Investors looking for a repeat performance from homebuilders in 2018 were quickly brought down to the earth after a wave of volatility sunk the market. Now well off its all-time highs, the sector faces a slew of challenges ahead in rising mortgage rates and surging home prices.
That’s a troublesome sign for the economy if real estate takes another leg lower. After all, housing contributes 15% to 18% of GDP across residential investments and consumption spending on housing services, according to the National Association of Home Builders. A pullback here could be the first shot at an otherwise healthy economy and job market.
Homebuilders are often the first sector to signal trouble in the economy. It’s considered a leading indicator of growth since construction requires extensive physical labor and a large supply of materials. Everything from laying the foundation to spackling sheetrock impacts some part of the economy.
The trouble is a potential trade war with China could upend material costs and threaten the profitability of homebuilders. Prices on lumber, copper and other materials needed in a building have already started to climb in response to the rhetoric. Some of those increases are being passed on to buyers. Home prices jumped nearly 6.7% from their peak in July 2006 and inched higher for 70 consecutive months.
There’s no telling when price growth will slow down. More buyers continue to chase a fewer supply of homes, causing even more upward pressure on prices. This comes at a time when mortgage rates are converging to the pivotal 5% threshold. The popular 30-year fixed rate is now right around 4.50%, low by historical standards, but well above the 3% mark buyers were accustomed to in recent years. It means buyers will soon start forking over a little more to acquire a loan. Over time, that extra mortgage payment and larger down payment may lead buyers to rethink their plans of home ownership.
At this point, the market appears to have baked in some of the downside potential. Leading home builders like Lennar (LEN), PulteGroup (PHM) and KB Home (KBH) fell deep into correction territory this year amid concerns about future growth. Even extensions of the sector in Home Depot (HD) and Lowe’s (LOW) tumbled over 10% year to date despite posting strong fourth quarter results.
Many view the new tax bill, which cuts state and local deductions, and ongoing rate hikes as catalysts for these significant drawdowns. It plays into the idea that higher prices and lower tax breaks could eventually stunt home sales and hurt builder’s bottom lines.
Yet some aspects of the housing sector still look encouraging. PulteGroup recently recorded better than expected first quarter numbers with strong forward guidance that indicated there is still room to grow. Meanwhile, home starts and permits both exceeded analyst’s expectations for the month of March. Starts came in at a seasonally adjusted rate of 1.319 million, well above estimates of 1.264 million on the crowdsourced platform Estimize, while permits reached 1.354 million, about 9,000 above forecasts.
The issue here is the relative weakness in single-family units which declined on a month over month basis. It reveals a lot about the current real estate trends. New and existing buyers are swooping up apartments in large city high rises over houses with a driveway and back yard, while homebuilders continue to focus on high-end markets in urban areas and neglect large parts of rural America. The culmination of these issues creates a scenario that could drag down homebuilders.
So as prices rise, mortgage rates move higher and investor confidence remains fragile, the housing sector may soon find themselves building new floors than ceilings.