Summary
• Homebuilder stocks and the homebuilder ETF XHB are rising again after DR Horton told investors demand for new homes far exceeds their supply.
• Housing formation is outpacing new housing supply, so new housing will be readily absorbed.
• We see little risk of a homebuilder overbuilding mania. The skilled labour supply is insufficient to boost housing supply significantly. As money from the new infrastructure bill flows to new projects, homebuilders will increasingly struggle to keep – let alone add – workers.
• Housing remains surprisingly affordable despite prices rising 18% over the past year. If mortgage rates rise, recent home price appreciation will ease or even reverse, supporting affordability.
Investment Recommendation
• Following our earlier note, we continue to recommend overweighting homebuilders via the XHB ETF and underweighting SPY due to strong underlying fundamentals.
• Homebuilders have previously been a boom-and-bust industry, so XHB may suffer periods of volatility or underperformance. Given current housing fundamentals, we would view these as opportunities to add to positions.
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Summary
- Homebuilder stocks and the homebuilder ETF XHB are rising again after DR Horton told investors demand for new homes far exceeds their supply.
- Housing formation is outpacing new housing supply, so new housing will be readily absorbed.
- We see little risk of a homebuilder overbuilding mania. The skilled labour supply is insufficient to boost housing supply significantly. As money from the new infrastructure bill flows to new projects, homebuilders will increasingly struggle to keep – let alone add – workers.
- Housing remains surprisingly affordable despite prices rising 18% over the past year. If mortgage rates rise, recent home price appreciation will ease or even reverse, supporting affordability.
Investment Recommendation
- Following our earlier note, we continue to recommend overweighting homebuilders via the XHB ETF and underweighting SPY due to strong underlying fundamentals.
- Homebuilders have previously been a boom-and-bust industry, so XHB may suffer periods of volatility or underperformance. Given current housing fundamentals, we would view these as opportunities to add to positions.
In early June, we recommended overweighting homebuilders via the XHB ETF and underweighting the S&P 500 via the SPY ETF. The trade languished through the summer for several reasons, including soaring lumber prices, labour shortages, and ongoing supply chain bottlenecks (Chart 1).
XHB abruptly jumped about 5% in recent days after homebuilder DR Horton (DHI) announced better-than-expected earnings, but softer-than-expected new orders. Management said demand was far stronger than they could satisfy, so they were being cautious about accepting orders until they knew they could fulfil them.
That Is Why We Are Bullish on Homebuilders
DHI’s outlook encapsulates the bullish case for homebuilders over the medium term.
Homebuilders have long been a classic boom-and-bust industry. When times are good, such as before the Global Financial Crisis, homebuilders overbuild. And when the tide turns, the industry takes a heavy hit.
It is always wise to greet with scepticism any claim that this time is different. But we think underlying housing fundamentals mean homebuilders should do well for some time.
A key variable is the inventory of housing stock.
During the housing boom of the 2000s, housing inventory outpaced population and household growth. New home sales swelled from 800,000-900,000 during the latter 1990s to 1.4 million in 2006 (Chart 2). That led to a drop in the occupancy rate of the housing stock, from 89% to 85.4%, or an excess of about 3.4 million housing units. Since then, home construction has been depressed compared with pre-2000 levels, and the occupancy rate gradually recovered.
The pandemic scrambled how people live, with many households either initially maintaining two homes or splitting up, with some members moving to other housing at least temporarily. That caused a temporary surge in households, which largely unwound in autumn 2020. But household formation remains elevated relative to the growth in housing stock (Chart 3). Consequently, people have been moving into previously vacant housing and pushing the occupancy rate to a relatively high 89.3%.
Housing may be vacant for various reasons other than overbuilding: because it is rental property, for sale, in estate proceedings, or for second home/seasonal use. The point is a certain level of vacancies is healthy, reflecting peoples’ lifestyle preferences and ongoing life adjustments.
The dust is still settling on how people will live as the age of Covid passes (and may do so for some time). But relative to the 88-89% of the 1990s, the current occupancy of 89.3% is high. The increment in percentage terms may seem small, but to push the occupancy rate to 89% would require an additional 500,000 housing units; a drop to 88% would require 2.1 million units. With builders adding about 1.1 million housing units annually and maxed out, just returning to 89% could take several years, especially if household formation stays well above 1 million per year.
The Labour Shortage Will Soon Worsen
The supply chain issues will resolve themselves in coming months, but the other constraint on builders – labour –could remain indefinitely.
Residential construction employment surged during 2004-2006, driving the housing boom. After the collapse, it gradually recovered, roughly in line with new home sales (Chart 4). It has risen steadily after the initial pandemic shock in spring 2020 as housing took off, but much of that growth came at the expense of the nonresidential labour market. There is simply too little skilled labour to meet a shortfall in housing quickly, let alone ignite another massive building boom.
With the signing of the $1 trillion Infrastructure Investment and Jobs Act, the nonresidential and infrastructure construction sectors will probably soon be bidding for many of the same workers as homebuilders. If anything, homebuilders will struggle to maintain the current level of building, no matter how strong demand is.
Housing Could Remain Affordable Despite Mortgage Rates at 6%
Also supporting housing and homebuilders is that buying a home remains surprisingly affordable. Although the Case-Shiller Index of home prices exploded by 18% over the past year, the National Association of Realtors’ (NAR) Housing Affordability Index is still about 150, meaning a median-income family has 150% of income to afford a median-priced house. Home prices matter; the NAR index is down from 180 in March 2021. But so far, mortgage rates near 3% trump rising home prices.
If mortgage rates rise – a risk with inflation running near 6% – housing affordability will fall at current prices. But our back-of-the-envelope calculations suggest mortgage rates must rise to 6% to lower the affordability index to 100.
What About Those Financial Buyers?
An influential real estate analyst, Ivy Zelman, recently argued red flags are rising for homebuilding. Her issue is that some of the housing demand is coming from financial investors rather than would-be homeowners and that the economics will not work for them if mortgage rates rise above 4%.
That may be. But while fewer financial buyers may pause the housing sector, it is unlikely to lead to anything like a collapse. One effect could be to ease or even reverse recent home price appreciation, which will offset higher mortgage rates.
A Few (Mild) Caveats
We are confident there is little danger of homebuilders entering an overbuilding mania. And, whatever financial buyers’ role in today’s housing market, even if they depart, the ongoing pace of household formation is more than sufficient to absorb every house that builders can supply.
The risk to our view is that Covid is still distorting the current rate of household formation, and the rate slows to something nearer or even below new housing supply. Even in this scenario, the need to rebuild inventory will give homebuilders some cushion until household formation recovers.
Stay Long XHB
We continue to recommend investors overweight the housing sector by overweighting the XHB ETF and underweighting SPY. We view this as a medium-term trade. Some periods of volatility or underperformance are possible. Given its chequered history, many investors may err on the side of caution if the economy or housing demand weakens or mortgage rates rise sharply. As long as the fundamental backstop persists, we would view these episodes as opportunities to add to positions.
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)