<July 1, 2021>
Despite growing evidence that inflation may stick around longer than the Federal Reserve expected, the debate on whether it’s transitory continues. We remain flexible and will view inflation through the eyes of the 300 companies on our possible buy list. Based on our analysis of recent operating results, we believe inflation is unquestionably trending higher. We also expect inflation will be a common theme during the upcoming earnings season. Although visibility in the second half of the year is less clear, most companies are expecting cost and pricing pressures to persist. It’s interesting. If operators in the economy are not planning for inflation to be transitory, how can the Federal Reserve be so confident?
In addition to rising real world inflation, asset inflation remains elevated and unconstrained. While it’s difficult to measure its impact precisely, we believe asset inflation has contributed to many of the economy’s current supply and demand imbalances. According to the Federal Reserve’s latest Z1 Report, household net worth increased $25.5 trillion over the past year, significantly higher than even the largest government stimulus program. In our opinion, asset prices and consumer demand (most of the economy) remain highly correlated. As such, we’re not surprised by the Fed’s determination to backstop asset prices via 0% rates and bond purchases.
While asset inflation is often considered “good” inflation by Wall Street, excessive price increases can spark financial and societal instability. For example, it’s becoming increasingly clear that the Fed's easy money has disproportionately benefited the ultra-wealthy over the past decade. Although most politicians and citizens have yet to pinpoint the source of rising wealth inequality, the post-COVID bump in net worth of the top 1% has raised eyebrows.
Assuming asset prices continue to rise, we believe wealth inequality will become increasingly controversial and divisive. Surging residential real estate prices have been particularly troubling for non-homeowners. When stock prices soar, non-equity holders miss out on capital gains. When home prices soar, non-homeowners typically experience rising shelter costs or a lower standard of living. People can live without stocks; they can’t live without shelter. And that’s what makes the extraordinary rise in home prices over the past few months so concerning. Given how sharply and quickly home prices have increased, a large segment of the population is being priced out of the housing market, with many homes being reclassified from expensive-to-own to unable-to-own.
Although the 19% year-over-year (ending April 2021) increase in the existing median home price is alarming, there are certain areas of the country experiencing even higher increases. As Florida residents, we have a front row seat to some of the country’s most vibrant real estate markets. We’ve been through multiple booms and busts, but the current boom is like nothing we’ve ever seen. The slope of the price increases is much steeper than past cycles. It’s as if we’ve had multiple years of price gains in a few months. Instead of trending higher, prices of many Florida homes are gapping higher, with asking prices of new listings vaulting well above completed transactions.
Based on conversations with local realtors, multiple offers and all-cash deals are becoming more common. Individual buyers are flush with excess capital, thanks to record stock prices and incredibly low interest rates. Desperate for yield, institutional investors are also aggressively competing for properties and driving up demand. Supply is an issue as well, with rational sellers quickly disappearing. Many possible sellers are fearful of being priced out of the market, while other sellers are having difficulty finding homes to buy upon completion of their sale. Rents have also increased meaningfully, reducing the attractiveness of selling and renting. Furthermore, homeowners considering selling and buying, risk paying significantly higher property taxes as tax assessment values are readjusted. Lastly, many distressed sellers have disappeared from the market, with foreclosures and bankruptcies in decline.
Our house is located in Ponte Vedra Beach, Florida. Ponte Vedra is located between Jacksonville and St. Augustine. It’s known for hosting the The Players Championship (TPC) golf tournament. Historically a quiet beach community, the Ponte Vedra real estate market has been anything but quiet!
Our neighborhood consists of approximately 2,000 homes and condos. As I write today (6/22/21) there is only one home for sale and zero condos! The limited supply has caused asking prices to spike for new listings. For example, below is a 2,390 sq/ft home that was sold for $500,000 on August 3, 2017. On March 24, 2021, the home was listed for $1.55 million! When the home initially went up for sale the listing went viral among local friends. Few of us could believe it and even fewer thought it would sell. On June 3, 2021, the home was listed as “pending” for $1.45 million.
We’ve discovered that many of the new listings in Ponte Vedra have similar Zestimate charts to the home above. For those unfamiliar with Zestimate, it is Zillow’s estimate of a home’s market value. According to Zillow, a Zestimate “incorporates public, MLS and user-submitted data into Zillow’s proprietary formula, also taking into account home facts, location and market trends.” While Zestimates may be accurate, they appear to be closely tied to the asking price of the home. For example, on the home above, when the home was listed for sale, the Zestimate immediately followed the asking price higher. It appears reactionary, reminding us of a sell-side analyst’s stock price target—when the asking price goes up, the estimated value goes up 😊.
With many existing homes in Ponte Vedra becoming unaffordable, maybe buying a lot and waiting for the market to cool down makes more sense. We found a potential lot below. It was sold for $535,000 in 2014 and is now on the market for $2.45 million! If sold at its asking price, the seller would make 358% (26.4% annualized) from its purchase price. And here we are attempting to generate 10-15% on our small cap ideas!
It’s an extraordinary environment. Based on recent listings, many homes in an entire zip code have become unaffordable in a matter of months. And while the labor market is extremely tight and wages are rising, increases are nowhere near the levels needed to keep up with rising home prices. Nevertheless, local businesses are doing their best to attract labor and pay workers more. To help fill needed positions, a nearby Chick-fil-A recently began replacing promotional coupons with help wanted inserts in their “to-go” bags. And while $15/hour and a meal with every shift is nice, it doesn’t come close to keeping up with local shelter inflation.
As home prices in Ponte Vedra and other overheated zip codes hyperinflate, the Federal Reserve continues its quantitative easing program and purchases of mortgage-backed securities. With recent home price increases mirroring the Federal Reserve’s balance sheet, we believe maintaining current bond purchases will only place more zip codes out of reach of potential homebuyers. And while comparing the Fed’s balance sheet to any spike in asset prices is becoming a little overdone, we couldn’t resist!
In its effort to control asset prices, we believe the Federal Reserve has lost control of the real estate market. While they have succeeded in building a floor under home prices, they forgot about the ceiling! Assuming zip code hyperinflation spreads, we expect wealth inequality and housing affordability to become an increasingly hot topic in upcoming elections. In the meantime, the Federal Reserve’s balance sheet continues to inflate as millions of potential homeowners are being squeezed out of the market. How much longer will the inequalities created from ultra-easy monetary policy be tolerated and left unchecked? We’re not sure, but given the growing extremes, we believe it is the Fed’s ability to QE without consequence that has become transitory, not inflation.
Eric Cinnamond
eric@palmvalleycapital.com
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Definitions
Federal Reserve Z1 Report: The Federal Reserve’s Z1 report includes flow of funds, balance sheet, and integrated macroeconomic account data. The last releases was on June 10, 2021 and included data as of March 31, 2021.
Ask price: The ask price is the price at which a market maker or broker offers to sell an asset.
QE: QE is an abbreviation for quantitative easing. Quantitative easing is a form of monetary policy in which a central bank purchases securities in the open market in order to increase the money supply and and manage interest rates.