Warning! A Housing Market Crash Will Tank These 3 Stocks.

If you feel like housing prices are out of control, you’re not alone.

A Pew Research survey conducted in 2021 found that half of Americans now consider the lack of affordable housing as a “major” problem, up from 39% in 2017. (Only 14% of Americans think it is not a problem at all).

Since then, housing costs have continued to rise. The National Association of Realtors now estimates that home prices will jump another 11% this year, outpacing wage growth by a 2x margin. The average U.S. home could soon be worth 7.5 years of median salary, up from 3.5 years in 1984.

These problems have stemmed from high home prices, rather than stagnant wages. The price-to-rent ratio of the average American home now sits at 21x, almost three times higher than in 1963. Deducting typical expenses and maintenance, residential cap rates now sit below 4% for the first time in modern U.S. history, according to data from Cornerstone Research and CBRE. Cap rates are the expected rate of return on a real estate investment, commonly calculated as its net operating income (NOI) to acquisition price.

High prices and declining demand have sent chills through the homebuilding industry – a bellwether for the U.S. real estate market.

“Many prospective buyers have paused and moved to the sidelines amid higher mortgage rates, along with ongoing inflation and a range of macroeconomic and geopolitical concerns,” warned KB Home (NYSE:KBH) CEO Jeffrey Mezger in a recent earnings call.

The homebuilding firm would post guidance of $2 billion revenue, $350 million lower than Street estimates. Shares of KB Home have now lost 37% year to date.

Real estate analyst Ivy Zelman of Zelman & Associates now predicts a 9% drop in home prices by 2024. A decline to more historic pricing could see a 20% fall or more in real terms, a future I can foresee happening over the next several years.

Fintech’s Real Estate Problem

These concerns, however, have been largely ignored by a new generation of real estate fintech firms. Many of these companies have only come public in the past several years; firms like insurtech Lemonade (NYSE:LMND) have never seen a financial crisis before. Others have only recently expanded into riskier elements of real estate. Much like banks in 2008, these unregulated fintechs could be sitting on time-bombs without ever knowing it.

Nowhere is this clearer than at Rocket Mortgage (NYSE:RKT), an online fintech that eclipsed Wells Fargo (NYSE:WFC) in 2018 as America’s largest mortgage writer.

In 2020, the Detroit-based fintech generated $16 billion in revenues and $9.4 billion in profits from a surge in mortgage refinancing. When a homeowner’s mortgage runs at 5%, he or she might gladly pay $20,000 to a company like Rocket Mortgage to refinance to a 2.5% rate.

Refinancings have turned into a windfall for Rocket Mortgage, which has used proceeds to load up on mortgages and their servicing rights (MSRs). At the end of 2021, RKT held $19 billion of mortgages on its books.

In good times, these strategies boost corporate bottom lines. Rocket Mortgage’s net income in 2021 was seven times higher than in 2018. Servicing fee income generated $1.3 billion in revenues that year.

But when the tide goes back out, it suddenly becomes clear why a bank like Wells Fargo was willing to cede ground so easily.

With demand for mortgage refinancings projected to collapse, analysts now expect Rocket’s net income to fall 98% to $214 million in 2022. Even worse, the $19 billion of mortgages on Rocket’s books could quickly become a powder-keg of bad assets if borrowers begin to default.

In the 2008 financial crisis, high banking leverage meant that the 15% decline in home prices magnified into far greater losses. Lehman Brothers’ 31x debt-to-equity ratio meant that a $2.8 billion loss was enough to trigger its complete downfall. Rocket’s 48x debt-to-equity ratio today means that a 2% decrease in assets is enough to wipe out its entire equity base.

No outsider will ever know for sure whether Rocket Mortgage’s balance sheet is as high-quality as management claims. But given finance’s long history of spectacular leverage and collapses, investors should tread carefully to avoid a repeat of history.

Leverage + Real Estate = Powder Keg

Fintech’s real estate leverage problem extends to iBuyers, companies that buy homes with the goal of flipping them for profit.

In November 2021, Zillow (NASDAQ:Z) announced it was exiting its iBuying business after losing over $1 billion in less than four years. And Redfin (NASDAQ:RDFN) has also backtracked from the business.

These firms failed despite concentrating on more homogenous housing markets like Phoenix. The “lemon” problem would have been even worse had they attempted to make sight-unseen, all-cash offers in Boston or another city with less uniform housing.

Yet, two real estate firms have continued to risk investor money: Opendoor Technologies (NASDAQ:OPEN) and Offerpad Solutions (NYSE:OPAD). Together, these two iBuying firms carry $11.6 billion in assets and $9.0 billion in liabilities, giving an average debt-to-equity ratio of 3.5x.

Ordinarily, investors would not worry about slightly elevated levels of debt. The average debt-to-equity ratio in the S&P 500 typically ranges in the 2.0x – 2.5x range, and blue-chip stocks like Gartner (NYSE:IT) and Amgen (NASDAQ:AMGN) can comfortably manage ratios of 5x or higher. These firms can use strong cash flows to cover interest payments ten times over.

But real estate companies generally require lower leverage because of their lumpier earnings. Today, the median U.S. real estate investment trust carries only 1x leverage, according to data from Thomson Reuters. And only nine of the 167 American-listed REITs have D/E ratios higher than Opendoor and Offerpad Solutions.

Meanwhile, Opendoor has already started warning investors that it could lose as much as $175 million in adjusted EBITDA this quarter. Add in interest and depreciation charges, and the firm could knock out over 15% of its equity value in a single quarter.

And home prices haven’t even fallen far yet.

If home prices fall 20% as the data suggests, Opendoor and Offerpad could quickly fall into a cash crunch. In the worst-case scenario, investors could see both firms go bankrupt within months.

The Dangers of a Rising Tide

The 12-year bull market has created a sense of complacency among younger real estate firms. On Aug. 3, CEO Glenn Sanford of real estate brokerage firm eXp World Holdings (NASDAQ:EXPI) announced record earnings.

“During the second quarter, eXp continued to increase its market share and revenue to record levels, reinforcing that our model was built for all market conditions and that our agent value proposition resonates around the world,” said Mr. Sanford.

Such claims are untested. The real estate brokerage was launched in October 2009, months after the bottom of the financial crisis. And its multi-level-marketing style of splitting commissions with recruiters is untested in bear markets.

I’ve warned investors before about the risks of buying fintechs focused on traditional, cut-throat business.

“Even though LMND has a fancy front-end website, its rear still looks like a P&C shop…

Lemonade will follow a similar all-or-nothing path to profitability. Either the company will become the next Geico (worth $50 billion or more) or it will blow up like so many other P&C insurers before it over mispriced risk.”

Since then, shares of Lemonade have lost 67% of their value.

But even these losses could pale in comparison to what Rocket, Opendoor and Offerpad could face if declining real estate values blow up their balance sheets. Highly leveraged firms are always playing with fire. This time, falling real estate prices could be the spark that turns into an inferno.

Tom Yeung is a market analyst and portfolio manager of the Omnia Portfolio, the highest-tier subscription at InvestorPlace. He is the former editor of Tom Yeung’s Profit & Protection, a free e-letter about investing to profit in good times and protecting gains during the bad.