Introduction

The junior portion of the CLO capital structure has seen solid performance so far in 2023. Over the course of the past several months, Pretium has highlighted this outperformance and made the argument that CLO mezzanine securities were undervalued relative to HY single-name credit, supporting this latter point by comparing the currently wide CLO BB spreads to the historical spread relationship the two asset classes have traditionally maintained. Given the uncertainty surrounding where the economy and the Federal Reserve may go from here, we have received inquiry from our investor base as to whether or not we view this outperformance as sustainable. In summary, we believe it is. Pretium believes that current CLO mezzanine and equity pricing reflects worst-case assumptions related to forward defaults and recoveries. While Pretium expects loan default rates to rise and recovery rates to remain depressed, we believe that current CLO spread and yield levels more than compensate for the fundamental strain that credit markets have already begun to realize and are likely to continue to experience over the coming quarters (Exhibit 1 below).

CLO BBs and CLO equity provided +8.6% and +7.6%, respectively, in (non-annualized) total returns over the first six months of the year vs. just +4.8% for HY corporate bonds1. Pretium believes this strong YTD performance for CLO instruments is sustainable across a variety of possible forward market outcomes. The market environment in the first half of 2023 reflected only muted spread changes and close to flat point-to-point long-term interest rate moves. Thus, the strong 23H1 CLO results for that period reflect what we see as only slightly above average expected returns for a sector which entered the year offering particularly generous spreads and yields.

BB CLOs began 2023 with average yields of approximately 14%, reflecting SOFR margins at the time of over 900 basis points2. The strong total return for BB CLOs over the first half of 2023 largely reflected interest carry, as opposed to mark-to-market price gains which might have been harder to replicate in the future. By contrast, BB corporate bonds have yields-to-maturity of just 7%, with correspondingly smaller scope for carry returns (Exhibits 2-3 below).

To assess the sustainability of CLO outperformance going forward in greater detail, we review expected returns for CLOs across a range of possible future interest rate and macro-economic scenarios. Our analysis suggests that mezzanine CLOs should outperform generic HY corporate bonds over a short-term (e.g., 1-year) horizon across most scenarios, with an even higher probability of outperformance over a hold-to-maturity horizon. Long-term expected returns for CLO BBs remain elevated under adverse scenarios at current pricing levels due to the fact that the investments benefit from significant structural protections which allow for full principal repayment under all but the most extreme default and recovery rate assumptions (Exhibit 4 below).

While CLO BBs can provide long-horizon downside protection in deep recession scenarios, CLO equity can complement the profile of CLO debt by offering a return distribution with significant upside potential in scenarios involving only mild recession or recovery. Combined, a portfolio which incorporates both CLO equity and CLO debt securities produces a highly attractive distribution of returns across a range of potential future economic outcomes.

Interest Rate Scenarios and Their Impacts on CLO Returns

The scenarios we include in our analysis are:

• 1. Follow Forwards (high probability). Current interest rate curve plays out in line with current forwards, inflation continues to move down from current spot levels but remains above 2% target, unemployment ticks up modestly and corporate earnings stay flat or see a muted pullback: a soft landing scenario in which credit will outperform vs. current pricing and realized defaults are slightly below the market baseline forecast.
• 2. Higher for Longer (high probability). Interest rates stay higher for longer, remaining close to current spot levels, inflation comes down slightly but remains elevated, unemployment ticks up and corporate earnings stay flat or see a muted pullback: a soft landing scenario in which credit will marginally outperform vs. current pricing and defaults are in-line with the market baseline forecast.
• 3. Stubborn Inflation (low probability). The Federal Reserve hikes rates over the next twelve months in response to stubborn inflation and strong corporate earnings, inflation remains unchanged vs.current spot levels and unemployment remains low: a short term bullish market for credit with default rates lower than forecast due to strong corporate earnings.
• 4. Hard Landing (low probability). Material economic weakness emerges in the second half of 2023, inflation trails lower towards target and unemployment becomes elevated: a hard landing scenario for the economy and credit with short term and long term default rates above baseline forecasts and pulled forward.

