It's a billion-dollar question: Following a 30-year bull run in bonds and falling interest rates, can the housing market survive a rising-rate environment?
Rising rates have a direct impact on housing affordability. Mortgages at a 5.5% annual rate are 12% more expensive than at a 4.5% rate. At 6.5%, monthly mortgage payments are nearly 25% more costly than at 4.5%
As rates go up, the amount a buyer can afford to spend on a home goes down, all else equal. But will it put a damper on a real estate recovery?
The great American upsizing
Bond values weren't the only thing going up over the last 30 years. Data obtained from the U.S. Census shows the average newly built American home swelled in size, too. The average home built in 1975 was 1,535 square feet. By 2010, the average build came in at 2,169 square feet.
What's behind the meteoric rise in home sizes?
Interest rates could be to blame. In fact, when you look at a chart of home sizes by year, they seem to be inversely related to interest rates.
As interest rates fell in the late 1970s, home sizes grew. As rates rocketed in the early 1980s, home sizes contracted. After reaching a peak in the 1980s, mortgage rates have fallen precipitously, and homes have grown in almost every single year since.
The great downsizing
The question to ask ourselves is whether the future American home will look anything like the homes built in the last 10 years, when interest rates were almost always treading on record lows.
I'm not entirely convinced that rising rates are the end to rising home values across the spectrum. Americans have largely forgotten that a home built recently is some 40% larger than a home built in the 1970s. There isn't a real, practical reason for the shift. We've just become accustomed to more space for the same number of people.
Many people could afford to live in smaller homes. Following the financial crisis, apartments added new tenants quickly. Vacancies fell to 4.3% in July, according to The Wall Street Journal. While it's likely renters feel cramped in smaller apartments, it's unlikely future homebuyers will need a subprime boom-style McMansion after moving out of a rented apartment space.
Big investments in small homes
Homebuilders would seemingly be an obvious way to play home construction, but they require impeccable timing. Leaders like KB Homes (NYSE:KBH) are profitable on the income statement, but virtually all free cash is reinvested into the business. Continuous reinvestment is good during the boom years, but when housing invariably slows, homebuilders are substantially leveraged to the downside because they carry their inventory on the balance sheet. Homebuilders face a systematic problem: They are always most invested in real estate at the top of a cycle, not the bottom.
How can investors play a shift toward smaller, more affordable homes? One of the best investments may just be Home Depot (NYSE:HD). It's certainly not cheap, at 17 times forward earnings expectations, but it is uniquely positioned to benefit from a housing recovery. Should small homes come back, buyers will be snapping up homes constructed in 30 or even 40 years ago -- homes which may require some remodeling to be move-in ready.
In the last 12 months, Home Depot generated $5.8 billion in free cash flow, giving it a free cash flow yield of 5.3%. Home Depot revealed on its conference call that it processed the largest number of customer transactions in its history during its blockbuster second quarter.
Finally, investors who aren't convinced that higher rates will cripple housing transactions should look to the title insurance industry. First American Financial (NYSE:FAF) is a title insurer trading at just 1.6 times tangible book value. Going forward, a shift away from refinances to purchase transactions should increase revenue and bottom-line profits. Title insurers sell only one policy in a typical refinance transaction; however, in a sale transaction, both the buyer and mortgage issuer buy title insurance. The company currently trades for less than 10 times forward earnings expectations.
As rates come off their lows, housing prices may feel a pinch, but we shouldn't forget there's still an option for buyers priced out at the margin: Buy a smaller home. When push comes to shove, renters annoyed with cramped apartments and hefty rental payments will find a smaller-than-ideal home a better alternative than no home at all. Home sales should continue their brisk pace, making money for well-positioned investors.