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Homebuilders: MRP Closes Theme on Plunging Housing Affordability

MRP launched LONG US HOUSING as a theme in the Spring of 2012 with our report, The Developing U.S. Housing Shortage. At the time, forecasters were predicting years of further decline for the sector. We, however, saw signs of a bottom forming and recognized several tailwinds that we believed would push home prices and homebuilder stocks higher in the years ahead.

In those 6 years since MRP launched the theme, housing has had a spectacular recovery. But, with stronger headwinds forming on the horizon, we’d like to take this opportunity to review the theme.

The positive factors we noted in our February 2018 report, Beyond the HOUSING HEADWINDS, are still at play. Homebuilder sentiment is near record highs, with the National Association of Home Builders/Wells Fargo Housing Market Index at 70. That’s well above the baseline of 50 necessary for a positive reading, almost triple April 2012’s level of 24, and just shy of the all-time high of 78 reached in December 1998. New home sales are accelerating, even as prices and mortgage rates are rising. In March 2018, sales of new units were up 4% from the previous month, and up 8.8% year-on-year.

Moreover, there continues to be pent-up demand from population growth, replacements, baby boomers forming new households, and millennials – now the largest age cohort in the labor force – who are finally entering the market for the first time, and whose share of housing sales is expected to rise over time. Increased interest from international buyers is another factor.

There is no question that a tsunami of maturing millennials, with improved employment and income prospects is a powerful longer-term force for the U.S. housing market. But supply-side factors risk retarding that potential, at least in the short-to-medium term.

Despite an acceleration of building activity these past 6 years, there is a housing shortage in the United States. The current 5.2 months of supply, though slightly better than the 4.9 months of supply that existed in April 2012, is still more than 40% lower than in ’09 and below the long-term average of 6.1 months.

Unless builders find a way to significantly ramp up production, inventories will remain tight, given today’s rate of sales. NAR data reveals a bifurcated Existing Homes market, where sales are rising for luxury units, but plunging for houses priced $250K and below, due to supply constraints.

Alleviating the shortage may prove to be difficult because rising land, labor, and materials costs have made it more expensive to build a house. It’s become less profitable for homebuilders to build entry-level homes, where supply is tightest, so they continue to mostly focus on supplying the luxury end of the market.

The supply/demand imbalance is such that home prices are increasing twice as fast as income, and affordability is steadily declining. The Housing Affordability Index is nearing its long-term average of 125, having declined from 195 in April 2012 to 150 currently. According to the NAHB priced-out model, for every $1,000 increase in the price of a home, about 152,903 households are priced out of the market for a median-priced new home. And, with each quarter-point increase in the rate on a 30-year fixed rate mortgage, as many as 1.2 million U.S. households will be priced out of the market for a median-priced new home.

We’re at a point where it’s cheaper to rent than to own. Home prices jumped 7.6% in April from a year earlier to a median of $302,200, and sellers got a record 98.8% of what they asked on average. Furthermore, the average rate for a 30-year fixed rate mortgage jumped to 4.61%, the highest since May 2011. With this jump, the monthly nut for the average family to own a home is $1,540, up from $1,424, at the beginning of the year when the average mortgage rate was 3.95%. In contrast, the U.S. Median Asking Rent is $954.

Bottom line: Rising mortgage rates and soaring home prices, fueled by the persistent supply deficit, are making homeownership less affordable for a large swath of the population. Housing affordability, which has plunged by 6% in the short time since our February viewpoint report, represents the greatest headwind for the housing sector. Trends like California’s decision to mandate solar panels on new homes constructed after 2020, and a rising interest rate environment will only make matters worse. All this is occurring even before the peak of the millennial generation reaches first-time homebuyer age, which should dislocate the market further. Unless income growth begins to catch up, affordability will continue to decline. It is too early to determine whether the administration’s stimulative fiscal policies will boost wage growth fast enough.

Homebuilders should continue to benefit as home prices escalate and construction accelerates towards the 1.5 million annual rate for housing starts. But, we’re nearing saturation in the upper price range of the market. That will force builders to eventually shift toward moderately-priced homes, which will eat at their margins. In anticipation of that, we are closing MRP’s longest running theme, which has had a spectacular run, as reflected by the 165% gain of the Home Construction ETF (ITB) in the six years since our launch. The housing recovery opportunity has been mostly recognized by the market at this point, and oncoming headwinds are bound to create drag on further upside potential.

 

 

MRP also believes the structural issues holding back the market will dissipate at some point. That’s because digitization and 3D printing will eventually revolutionize real estate, and change the way homes are designed, built and produced. Although we are still in the early stages of 3D-printed construction, companies from Russia to China, the U.S. and the Netherlands have already proven that, not only can a home be 3D-printed, it can be done cheaply, efficiently and easily. In time, it would be possible to correct the U.S. supply deficit. But, that’s still a few years away.

 

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