Further detailed assumptions regarding these scenarios, including the assumed unemployment rate, inflation rate and short and longer term interest rates, are provided in Appendix A.

The calculations of expected CLO and corporate bond returns under the alternative scenarios incorporate both projected coupon income (e.g., with lower income for floating rate CLO instruments in falling rate scenarios) combined with, over the short horizon, expected mark-to-market price changes, and, over the longer term, potential realized credit losses.

Short-Term Outlook

Exhibit 5 below shows the estimated scenario returns over a one-year horizon holding period. In scenarios 1 to 3 the returns for BB CLOs are projected to significantly exceed those for BB corporate bonds. This outperformance is driven by higher coupon income for CLOs. In effect, the projected outperformance of CLOs in these scenarios mirrors the recent historical outperformance of CLOs vs. HY bonds, which has also been largely driven by superior carry for the CLOs.

For scenario 4, a Hard Landing, CLO BBs are projected to deliver lower returns than fixed rate HY bonds. This modeled underperformance is a consequence of an expected decline in CLO floating rate coupons as the Federal Reserve cuts interest rates in response to an economic contraction, combined with an assumption that generic fixed rate bond spreads widen less sharply than CLO BB spreads into the contraction.

The short-term CLO equity performance estimates shown in Exhibit 5 are calculated from the cash-on-cash equity yields expected in these scenarios combined with expected instrument price changes; the price change estimates, in turn are estimated based on the historical relationships between CLO equity and HY bond prices across different market environments. In scenarios 1 to 3, CLO equity is projected to significantly outperform BB corporate bonds as high current carry is offset by only marginal changes in cash flow discount yields. Near-term changes to discount rates remain range-bound as default expectations over the first year are primarily constructed from credits that are already identified as candidates for default as a function of their current trading price. In scenario 4, CLO equity is projected to underperform as the pull-forward of defaults in credits that are currently trading above $90 is likely to result in a downward revision to forward cashflow projections combined with an increase in market yields used to discount the cashflows.

Hold-to-Maturity Outlook

Exhibit 6 shows the expected hold-to-maturity returns for the different asset classes across scenarios. Here, CLO BBs are projected to outperform HY BB bonds across all the scenarios, including the Hard Landing. Historically, only a small percentage of BB CLOs have ever experienced principal losses, including during the global financial crisis period, due largely to the structural protections from which the bonds benefit3. Accordingly, we project no CLO BB losses under the four scenarios considered. Generic HY corporate bonds lack these structural protections and hence, are projected to experience small but non-zero performance drags due to defaults, which are modeled here as ranging from a 0.1% annualized yield degradation in the more benign scenarios to a 0.3% yield impairment in the Hard Landing scenario. Most of the projected BB CLO vs. BB corporate bond outperformance though, comes not from differences in credit loss assumptions but rather, from the substantially wider spreads CLO BBs currently contain, which helps generate much stronger carry income over the lives of the respective bonds.

While CLO debt is seen in Exhibit 6 to provide high prospective yields and significant long-horizon downside protection, CLO equity offers a return distribution with significant upside potential in scenarios involving milder recession or recovery. For example, in the Follow Forwards scenario, CLO equity would be expected to deliver a 17% annualized return. Combined, a portfolio incorporating CLO equity and CLO BB securities can produce a risk-return profile superior to those available in public equity or single-name HY credit markets.

The hold-to-maturity CLO equity performance estimates in Exhibit 6 are based on IRR calculations which project CLO equity cash flows under the alternative scenarios. The modeled CLO equity held-to-maturity return is lowest in the Hard Landing scenario, in which loan default rates are assumed to be relatively elevated and CLO equity cash flows are consequently reduced. Lower interest rates in this scenario also put downward pressure on CLO equity cash flows in this adverse scenario. Even in the Hard Landing scenario however, we project a portfolio of CLO equity securities to ultimately deliver low double-digit IRRs given the currently favorable pricing of these instruments

Summary

Our analyses suggest that the strong total returns delivered by CLO mezzanine debt and equity securities in the first half of 2023 are sustainable going forward given current pricing. An analysis of the projected returns for CLOs vs. fixed rate HY corporate bonds suggests that CLOs should outperform over a 1-year horizon across most economic scenarios, with outperformance even more probable over longer holding periods. Pretium believes the attractive relative value provided by a portfolio of CLO equity and CLO BBs clearly indicates that CLOs should be an integral component for every allocator looking to optimize their corporate credit exposure in this environment.

