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Industry Outlook

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Undeniably, the homebuilding industry saw the fastest quarterly home sales in a decade in the first quarter of 2017, and lent some much-needed support to the economy. The solid sales pace was especially appreciable considering higher prices and mortgage rates.

Though a healthy job market and an impressive demand-supply balance will probably draw buyers, there are other factors that might deal a fresh blow to the housing industry.

Rising interest and mortgage rates, as well as land and labor shortages, raise concerns -- as do tedious underwriting standards. Intensifying competition also poses a threat.

It would be prudent for investors 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.

Labor/Land Shortage

At present, the problem of skilled labor shortage is taking its worst shape in the homebuilding industry as demand continues to scale up. Meanwhile, rising land and labor costs are threatening margins as they limit homebuilders’ pricing power. Labor shortages are resulting in higher wages while land prices are inflating due to limited availability. There could be more inflation ahead. This is eating into homebuilders’ margins.

The impact of labor/land shortage is twofold. On the one hand, residential construction is failing to meet demand in the absence of sufficient workers. On the other hand, to make up for rising labor costs, homebuilders are compelled to raise home prices to maintain margins that would deter entry-level home buyers.

Meanwhile, a recent report by the National Association of Realtors showed that average supply during the first three months of 2017 was 3.7 months, down from 4.2 months in the first quarter of last year. Land supply could remain a challenge for the housing industry in the coming quarters as well.

Rising land and labor costs -- mainly the latter -- have hurt gross margins for the likes of Lennar Corp. (LEN - Free Report) , KB Home (KBH - Free Report) , D.R. Horton, Inc. (DHI - Free Report) , PulteGroup Inc. (PHM - Free Report) and Toll Brothers Inc. (TOL - Free Report) in recent quarters. While KB Home holds a Zacks Rank #2 (Buy), all the other stocks carry a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Volatile Mortgage Rates

On Mar 15, 2017, the Federal Reserve raised interest rates for the third time since the 2008 financial crisis. Interest rate increased by 25 basis points to the range of 0.75–1%.

Speculation of further rate hikes is bothering investors in this space. Although we see limited impact on housing demand from the recent rise in mortgage rates on job market strength, its influence on the industry in 2017 is undeniable and uncertain.

However, with the Federal Reserve announcing a hike in the benchmark Federal Funds’ target rate, mortgage rates will probably rise in 2017 or thereafter. High mortgage rates dilute the demand for new homes as mortgage loans become expensive. This lowers the purchasing power of buyers and hurts volumes, revenues and profits of homebuilders.

Additionally, the rise in mortgage rates may impact affordability at a time when millennials are taking baby steps into the housing market. Higher interest rates will only flare up the issues and further delay home purchases by millennials.

Bottom Line

In How Homebuilding Can Be Constructive to Your Portfolio we focused on the conditions that are expected to drive the industry going forward.

As you can see, there is some catching up to do 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 short-term investors?

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