Growing demand and the spring selling season are no doubt building homebuilders' hopes. Yet supply shortage, burdensome mortgage underwriting standards, cutthroat competition and cost inflation amid moderating home price increases could hold back the recovery this year.
It would be prudent to take a closer look at these dampeners before investing in this space. Below, we discuss the impact that these can have on the sector in the coming months and years.
Increasing Competition & Incentives
Many homebuilders are increasing the incentives to drive volumes as the competitive environment heats up. Higher incentives and cost inflation amid moderating price increases are hurting homebuilders' margins. Most homebuilders expect increased cost and pricing pressure in 2015 to be major headwinds to the housing industry.
Several years of production deficits during the housing downturn resulted in a limited supply of both rental and new homes in the country. At present, a shortage of buildable lots, skilled labor and available capital for smaller builders are limiting home production, thereby lowering the inventory of homes, both new and existing.
New homes inventory for sale was 210,000 units at the end of February. This is just 4.7-month of new home supply, down from the January levels and also the lowest level since June 2013. The supply of existing homes is also tight, with an available supply of just 4.6 months. Analysts expect prices to flare up if the supply picture does not improve.
Rising Labor, Land and Material Costs
Rising building materials and labor costs are threatening margins as they limit homebuilders' pricing power. Both labor and construction material costs are rising proportionally with increasing housing starts, and there could be significant inflation going forward. This could eat into homebuilders' margins considering that home price increases are moderating.
Rising construction, labor and material costs have hurt gross margins of many homebuilders like Lennar Corporation ( LEN ), KB Home ( KBH ) and D.R. Horton, Inc. ( DHI ) in the past couple of quarters.
Slowing Economy in Oil States
Low oil prices can affect consumer confidence and eventually slow down the economy, and thereby home demand in energy driven states like Texas. Lennar witnessed slower order growth in the Houston region -- mainly across higher price points -- in the past quarter, hinting at a slowdown in Houston's economy.
However, it is noteworthy that other homebuilders like PulteGroup, Inc. ( PHM ) and D.R. Horton neither witnessed a drop in demand nor did they lower home prices in Texas/Houston. Nevertheless, another homebuilder, Meritage Homes Corporation ( MTH ), is "being very cautious" and not securing new land positions in Houston, even though it did not witness any demand slowdown in the region in the fourth quarter. We cannot however rule out a decline in home demand and prices in the Houston/Texas region in the future quarters.
Federal Government Actions
The federal government's actions related to economic stimulus, taxation and borrowing limits could affect consumer confidence and spending levels which, in turn, could hurt both the economy and the housing market.
There is a high probability of a rise in short-term interest rates later in 2015, considering the fact that the Fed ended its six-year-long quantitative easing program in Oct 2014. A short-term fund rate hike would increase mortgage interest rates. High mortgage rates dilute the demand for new homes as mortgage loans become expensive. This lowers buyers' purchasing power and hurts volumes, revenues and profits of homebuilders.
As you can see there is a long way to go for these homebuilders even though the economy paints a picture of recovery. But what about investing in the space right now -- will the opportunities outweigh the risks to lure in the short-term investors?
Check out our latest Housing Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.