Appendix A — Economic scenario assumptions

Mezz opportunities

Pretium structured credit and CLO liabilities MD Ian Wolkoff and Director Marty Young argue that mezzanine CLO bonds should be on the radar screens of most asset allocators with long investment horizons

US CLO mezzanine debt offers high expected return rates, with yields maintained under a default scenario more extreme than the GFC credit cycle and with upside potential in a market recovery scenario.

CLO debt offers strong long-run expected returns with bounded downside

In the current market context, macro uncertainty and the potential for a growth downturn loom large while valuations across many sectors still screen as relatively expensive. Given this set-up, asset allocators are searching even more actively than usual for investment opportunities which offer high potential yields but with contained downside protection in bearish scenarios. CLO mezzanine debt is a sector which appears to offer this combination.

The US CLO market has grown to over US$950bn in outstanding balance, with over US$160bn of balance in mezzanine (single-A through single-B) tranches. As a result, a CLO mezzanine debt strategy addresses a market large enough to allow investors to allocate selectively while still targeting high yields with contained risks.

Yields on CLO mezzanine debt securities have moved up sharply over the past two years; double-B CLO bonds purchased in the secondary market offer average lifetime quoted yields of 14.4% as of June 2023 versus 7.7% in mid-2021. The current baseline yields for double-B CLOs compare quite favourably to the yields available from other similarly rated fixed income assets: double-B leveraged loans and double-B corporate bonds, for example, currently yield just 7.6% and 7.2% respectively.

The extra yield earned by double-B CLOs versus double-B corporate bonds does not appear to reflect added default risk as the comparison holds debt ratings constant; indeed, during the 2008 financial crisis episode, CLO bonds had significantly lower default rates than similarly rated corporate bonds. CLO transactions are designed so that the bond classes can withstand elevated default rates on the underlying loan portfolios without taking principal losses; the double-B CLO bonds benefit from multiple structural protections, including overcollateralisation and excess spread that absorb losses before they can be passed to the double-B bonds.

A price-yield analysis of a double-B tranche from a sample 2021 vintage CLO transaction indicates that the double-B bond yield remains in double-digits under a scenario in which 28% of the underlying loan assets default over the next five years with a 60% recovery rate – a default intensity over 1.6 times the five-year cumulative default rate experienced following the global financial crisis. Indeed, the double-B tranche yield remains positive, even if the assumed five year cumulative loan default rate rises to 35%, more than 2x the level seen during 2007-2013. CLO double-B bond yields remain positive in this high default rate scenario, despite the fact that much of the bond principal would be projected to be written down in such an event, as the high projected coupon payments over the lifetime of the bond would compensate for the principal loss.

CLO debt offers upside potential in a market recovery scenario

Per above, double-B CLOs can offer around 14% yields under a moderate recession baseline scenario. The bonds can maintain these double-digit yields in a loss scenario comparable to that experienced during the global financial crisis and can continue to earn positive yields in scenarios significantly more extreme than in 2008. Thus, the long-run downside risk for the majority of bonds in the double-B CLO sector, while not zero, appears bounded.

At the same time, the bonds provide meaningful potential return upside in a scenario in which double-B CLO spreads partially normalise relative to their current wide levels. Double-B CLO spreads are currently trading 250bp above the level that would be predicted, given their historical relationship to high yield corporate bond spreads. If 60% of this pricing anomaly were to be slowly corrected over a two-year period, the double-B CLO horizon yields would be expected to reach around 18%, with 14% of the yield coming from coupon income and 4% from price appreciation.

Summary

Mezzanine CLO yields are currently elevated relative to the yields available on comparably rated corporate bonds. While CLO bonds may experience short-term mark-to-market price volatility, over a longer-term horizon, yields would be expected to remain in double-digits across a wide range of loss scenarios – including scenarios featuring default rates more extreme than those that were realised during the challenging 2007-2013 period.

