Thomvest Housing Report: What’s Next in the Housing Market & How Will Startups Respond?

It’s been a dizzying two years in the U.S. housing market — 2021 was arguably the hottest year on record for residential real estate, driven by pandemic-related fiscal stimulus and historically low interest rates. In 2022, the Federal Reserve reversed course and began aggressively hiking interest rates in an effort to cool inflation. This has led to a sharp rise in mortgage rates — from about 2.5% in 2020, to nearly 7% as of October 2022. As a result, housing affordability has deteriorated faster than at any point in the last 30+ years. Many prognosticators expect a housing market correction in 2023.

To help make sense of market conditions, we are releasing an update to the Thomvest Housing Report which includes data through Q3 2022. The full report is accessible here, and I’ve included several highlights below.

What effect will rising mortgage rates have on home prices?

After record mortgage origination volume in 2021, rising interest rates have effectively wiped out the refinance market in the U.S. (refinancings are expected to decline 74% year-over-year) and impaired the purchase origination market (expected to decline 14% year-over-year). Prospective home buyers are grappling with mortgage costs that are at a record-high relative to income — according to the NAHB/Wells Fargo Housing Opportunity Index (HOI), just 42.2% of new and existing homes sold between the beginning of July and end of September were affordable to families earning the U.S. median income of $90,000.

Despite rising rates, home price appreciation has yet to decline meaningfully — in fact, many markets (like Nashville, Raleigh, Dallas and Phoenix) experienced double digit home price growth in 2022. Why have home prices remained stubbornly high? A few factors…

First, there are several persistent demand tailwinds — most notably, demographic data suggests that the universe of first-time homebuyers (median age of 33) over the next 24 months will be the largest it has been in 30+ years. Additionally, a growing number of institutional buyers of real estate have entered the single-family home category — more than $45 billion was committed to the single-family rental (SFR) space by institutional investors in 2021. In some ways these institutions create a pricing floor in markets like Atlanta, Phoenix and Dallas where rentals common.

Second, the supply of homes for sale remains very low by historical standards. In a rising interest rate environment, existing homeowners with sub-3% interest rate mortgages may not be motivated to sell their homes in order to purchase a new home with a higher-rate loan. This has driven down transaction volume meaningfully — Fannie Mae forecasts 3.9M existing home sales in 2023, a 23% year-over-year decline. Additionally, lack of new housing construction is a major contributor to home price appreciation — housing completions have trailed household growth in every year since following the Great Recession. 12.3 million U.S. households were formed from January 2012 to June 2021, but just 7 million new single-family homes were built during that time.

And finally, foreclosures remain low, driven by strong employment and wage growth remain. We have not yet seen a meaningful spike in delinquency rates in the mortgage space — as of Q3 2022, only 0.5% of mortgage balances are 90+ days past due, which is up slightly vs. 2021 but still very low by historical standards. Whereas the pre-recession origination boom (2003–2006) was spurred by a relaxed credit standards and private (non-GSE) securitizations of mortgages, origination volume during the COVID-period is a byproduct of low interest rates, refinance volume, and demand for single-family housing. Credit standards have remained high throughout the pandemic, despite the spike in origination volume

So while we have yet to experience a meaningful decline in home values, we are experiencing what many analysts describe as a frozen market, leading to a rapid decline in transaction volume across most markets. For instance, mortgage origination volume in Q3 2022 declined 47% from the third quarter of 2021 — the biggest annual drop in 21 years. Institutional investors in the single-family rental space have largely stayed on the sidelines with the expectation that pricing would become more attractive over the next few quarters.

Many participants in the real estate ecosystem are waiting for clarity from the Fed on how the interest rate environment may change in 2023 and where mortgage rates may ultimately settle. Housing is an important component of CPI, and the Fed has a stated goal of driving down housing demand and pricing:

After a housing boom partly driven by pandemic-era FOMO beliefs, cooling market participants’ expectations is key to shifting house prices toward a more sustainable path and avoiding the peril of a disorderly market correction.

We will be watching closely as the Fed attempts to navigate a bit of a tightrope: steering towards a gradual slow down of home prices and rents (a “soft landing”) without triggering a more widespread housing recession.

How will the real estate technology sector respond?

This period of volatility and uncertainty has impacted every consituency in real estate — agents, lenders, investors, service providers and technology companies. Many real estate companies generate revenue on a transactional basis, meaning a softening or frozen housing market has a direct impact on revenue growth expectations. I’ve written previously about the worsening valuation environment for public real estate technology companies such as Opendoor, Zillow and Redfin, which have traded down meaningfully in 2022.

This is certainly a period in which CEOs must make difficult decisions around strategy, team and managing cash flow in order to survive. Ben Horowitz describes this moment well:

In wartime, a company is fending off an imminent existential threat. Such a threat can come from a wide range of sources including competition, dramatic macro economic change, market change, supply chain change, and so forth.
A classic wartime mission was Andy Grove’s drive to get out of the memory business in the mid 1980s due to an irrepressible threat from the Japanese semiconductor companies. In this mission, the competitive threat — which could have bankrupted the company — was so great that Intel had to exit its core business, which employed 80% of its staff.

In real estate tech, startups are quickly adapting to today’s market conditions—for example, implementing austerity measures as a means of extending runway, or refocusing businesses around products that have strong demand in this market environment. A few tactics we’ve observed:

  • Companies are adjusting burn in order to extend runway and defer an external fundraise to 2024, in hopes that market conditions improve over the next 12 months.
  • Startups in the real estate lending space are tightening their credit standards, lowering loan amounts to manage risk, and diversifying sources of capital.
  • In some cases, startups are opting to raise PropCo capital in order to build a more permanent capital base as compared to credit providers who may be pulling out of real estate lending. In this “balance sheet light” model, assets are owned by the PropCo and management fees flow into the OpCo.
  • Management teams must embrace agility in order to develop counter-cyclical products (i.e. HELOC) that appeal to customers even in a high interest rate environment.

The next several months will be quite interesting for these companies: investors will certainly monitor the macroeconomic environment (CPI, rate hikes, geopolitical risk, etc.) and its impact on real estate. More importantly, however, they will track whether leadership teams can successfully steer their companies towards positive cash flow despite choppy market conditions. Over the long term, startups that survive this period will ultimately evolve into more agile organizations that can thrive despite the inherent cyclicality of the real estate sector.

Thomvest Housing Report: What’s Next in the Housing Market & How Will Startups Respond? was originally published in Thomvest Ventures on Medium, where people are continuing the conversation by highlighting and responding to this story.