Homebuilders Are in A Sweet Spot

Summary

• The latest housing data shows homebuilders struggling to build houses fast enough – and consequently home prices are soaring.
• Demand comes from people reorganizing their post-pandemic lives, millennials raising young families, and baby boomers retiring. Even with rising prices, housing remains affordable.
• After a decade of underbuilding, the housing stock may be short upward of 1.5mn units. At current building rates and pace of household formation, it could take several years or more to fill that hole.

Market Implications

• Homebuilder equities and related ETFs have had a strong run since March 2020, and much good news is priced in. Nevertheless, given the healthy underlying fundamentals, we believe homebuilders are an overweight.
• XHB and ITB are ETFs that give exposure to homebuilders and related sectors.

The latest housing data was a source of both relief and worry. The relief is because slowing home sales perhaps indicate the US is not headed for another toxic housing boom. And the worry is because soaring home prices will feed into inflation.

Housing is a microcosm of the many imbalances in the economy as it struggles to return to normal, but underlying fundamentals are quite robust. If there are clear winners here, they are probably baby boomers and homebuilders.

Supply Hits Capacity Constraints

On the sales and supply side, existing and new home sales dropped in April, by 3% and 6%, respectively. Housing starts fell a surprising 13.5% (Charts 1 and 2).

The explanations were obvious. Record low inventories have hobbled home sales. And like many other industries, shortages and bottlenecks of key materials have hampered homebuilders.

But we suggest that April’s data represented more a return to normal after the extreme fluctuations of the past year. Inventory issues aside, existing home sales seem to be returning to a rate near 5mn units per year. And new home sales may settle in near 850,000-900,000 houses annually – similar to the rate during the 1990s and early 2000s before the housing boom took off. And housing starts are below levels of that era.

Other long-term data suggest the housing stock may be slightly below historical norms. Before the housing boom of the 2000s started, the occupancy rate of US housing stock was about 88% (Chart 3).^[1] After a few years of go-go building, it dropped to a low of 85.5% just before the GFC and has been gradually recovering since. The pandemic caused some combination of a massive housing shuffle and (probably) difficulties compiling quality data, but now the occupancy is 89%. Housing units per household tells a similar story, going from 1.13 to a high of 1.17, and to 1.12 now. This is probably due to both years of underbuilding and working off excess housing, and ongoing temporary housing arrangements resulting from the pandemic.

Demographics and Low Rates Drive Demand

Whatever the supply fundamentals might suggest, the demand side of the housing market is hot. Plenty of anecdotal evidence exists of bidding wars and people unable to find a house to buy. But the key data point is house prices, which are up a massive 17% over the past year (Chart 4). During the housing boom before the GFC, home prices rose about 9% per year.

But even with that pressure, the National Realtors Association’s housing affordability index is 174, near the high of the past eight years.^[2] A big reason for that is low interest rates (Chart 5). Mortgage rates are still hovering near 3%. Even as the 10-year Treasury rate rose some 70bp since early 2021, mortgage rates only rose 25bp. Consequently, the mortgage rate spread to Treasuries is 120bp, the tightest since the depressed housing market of the early 1990s. A more normal spread is 175-200bp.

Affordability aside, other demographic factors are driving housing demand. The pandemic has caused many people to relocate and reevaluate where and how they live. Millennials are reaching a point in life where they are starting families and want to move out of apartments and into a house. And baby boomers are retiring en masse and looking to change their living arrangements.

The low mortgage rates fuelling housing demand are a direct consequence of quantitative easing and the Fed buying $40bn of mortgage-backed securities a month.^[3]

There is little question in our minds that when the Fed starts its taper, mortgage rates will rise. If the mortgage spread to Treasuries returned to normal levels, a mortgage payment would rise by more than 10% – and that is optimistically assuming the 10-year Treasury rate remains near 1.6%.

Housing Has Room to Run

On balance, housing could continue to be a hot market for some time.

On the supply side, builders are near capacity. They will require time to add the staff and equipment needed to build houses at a significantly higher pace. And room exists to add housing units to meet organic demand, so for now, there is little risk of a housing glut developing. To lower the occupancy rate from 89% to 88%, builders would have to add about 1.5mn housing units to current supply. Given current homebuilding rates roughly align with the annual growth in population and households, it could be several years at least before the housing stock catches up and housing settles into equilibrium.

On the demand side, the NAR Housing Affordability Index suggests that both mortgage rates and house prices also have room to rise before would-be buyers are simply priced out of the market. The pandemic-related factors affecting housing demand will probably subside over the next two or three quarters, but the baby boomer and millennial resettlements will remain for some time. Home price appreciation will slow but could remain elevated for the foreseeable future.

Housing Is a Winner

Homebuilder equities have had an extraordinarily strong run since the lows of March 2020, outperforming the S&P 500 by 20% in 2021 (Chart 6). Housing-related ETFs (XHB and ITB) outperformed by 13%. The 8% price surge in late April and early May 2021 occurred as the 10-year Treasury yield dropped from 1.75% to 1.6% – giving some indication of how the sector may react if rates were to drop further.

But given housing’s underlying fundamentals, we think homebuilders will be able to shrug moderately higher rates.

True, homebuilders have priced in much good news – but so have most sectors. We recommend holding an overweight in homebuilder equities or homebuilder ETFs (see below).

The other winner in this saga may turn out to be baby boomers. Those that sell their houses and downsize will cash in on the housing price rally.

Housing ETFs

The two major housing-related ETFs are XHB and ITB. They are not pure homebuilder plays as they include various housing-related sectors. These include retailers such as Home Depot and Lowes, and companies that make various building materials, furniture, etc. As Chart 6 shows, these track each other and homebuilder equities closely.

1. Housing units may be vacant for various reasons, including second/vacation homes, unoccupied rental units, major repairs, and houses on the market or in a real estate transaction. ↑

2. The Affordability Index measures the ability of a household with the median income to buy a median-priced house. A level of 100 means the median family has 100% of the income required cover a mortgage payment on a median-priced house. Likewise, 174 means median income is 174% of what is needed for a mortgage payment. The index does not cover other required expenses, including down payments and taxes. ↑

3. Under the Fed’s quantitative easing program, it is buying $120bn of Treasuries and mortgage-backed securities a month, with one third allocated to the latter. ↑