At the same time, mezzanine CLO bonds offer realistic chances of return upside if bond spreads partially revert back to more historically typical levels. Given this favourable risk/return profile for mezzanine CLO debt, Pretium believes the sector should be on the radar screens of most asset allocators with long investment horizons.

Based on Pretium’s research, data and estimates from publicly available sources. Statements throughout these materials, including those regarding the market, represent the opinions and beliefs of Pretium. There can be no assurance that these will materialise.

This article was published in Structured Credit Investor on 28 June 2023.

Rehabitation and remodeling are important tools in addressing the U.S. housing undersupply problem

A recent Harvard study notes that across the U.S., 49% of owner-occupied housing was built before 1980; in certain geographic areas – including Boston, New York and Los Angeles – two-thirds or more of the owner-occupied homes were built before 1980.¹ The aging of the U.S. housing stock is a consequence of the sharp slowdown in new home construction that began in 2007 and that has extended through 2023, per Exhibits 1-2 below.

The continued aging and deterioration of the U.S. housing stock points to a large market of homes in need of rehabilitation. The 2023 Harvard study notes that recent improvement spending has focused not just on cosmetic enhancements but has also been directed at core replacements of basic housing components including roofing and HVAC systems which have extended beyond their functional lifetimes.¹ Pretium and our affiliated lending partner Anchor Loans believe that modernization and rehabilitation of the already existing U.S. housing stock will play an important role in addressing the general problem of housing undersupply across the country. Further, it is likely that the extensive amount of modernization required for many homes will be difficult for typical homeowners to manage and finance; rather, such extensive rehabilitation will often be most conveniently executed by professional developers who purchase homes for sale, bring them up to modern standards, and then subsequently resell the homes once the improvements are complete.

Post-pandemic shifts in living patterns provide additional positive impulse for home improvement

Post-pandemic changes in patterns of housing activity are another force that is likely to put upward pressure on the demand for home improvements. Measures of U.S. office space occupancy remain at below 50% of pre-COVID levels, now three years after the initial pandemic shock (Exhibit 3), suggesting that the move towards work-from-home has become structural. Exhibit 4 relatedly shows a large increase in inflation-adjusted consumer spending on categories such as exercise equipment and furniture since the start of the pandemic. With the growing amount of both work and leisure activity taking place at home, homeowners will demand newer and better housing features that can support these pursuits. Again, it is likely that the extensive home remodeling needed to bring housing quality and size up to the level that can facilitate increased home-centered living activity will often be most efficiently executed by professionals with access to scale economies and efficient and stable financing vehicles.

Demographic trends are supportive of housing rehabilitation

Not only is the U.S. housing stock aging, the population of U.S. homeowners and homebuyers is aging as well. The National Association of Realtors has noted that over 40% of all the 2022 U.S. home purchases were made by homebuyers from the so-called baby-boomer or silent generation cohorts⁶; per Exhibit 5, the share of homes purchased by older homebuyers has trended higher over the past two decades. An older homebuying population will likely be supportive of housing rehabilitation activity: the Harvard home improvement study notes that older homeowners will tend, for example, to value homes modified for improved accessibility and safety. Older homebuyers also have relatively high levels of average net wealth, per Exhibit 6 below, to help facilitate the purchase of improved homes.

The aging of the U.S. housing stock, combined with post-pandemic shifts in lifestyles that benefit from expanded and modernized single-family housing, and demographic trends leading towards an elevated share of older homebuyers, are strong tailwinds for the housing rehabilitation industry. Pretium and Anchor Loans remain constructive on the long-term outlook for the professional home improvement sector and look forward to playing a role in the ongoing process of rehabilitation of the U.S. housing supply.

This is not an offer, advertisement, or solicitation for interests in any Pretium managed vehicle and should not be construed or relied upon as investment advice or as predictive of future market or investment performance. Past performance is not indicative of future results.

