Builders are an important part of any plausible fix for the housing shortage in the United States — not only constructing more homes but also finding ways to improve affordability. That makes the intensifying squeeze on the industry a concern. New home construction and sales have been the one bright spot in a difficult and dysfunctional housing market for the past couple of years, but it’s no longer clear that the sector will be able to serve that role in 2025.
Homebuilders were the only game in town when much of the housing market seized up in early 2023. High mortgage rates after a period of soaring home prices made affordability the worst it had been in decades. Inventories of existing homes for sale and new listings were very low as those with pandemic-era rates held on to homes they might otherwise have sold. That enabled builders to step in and offer inventory that the resale market lacked and use the tools at their disposal to lower costs for buyers.
The best enticement was mortgage rate buydowns (where companies sacrificed some profit to give buyers a lower rate via their financing arms), but smaller floor plans and other cost-saving measures have been part of the mix as well.
This wasn’t desperation — builders were actually operating from a position of strength. Profit margins were elevated relative to pre-Covid levels in part because much of the land being developed had been acquired relatively cheap prior to the surge in values in 2021 and 2022. Selling homes at 2023 prices on land bought in 2019 was a great business. Companies also enjoyed a tailwind from the post-pandemic easing of snarled supply chains. Lumber prices fell significantly, for example, padding profit margins and offsetting softer home prices in certain markets. Fewer construction delays freed up cash for use in paying down debt and returning capital to shareholders.
More housing inventory than would otherwise exist and construction that chipped away at the two-million-home shortage in the country, better affordability than in the resale market, and solid profitability for investors — everybody was winning.
Now, some cracks that emerged earlier in the year have turned into chasms, raising doubt about the industry’s prospects heading into 2025. Profit margins have been shrinking, going from an expected normalization to a more worrying crunch over the past few months. PulteGroup Inc. and DR Horton Inc., two large homebuilders that recently reported quarterly earnings, said that their use of incentives rose in the third quarter relative to the second quarter, and they guided to even higher incentives and lower profit margins in the current quarter.
Notably, mortgage rates were briefly at their lowest level in two years at the end of September, a move that should have benefited homebuyers and homebuilders alike, and still the need for incentives rose.
The factors working against builders are mounting. Buyers were more likely to close a deal when a 6.5% mortgage rate was bought down to 5% or 5.5% and it was easy to find a new job and wage growth was closer to 5% in 2023. Rates are now around 7%, and the labor market and wage increases are cooling. The tailwind from healing supply chains is also behind us, while other costs such as land prices are high.
And while the market is undersupplied for housing in the long run, the near-term inventory situation isn’t as acute as it was a year ago. In fact, there are more completed new homes for sale today than there have been at any point in the past 15 years. DR Horton said it has more ready-to-sell inventory than it would like.
The biggest disappointment is how mortgage rates have responded since the Federal Reserve lowered its benchmark by half a percentage point in September, soaring back to 7% from just over 6% due to better-than-expected economic data and perhaps election-related uncertainty. That’s rocked confidence among many would-be buyers, who had expected to see the opposite.
Developers don’t need to make a big bet on next year’s market because supply chains have healed and there are no longer lengthy delays in building homes. They can just wait to see how things evolve. If mortgage rates remain around 7%, my concern is that the industry, which is now well-managed and relentlessly shareholder-focused, will be quick to retreat to a mindset of carefully managing supply. That would leave us with the worst of all worlds: high mortgage rates, poor affordability and a homebuilding industry that is no longer incentivized to increase supply in any meaningful way.
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