U.S. Housing Market Due for a Reset: Part Two

September 21, 2023

Source: Bloomberg; Note, a value of 100 means that a family with a median income has exactly enough income to qualify for a mortgage on a median-priced home. A 120 value means a family has 120% of the income necessary to qualify. Source: Bloomberg; Note, a value of 100 means that a family with a median income has exactly enough income to qualify for a mortgage on a median-priced home. A 120 value means a family has 120% of the income necessary to qualify.

In July of 2022, I wrote about homebuilders and the dilemma they faced, given the effects of the rising-rate environment on demand and tight housing supply. I felt that builders would be forced to lower prices or offer incentives in an effort to attract potential buyers, and as a result, homebuilders would struggle to fill orders. Rising mortgage rates and raw material costs would ultimately constrain their top and bottom line growth. I was wrong.

We saw homebuilders continue to increase supply and offer mortgage rate buy-downs and incentives to attract buyers to new homes. While mortgage rates in August hit the highest level since 2000, homebuilders continue to offer rate buy-downs whereby they offer a lower rate upfront to reduce the monthly mortgage payments for the buyer for a set period of time.1 After that time, the mortgage rate resets to the original higher rate. This incentive has helped attract potential buyers to new construction, where buy-downs are typically more common than existing home sales. The incentive has helped buoy performance for the builders during this rising-rate environment.

The S&P 500 Homebuilding Index is among the best performers year-to-date in 2023. The housing market remained surprisingly resilient through the back half of 2022 and into 2023, despite elevated mortgage rates. The psychology changed as buyers anticipated a decline in rates associated with a so-called “soft landing,” and many decided to purchase homes with the intent to refinance at a later date.

However, mortgage rates, which track U.S. Treasuries, climbed again to a recent high in August as the resilient economy will likely prompt further rate hikes before the Federal Reserve (Fed) deems it appropriate to pivot. With persistently higher rates, home prices will remain elevated, putting further stress on the housing market. I think this scenario is part of the reason why homebuilders have fared better than expected. Current homeowners are reluctant to move and take on a much higher mortgage rate, so the supply of existing homes for sale has shrunk. Potential buyers have had to turn to new home construction as a result.

This is reflected in recent affordability measures and mortgage applications, where housing affordability dropped to the lowest level on record, and U.S. mortgage applications nearly fell to a three-decade low.2 The lack of available new and existing housing has kept selling prices and rents near-record-high levels. Furthermore, the typical seasonal slowdown has driven homebuilder sentiment even lower, and shares for the sector have recently underperformed the broader market.3

I still believe the lag effect of higher rates will catch up with builders. As homebuilders turn to incentives and mortgage buy-downs to drive traffic, margins should be pressured, and I think topline growth could stagnate as mortgage rates eventually abate and existing home sales recover. The builders face two dilemmas: 1) the “hard landing” where the economy weakens and housing activity comes to a halt and 2) the Fed decides to pause or cut rates and existing home sales recover as mortgage rates decline. The resilience of the builders over the last 12 months has surprised me, especially given the confluence of the rate environment and supply/demand dynamics.

Key Takeaway:

Throughout 2023, I was surprised by several new home sales readings and the relative strength of homebuilders, but as we enter the seasonal slowdown for the housing market, I still carry the same skepticism as before. Fundamentals for the homebuilders may begin to deteriorate. It also seems they’ve largely been supported by the lack of existing homes and the buyer incentives they’ve offered. New homes have been the best alternative for many potential homebuyers as they face mortgage rates north of 7%. One question remains — how much of an impact will lower rates have on new home sales and, ultimately, the homebuilders?    




1Bloomberg – US Home Purchase Applications Hit Lowest Since 1995 on Rate Rise; 8/23/23

2Realtor.com – July 2023 Rental Report: Rents Fall for the Third Month in a Row; 8/21/23

3Bloomberg – Citi Sees Homebuilding Investors Tuning Out Through Year-End; 9/18/23

Tags: housing market | Mortgage rates | Interest rates | Existing home sales | Federal Reserve

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