The residential real estate market has held up well year to date. While many real estate stocks have fallen as much as 60%, average home prices have remained solid — so far. But the question is: How long will they hold up?
Prior to recent moves by the Federal Reserve to raise interest rates and tame inflation, housing inventory stats showed that there were far more buyers than sellers in the market. Let’s take a look at how that equation has flipped, starting with interest rates.
Interest rate woes
Mortgage rates were under 3% for most of 2021 and stayed below 4% until the Fed increased the federal funds rate. Mortgage rates responded to that move by reaching a national average as high as 5.80%. The 30-year mortgage payment on $500,000 mortgage is $2,437 with a 3% interest rate and $3,262 with a 5.8% interest rate.
Assuming a 36% debt-to-income ratio, that change in mortgage payment would require $27,500 in additional annual income to qualify. Unsurprisingly, home sales started dropping off.
Faced with budget constraints, U.S. homebuyers stopped buying houses. However, sales prices remained steady, as seen in the chart. There could be many reasons for this. My guess is that many sellers had sale price FOMO and chose to either wait longer to sell or simply take their home off the market. The consequence is that new homes for sale started to drop, relatively speaking.
Meanwhile, construction costs rise
New home sales have certainly gone down, and prices may be on the way there, but that isn’t the only problem for homebuilders. Construction materials prices are going straight up with inflation, as seen in the chart.
Residential construction input prices are up 17.7% over the last year and 34% since the start of 2021. Supply chain problems, rising gas prices, and big jumps in demand all contributed to the rising prices.
And remember, this chart represents materials only. Labor prices and lead times are up as well. For example, at the construction company where I work, we were recently told that materials for fiber installation have a year-long lead time. Most suppliers only hold prices for a week — if that.
Homebuilders feeling the pain
It all adds up to a bad time for homebuilders. Traditionally, the homebuilder will estimate the price to build a house, slap on gross margin and overhead costs, and sell it for at least that price. That works fine when prices are consistent. What do they do when suppliers won’t hold their prices for the six to 12 months it takes to build a house? What do they do when subcontractors will go bankrupt if they stick to their contract price? And what about when none of their spec homes are selling?
The market is well aware of the problems, and homebuilders have taken a huge hit this year. Take a look at the year-to-date performance of the S&P Homebuilders Select Industry Index.
At one point, the index was down 39% YTD. Many homebuilders trade for single-digit price/earnings ratios, and that may not really be cheap. The industry has staged a mini-comeback — it is up 16.5% since the low in June, but the outside forces that drove prices down in the first place are still lingering.
Homebuilders are between a rock and a hard place right now. If the Fed keeps raising interest rates to fight inflation, it could suck up much of the remaining demand in the market, leaving builders with empty backlogs and unsold inventory. If the Fed pauses rate hikes, material inflation could kill the business just as fast.
So what’s next for investors?
At this point, I think investors need to be very picky about which homebuilders they have in their portfolio. Look for builders with a strong balance sheet that sell niche homes, which could help them dodge the factors we talked about here.