those markets, so it’s very competitive, and we have seen affordability become more and more challenging.
There are some things that have changed. The (Joint Center for Housing Studies of Harvard University’s) study of the rental market found 1 million rental households formed per year, and that’s certainly a lot of demand. What’s notable is that from 2015-2025, we’re still seeing a drop of 500,000 rental households (formed) per year. If we’re doing around 350,000 new completions on the high end, we’re really not keeping pace. There continues to be demand into the mid-2020s.
What would need to change to materially affect the supply-demand imbalance?
Khater: Certainly, there’s some hope that there’s some trickle-down in apartments. Earlier in the cycle, as the buildings started in multifamily and people were saying that looked like a lot of supply, there was a little bit of a view that there were some underserved markets in terms of the quality of the housing. The buildings from decades ago didn’t have the amenities, and then when people moved into the newer buildings, there was some trickle-down of the older units. There’s a lot of incentive for people to rehab those units.
As we said, the demand is still holding up. Looking at the most recent Reis data, which is not broken up by class, in 80 of the 82 markets (it covers), effective rents went up last quarter, so while there is some softness and there are concessions, it’s in the context of a market that’s still growing.
What challenges and opportunities exist in housing finance, and how do recent shifts—including tax reform and demographic changes—affect the sector?
Guggenmos: The multifamily market has been strong for quite a while and is now a more accepted asset class on debt side. There are many players who are interested in becoming involved in multifamily finance. I think there’s a lot of competition, so it really matters how you look at credit.
Freddie Mac views itself as a through-the-cycle lender and keeps the same underwriting approaches throughout. We’ve been very careful, which has led to very good performance, helping us through the recession with (minimal) losses. But right now, as people are aggressive in their underwriting, that creates challenges for us in terms of keeping our credit stance.
Affordability is always a challenge at the forefront of our minds. We’ve looked at creating a product to try and serve this market. We aim to bridge the gap to make sure units are available on the market and that there’s continued growth in the market and preservation of affordable units. We’ve tried to find ways to create programs that will allow units to stay in the market and not become obsolete.
The target of tax reform was to help corporations, and most multifamily investors aren’t corporations. I think some changes that came about towards the end, as the bill was approved, do actually benefit multifamily investors (because) they can deduct some of their original investments. We think that will continue to support multifamily values. Even though prices have been going up for a while, we think that some of what will happen with the tax law change is that real estate investors will get tax savings. And when you give real estate investors money back, they generally like to leverage up and reinvest it in real estate.
Within the 55+, Baby Boomer cohort there’s not a huge percentage planning to move into rental housing in the near future, but the number of people in that age group is so big that if you move that even a little bit, it can move the demand for rental housing quite a bit. This group represents something like 2 million households.
Khater: When we look at potential loan performance, we consider going-out mortgage rates—5, 7, 10 years out for fixed-rate mortgages. Based on what we look at, rates have been coming in, so that makes it easier to get a new loan, in terms of coverage. As rates start to move up a little bit, that produces a little bit more risk at maturity. But we are careful (in that) we look at that on the front end for each loan and verify that we’re comfortable with the exit. I think people are more concerned about balloon maturity risk than they were (1-2 years) ago because they’ve seen that rates are moving up (gradually).
At Freddie Mac, we run a refinance test as part of the underwriting to (determine) how well the loan can refinance in a higher-rate environment. We’ve done that throughout the cycle and feel that it’s one of the things in our underwriting that protects us.