For the past few months, existing home sales levels have been
weaker than expected. The focus, however, should not be on the
weakness of the headline numbers. In actuality, the softening in
existing home sales is showcasing the potential for acceleration in
new home sales.
The shift in trends should bolster homebuilder profitability and
generate stronger GDP growth. That means companies like NVR Inc. (
), D.R. Horton (
), Toll Brothers (
), Lennar (
), PulteGroup (
), M.D.C. Holdings (MDC), KB Home (KBH), Ryland Group (RYL),
Standard Pacific (SPF), Hovnanian Enterprises (HOV), and Beazer
Homes USA (BZH) are positioned to outperform the S&P 500.
The key is where the unexpected slowdown in existing home sales
is taking place.
If sales demand was suffering from broad-based demand declines
across the existing home space, then the weak sales numbers would
suggest a downturn in the new home sector would be coming soon as
The weakness, however, is coming from only one area of the
existing home space: distressed properties.
Existing home sales are falling because investor demand has
slowed. Non-investor demand has not wavered and has been showing
Typically, a distressed property sells for about 20% less than a
comparable existing home. The price differential has caused
investors to become a key market group for existing home sales.
Investor influence on the housing market, however, is beginning to
Over the last several months, the increase in demand for
distressed properties has led to shortages of desirable distressed
Consequently, sales of distressed properties as a percentage of
total home sales have diminished greatly since January and are not
expected to recover unless foreclosure rates suddenly worsen and
There is no reason to suspect a sudden acceleration in the
number of available distressed properties anytime soon.
Foreclosure rates have declined precipitously since 2006. That
decline has essentially choked off the incoming supply of
As a result, the number of shadow inventories - homes that are
currently severely delinquent, in foreclosure, or held as real
estate owned (REO) by mortgage servicers but not currently listed
on the multiple listing services ((MLS)) - peaked in 2009 and have
fallen at a fairly steady -10% y/y pace each month since early
Absent another recession, a pullback in investor sales will
likely drag on the overall home sales recovery. Non-investors, who
are likely to purchase non-distressed properties, will have to
provide the bulk of demand growth in order to keep home sales
levels moving higher.
Non-Investors to the Rescue
Even though the economy is currently growing at a tepid pace,
conditions are thankfully still ripe for non-investor demand to
strengthen in the near term.
Household formation rates have returned to normal following an
almost two-year collapse. The recent recovery, however, still
leaves a sizable backlog of households that have not formed, but
would have if the recession had not taken place. In other words,
there is a tremendous amount of pent-up housing demand that should
keep sales demand moving steadily higher.
Furthermore, all-time low mortgage rates and depressed housing
prices have driven home affordability levels to their highest point
since data started being collected in the early 1990s.
The conditions that helped elevate home affordability levels,
along with strong pent-up demand, have caused sales of
non-distressed home to grow more than 10% year-over-year.
As long as the economy continues to expand - which we expect -
non-distressed home sales growth should remain solidly
Homebuilders to Reap the Benefits
Distressed properties tend to sell at about a 20% discount to
comparable existing homes. Prior to the housing crash, new home
prices were at a 10% premium to existing home prices.
As the housing market crashed, the massive influx of distressed
properties caused existing home prices to plunge. New home prices,
however, remained elevated as sunk costs prevented homebuilders
from immediately dropping prices. The premium to buy a new home
widened to more than 40% in early 2012.
The extended markup - which was well above normal economic
conditions - led to depressed sales conditions and eventually an
exodus of buyers from the new home space to the existing home
Now that inventories of distressed properties have fallen, their
negative effect on overall existing home prices has lessened.
Essentially, the combination of stronger demand for existing homes
and low distressed sales should translate into upward trending home
Higher existing home prices will eventually shrink the new home
premium back to its pre-crisis levels and pull buyers from the
existing home sector back into the new home sector.
The premium for prices on new homes appears to be on the verge
of becoming more attractive in relation to existing homes, which
should be enough to push new home sales higher.
Stable Construction Growth Is Finally Here to
With demand for new homes expected to increase, homebuilders
will need to change their inventory management activities.
Inventories of new homes available for sale are at their lowest
level in the nearly 40 years that data have been available.
Even with the extraordinarily high new home price premium, the
number of months of supply of available new homes has returned to
its pre-housing crash norm.
Any increase in new home sales from the current level will
require construction growth or new home inventories to fall further
below normal market levels. That means builders have an incentive
to break ground on new homes or run the risk that low inventories
will turn off potential homebuyers and drive them to the existing
For the first time since 2006, the number of homes currently
under construction has increased on a year-to-year basis. That
means sales at large home improvement stores, such as Home Depot
(HD) and Lowe's (LOW), should benefit over the next several
quarters from increased demand from smaller private construction
Furthermore, the pickup in construction was not limited to just
one area. All four census regions saw year-over-year growth. The
growth in homebuilding is happening across the entire country.
With demand expectations on the rise, the homebuilding sector
should continue to expand on a stable, upward trend for the
foreseeable future. As a result, the residential construction
sector will likely be a leading contributor toward GDP growth over
the next several quarters.
Sales in 2011 were buoyed by strong demand from investors for
distressed properties. Available inventories of distressed
properties have fallen in recent months, however, and investor
demand has softened as a result.
The underlying trends - high affordability levels combined with
a glut of pent-up demand - point toward a rise in non-investor
sales that should be more than enough to offset the decline in
The shift from investor to non-investor sales growth is expected
to be a boon for homebuilders.
As homebuyers buy more non-distressed properties, the prices for
existing homes will rise. In turn, the premium that is currently
needed to buy a new home will shrink. Essentially, new homes will
become more competitively priced in the coming months, which will
lead to more new home sales.
New home inventory levels are at their all-time historic lows.
Any increase in demand in the new home sector will require
additional construction or homebuilders will risk not having enough
inventories to support sales.
We expect builders will satiate the increase in demand by
beginning new construction and actively adding to their
inventories. As a result, the residential construction sector will
likely be a leader for GDP growth over the next several
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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