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Undoubtedly, the overall outlook for the U.S. housing industry remains positive, with a healthy economy, strong job market and historically low mortgage rates. However, we cannot ignore that sales are decelerating in recent times, and U.S. homebuilders are not feeling quite so optimistic about their sales prospects.

What is plaguing the industry of late is the inventory shortage that is prevailing in the U.S. real estate market and the upward pressure it is creating on prices in several parts of the country. Meanwhile, Hurricane Harvey hit Texas and Louisiana in late August 2017, and Irma lashed Florida in early September 2017. The two devastating hurricanes have also created uncertainty for builders.

A healthy job market and an impressive supply-demand balance will probably draw buyers, but there are other factors that can 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

Presently, 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 being 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 (NARs) showed that total housing inventory declined 6.5% year over year to 1.88 million, marking the 27th consecutive year-over-year decline. That’s only 4.5-month supply. Investors should note that it is preferable to have about six months’ supply for a healthy market. Land supply could remain a challenge for the housing industry in the coming quarters as well.

Rising land and labor costs 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) , Toll Brothers Inc. (TOL - Free Report) and others. While Toll Brothers and KB Home hold a Zacks Rank #2 (Buy), the others carry a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Impact of Hurricanes Harvey and Irma

August housing data has been weak due to hurricanes Harvey and Irma, and the sales pace is expected to remain subdued through 2017 both in Houston area and parts of Florida.

NAR has cut its 2017 forecast for sales in the wake of a tepid spring selling season and the impact of hurricanes Irma and Harvey. The group now expects 5.44 million homes to be sold in 2017, down 0.2% from 5.45 million in 2016 and well below 5.52 million expected earlier.

Further, economists are of the opinion that shortage of skilled construction labor is expected to worsen following the two devastating storms and rebuilding operations are likely to drive construction costs higher causing delays.

Volatile Mortgage Rates

On Sep 20, 2017, the Federal Reserve (Fed) left interest rates unchanged, at 1.25% to 1.5%. However, the Fed committee expects to raise borrowing costs once again this year, followed by three raises in 2018.

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

However, with the Fed announcing a hike in the benchmark Federal Funds’ target rate, mortgage rates will probably rise in 2018 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.

Rising Prices Hurting Affordability

Rising material prices, particularly lumber, along with shortages of buildable lots and skilled labor are creating upward pressure on home prices and hindering a stronger housing recovery.

Median sales price of existing homes rose 5.6% in August from a year earlier. The national median existing-home price this year is expected to increase about 6% compared to a 5.1% increase in 2016. Additionally, the median sales price of new homes sold in August was $300,200, 0.4% higher than a year ago.

Rising prices have kept home buyers at bay with many postponing their search for the time being. Housing affordability fell in the second quarter of 2017, according to a National Association of Home Builders or NAHB survey.

We would prefer to avoid Century Communities, Inc. (CCS - Free Report) for the time being given its unfavorable Zacks Rank #4 (Sell).

Bottom Line

In Will Economic Growth, Job Creation Support Housing Stocks? 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 short-term investors?

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