CLO debt offers strong average returns due to persistent complexity and liquidity premiums

CLO debt securities have historically delivered strong positive returns across a wide range of economic environments: Exhibit 1, below, shows that BB-rated CLO bonds have outperformed leveraged loans and high yield corporate bonds over the past 3-year, 5-year, 7-year and 9-year horizons. Pretium believes CLO debt has the potential to continue to outperform other assets with comparable ratings profiles: Exhibit 2, for example, shows that BB CLOs currently offer average yields of 13.7%, 6.5% above the yields available on similarly rated corporate bonds. Exhibits 1 and 2 represent the average opportunity accessible through the CLO market – that is, by passively allocating to the entire universe of outstanding BB CLO debt instruments, an investor can earn high average returns relative to the returns available from competing asset classes due to the persistent presence of a CLO complexity premium.

CLO debt offers significant alpha opportunities

In addition to the opportunity for earning strong average index-level returns, the CLO market also features a meaningful amount of return dispersion across different CLO transactions; as a result, there is potential for earning additional alpha returns through judicious active selection of specific CLO bonds. Exhibit 3, for example, shows the annualized total unlevered returns of the underlying loan portfolios for the population of CLOs issued between 2013 and 2022: for a typical quarterly vintage of CLO transactions (e.g., those issued in 2019Q2), the range of loan portfolio returns exceeds 200bp. Given the degree of natural leverage embedded within CLO transaction structures, this amount of return dispersion across loan portfolios translates into an even larger amount of dispersion in returns for junior CLO debt and equity tranches, providing an alpha-rich environment for active CLO investors.

Exhibit 3 highlights one potential means by which active CLO bond investors might outperform the index – namely, by identifying specific CLO managers whose loan portfolios consistently manage to deliver high average returns. In this Exhibit, the loan portfolio returns delivered by one particular CLO manager, here labeled as “Manager X”, are seen to frequently come in near the high ends of the ranges of returns of CLOs issued in nearby time periods. CLO bond investors with tools for and expertise in monitoring CLO manager performance may thus be able to generate alpha by over-allocating to CLO bonds issue by such high-performing managers.

Exhibit 4 shows an alternative sample screen that may be used to actively select CLO bonds with high return potential. The chart in this Exhibit compares the yields on BB CLO bonds traded in the secondary market in the month of February 2023 to a proprietary quantitative measure of risk levels of the bonds. The bond yield and the aggregated risk measure levels are fairly highly correlated, with high risk bonds usually trading at wide spread levels, suggesting the CLO market is roughly efficient. However, there are bonds, such as the ones labeled “Bond Y” and “Bond Z” in the chart, which appear to have high yields relative to the measured amount of risk. CLO investors aided by tools that can similarly help identify bonds with high risk-adjusted yields thus have the potential to generate positive alpha and deliver returns above those earned by the broad CLO index.

The CLO asset class has grown significantly over the past two decades, in large part because of the consistently strong performance of the sector through a wide range of economic scenarios including the global financial crisis episode. The CLO sector offers strong index-level return potential given the high average yields available across the sector’s bonds; there are also meaningful opportunities for earning alpha, or extra returns above the average CLO index, via active management. The potential for earning high returns from CLOs in the current environment suggests that many investors who allocate to sectors such as high yield corporate bonds could benefit from investing as well in CLO debt.

Confidentiality and Other Important Disclosures

This confidential presentation was prepared exclusively by Pretium for the benefit and internal use of the party to whom it is directly addressed and delivered (the “Recipient”). None of the materials, nor any content, may be altered in any way, transmitted to, copied, reproduced or distributed in any format in whole or in part to any other party without the prior express written consent of Pretium. As used in this presentation, “Pretium” refers to Pretium Partners, LLC and/or its affiliates.

