Undoubtedly, the overall outlook for the U.S. housing industry remains positive, with a healthy economy and strong job market helping the demand side of the equation. However, the limited supply of homes for sale has been the biggest issue facing the market and it will continue to be so in 2018.
Meanwhile, there are other factors that can deal a fresh blow to the housing industry. The newly enacted tax reform bill creates a complicated set of impact on the industry.
Although a healthy job market and an impressive supply-demand balance will probably draw buyers, 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.
How Damaging the New Tax Law Could Be to Housing Demand
The recent tax-cut legislation that limited deductions for mortgage interest and property taxes is also expected to hurt sales to quite an extent. The qualifying loan amount for the mortgage interest deduction is now capped at $750,000 (previously $1 million), and the property tax deduction at $10,000.
The value of both deductions is reduced by doubling of the standard deduction. This will considerably lower the number of households that itemize on their tax returns to take advantage of the deductions.
Again, housing prices are likely to suffer once the tax breaks are scaled back, as they are in the new tax law. Housing experts are of the opinion that the changes will slow down the pace of the price increases in expensive housing markets. According to the Standard & Poor’s/Case-Shiller index, housing prices have been growing about 6% per year over the past five years in the United States.
Market pundits now expect these areas to witness some slowdown in the coming years, particularly in expensive areas such as the Northeast Corridor, parts of the West Coast and Florida, and in a number of Midwestern cities. Hence, this could hurt homebuilders’ top line to some extent. Nevertheless, housing values will not decline given the overall strength of the economy and owing to the supply issues in top markets.
Meanwhile, few experts believe that the new tax legislation will also hit housing via higher mortgage rates. The big tax cuts to corporations and taxpayers will temporarily fuel growth, thereby prompting the Federal Reserve or Fed to raise rates.
Amid this ongoing debate over the impact of new tax legislation on housing, the new rules are likely to put a lot of prospective home buyers in the wait-and-see mode, which could prompt a slowdown in the market.
Limited supply of homes for sale has been the biggest issue facing the market and the problem will continue, particularly in the entry-level market. Per a recent report by the National Association of Realtors (NARs), the supply of December existing homes decreased 11.4% from November and 10.3% from the year-ago period. It has fallen year over year for 31 consecutive months.
As such, it will take only 3.2 months to deplete the current supply of homes in the market, according to NAR. This is also the lowest reading since the group began tracking the data in 1999. 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.
Also, the problem of skilled labor shortage is taking its worst shape in the homebuilding industry, as demand continues to scale up. 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 homebuyers.
Rising land and labor costs have hurt gross margins for the likes of Lennar Corp. (LEN - Free Report) , PulteGroup Inc. (PHM - Free Report) , Toll Brothers Inc. (TOL - Free Report) and others. While Lennar holds a Zacks Rank #2 (Buy), Toll Brothers and PulteGroup 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
In December 2017, the Fed raised the benchmark interest rate by a quarter percentage point for the third time in the year to the range of 1.25-1.5%. However, the Fed committee expects three hikes in 2018 and two in 2019.
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.
December’s median sales price grew 5.8% from the comparable period a year ago to $246,800, marking the 70th straight month of year-over-year gains. For 2017, prices increased 5.8%, rising for the sixth straight year. Additionally, the median sales price of new homes sold in December was $335,400, 2.6% higher than a year ago.
Overall, rising prices may keep home buyers at bay with many postponing their search for the time being.
We would prefer to avoid Loma Negra Compañía Industrial Argentina Sociedad Anónima (LOMA - Free Report) for the time being, given its unfavorable Zacks Rank #5 (Strong Sell).
In “How Far Will Economic & Wage Growth Push Housing Demand?” 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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