Pretium’s Credit investment strategies are focused on corporate credit, structured products collateralized by corporate credit, distressed debt and equity and legal opportunities financing. The team invests in broadly syndicated loans, debt and equity of public and private companies, as well as securities issued by CLOs. Investments in high yield securities are subject to greater risk of loss of principal and interest than higher-rated securities and are generally considered to be predominantly speculative with respect to the issuer’s capacity to pay interest and repay principal. Investments in distressed situations expose the investor to the difficulty in obtaining information as to the issuer’s true condition; legal risk, including laws relating to fraudulent conveyances, voidable preferences, lender liability, and bankruptcy; litigation risk; and liquidity risk. In addition, accounts will not be diversified among a wide range of types of securities, industry, markets, or countries. Litigation finance depends on whether the cases in which the fund invests will be successful, will pay the targeted returns and will pay those returns in the anticipated time. Assessing the values, strengths and weaknesses of a case is complex and the outcome is not certain. Should cases, claims, defenses or disputes in which the fund invests prove to be unsuccessful or produce returns below those expected, the performance of the fund could be materially adversely affected. Furthermore, laws and professional regulations in litigation funding can be complex and uncertain and details of certain cases are unlikely to be disclosed because of confidentiality and other restrictions.

There can be no assurance that Pretium’s objectives will be achieved, that any risk management will adequately protect against downside losses, or that an investor will receive any return on its investment. An investment should only be considered by persons who can afford a loss of their entire investment. Past activities of investment entities sponsored by Pretium provide no assurance of future results. Past or targeted performance is not a guarantee, projection or prediction and is not necessarily indicative of future results.

These materials do not constitute, or form part of, any offer to sell or issue interests in an investment vehicle or any other entity. Any such offer or solicitation will be made solely by means of a definitive offering document, which will describe the actual terms of any securities offered and will contain material information regarding the securities. Any information contained herein will be superseded by information delivered to Recipient as part of an offering document. No representation, warranty or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained herein.

Past performance is not necessarily indicative of future results and there can be no assurance that targeted returns will be achieved. There can be no assurance that Pretium will achieve results comparable to or that the returns generated will equal or exceed those of other investment activities of Pretium or that Pretium will be able to implement its investment strategy or achieve its investment objectives. Pretium does not make any representation or warranty, express or implied, regarding future performance.

Certain information contained in these materials constitute “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “seek,” “expect,” “anticipate,” “project,” “estimate,” intend,” continue,” “target,” “plan,” “believe,” the negatives thereof, other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results of the actual performance of an investment vehicle or strategy may differ materially from those reflected or contemplated in such forward-looking statements.

Certain information contained in this presentation has been obtained from published and non-published sources prepared by third parties, which, in certain cases, have not been updated through the date hereof. While such information is believed to be reliable, Pretium has not independently verified such information nor does it assume any responsibility for the accuracy or completeness of such information. Except as otherwise indicated herein, the information, opinions and estimates provided in this presentation are based on matters and information as they exist as of the date these materials have been prepared and not as of any future date and will not be updated or otherwise revised to reflect information that is subsequently discovered or available, or for changes in circumstances occurring after the date hereof.

These materials are intended to assist the Recipient in connection with its due diligence and to assist the Recipient in understanding the strategies that Pretium intends to pursue to seek to maximize portfolio performance. They are not intended as a representation or warranty by Pretium as to the actual composition or performance of any future investments that would be made by Pretium. Assumptions necessarily are speculative in nature. It is likely that some or all of the assumptions underlying the potential investments will not materialize or will vary significantly from any assumptions made (in some cases, materially so). The Recipient should understand such assumptions and evaluate whether they are appropriate for its purposes.

Recipients should note that COVID-19 has, among other things, significantly diminished global economic production and activity of all kinds and has contributed to both volatility and a decline in all financial markets. The ultimate impact of COVID-19 — and the resulting precipitous and near simultaneous decline in economic and commercial activity across several of the world’s largest economies — on global economic conditions, and on the operations, financial condition and performance of any particular industry or business, is impossible to predict, although ongoing and potential additional materially adverse effects, including a further global or regional economic downturn (including a recession) of indeterminate duration and severity, are possible. The extent of COVID-19’s impact will depend on many factors, including the ultimate duration and scope of the public health emergency and the restrictive countermeasures being undertaken, as well as the effectiveness of other governmental, legislative and financial and monetary policy interventions designed to mitigate the crisis and address its negative externalities, all of which are evolving rapidly and may have unpredictable results. Even if and as the spread of the COVID-19 virus itself is substantially contained, it will be difficult to assess what the longer-term impacts of an extended period of unprecedented economic dislocation and disruption will be on future macro- and micro-economic developments, the health of certain industries and businesses, and commercial and consumer behavior.

During the pandemic, both single-family and multifamily construction climbed in response to strong home purchase and rental demand. The contraction in construction over the past nine months has played out differently, with single-family construction falling sharply while multifamily construction has been much slower to react. As of January, single-family starts have been falling for a year and are already down 35% from their pandemic peak; on the other hand, multifamily starts were still reaching new multidecade highs in November¹. The differing trajectories are partly driven by the inherently greater flexibility of single-family homebuilding where each unit is started independently vs. multifamily projects where all units in a structure are started at once. Also, single-family projects typically have shorter timelines and are less complex compared to multifamily projects². Finally, since 95% of singlefamily homes are built for homeowners, their rate of building is especially sensitive to changes in consumer behavior and mortgage rates; on the other hand, 94% of multifamily units are built for investors who have longer-term time horizons³.

The difference in trajectories of single-family vs. multifamily construction has important implications for the rate at which construction backlogs are likely to be worked down. The number of housing units under construction reached record highs during the pandemic driven by the synchronized surge in home purchase and rental demand. The sharp contraction in single-family construction means that as of January, the pace of single-family completions is 45% higher than the pace of new single-family units being permitted¹. As shown in Exhibit 1, single-family construction backlogs have been falling since mid-2022 and at their current pace of decline will be back at pre-pandemic levels by mid-2024. By contrast, multifamily construction backlogs are still rising since multifamily permits remain 70% higher than multifamily completions. As shown in Exhibit 2, multifamily construction backlogs are approaching their all-time highs of 994,000. Even if multifamily construction backlogs began to decline immediately, Pretium estimates that it could take until mid-2026 for multifamily construction backlogs to return to their pre-pandemic levels.

As described in Pretium’s November 2022 Housing Insights, we believe that supply-demand imbalance will remain a central driver of US housing market dynamics⁴. Elevated construction pipelines aren’t enough to resolve a supply-demand imbalance that measures in the millions⁵; however, they do represent both an investment risk and opportunity as developers work their backlogs down. Over the next 12-18 months, we expect single-family homebuilders to continue to be proactive in working to reduce their construction backlogs, but not in a manner broadly disruptive to single-family home prices. The multifamily outlook is cloudier given the continued momentum of construction and the potentially long period over which it will be resolved.

One of the most important debates about the pandemic’s impact on the housing market is whether the surge in demand that began in mid-2020 is a temporary or structural phenomenon. There are numerous indicators of structural pandemic driven changes in household behavior, including the persistence of work-from-home,¹ increased online shopping,² a greater focus on wellness,³ and elevated business formations.⁴ However, many investors still question whether the pandemic simply pulled forward housing demand, especially since rising rates have obscured underlying trends. Consumer surveys find that households continue to expect the pandemic to have a permanent impact on their housing choices.⁵ Also, recently released data from the Census indicates that the pandemic boost to long distance migration accelerated well into 2022 even as many other aspects of life returned to prepandemic patterns.⁶ The Census data is notable because it is a direct measurement of long-distance migration whereas indirect measurements of migration such as postal change of address forms had indicated that migration slowed during 2022.⁷

As shown in Exhibit 1, interstate migration increased meaningfully in the year ending July 1, 2021 – the first year of the pandemic. If the pandemic’s impact on housing demand was mainly temporary in nature, migration levels should have slowed in the second year of the pandemic as its impact on day-today life waned. Instead, interstate migration increased further in the year ending July 1, 2022 to 1.5x pre-pandemic levels. As shown in Exhibit 2, the increase in migration was a combination of larger outflows from states such as California and New York as well as larger inflows into states such as Florida and Texas. Migration levels are likely to decrease as higher mortgage rates and a slowing economy limit households’ financial ability to move; however, online home search activity indicates that the desire to move to a different metro continued to increase in 2H22.⁸ Pretium believes that migration data demonstrates the likely structural impact of the pandemic on long-term housing demand and that this increased demand should become apparent again as economic and rate pressures ease.