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These Factors May Pull Down Homebuilding Momentum

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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 is the biggest issue facing the market right now and will prevail in the balance of 2018.

Meanwhile, there are other factors that can deal a fresh blow to the housing industry. The U.S. Government’s recent move of imposing tariff on imported steel and aluminum has spurred concerns among investors about certain U.S. sectors, particularly Construction.

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 the dampeners before investing in this space. Below we discuss the impact that these can have on the sector in the coming months and years.

Trump Tariff & Rising Material Costs to Shake the Industry

Construction materials’ prices continued to rise in March, after a notable spike in February. Meanwhile, tariffs on steel and other goods could push up construction costs.

According to an Associated Builders and Contractors (“ABC”) analysis of information provided by the U.S. Bureau of Labor Statistics (“BLS”), March construction material prices increased 0.8% month over month. On a year-over-year basis, the price of construction materials increased 5.8%, marking the steepest rise since 2011.

“Prices increased for many items in March, even before tariffs announced for steel, aluminum, and additional items imported from China have taken effect,” said Ken Simonson, AGC of America’s chief economist.

Notably, in March 2018, U.S. President Trump has announced hefty new tariffs for imports of steel, at 25%, and 10% for aluminum in an attempt to boost U.S. manufacturers. The proposal, which is in sync with Trump’s America First policy, however, will hit the Construction sector that accounted for 40% of U.S. steel demand in 2017 (as per the data provider Statista).

Steel is an integral part of the supply chain and widely used in every part of it, from sourcing raw material to construction and manufacturing activities as well as for freight purposes.

An increase in import tariff will escalate raw material cost for homebuilders already grappling with increased cost thanks the recent imposition of lumber tariff. Notably, in 2017, tariff was imposed on lumber, another major input material in the construction sector. The tariff imposed in retaliation to Canada's restrictions on the import of U.S. dairy products, averaged 20.83% on Canadian lumber imports, which are used mostly for home building in the United States.

Association officials warn contractors that the Trump administration’s additional proposed tariffs might further increase construction costs, resulting in potential project delays and cancellations.

Labor/Land Shortage Continues to Hurt

Apart from the rising material costs, the U.S. housing industry is already challenged by a shortage of homes for sale, suitable land and skilled labor. 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 existing homes in April 2018 decreased 6.3% from April 2017 but increased 9.8% month over month. It has fallen year over year for 35 consecutive months.

As such, it will take only four months to deplete the current supply of homes in the market, according to NAR. 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 these limit homebuilders’ pricing power. Labor shortage is 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. In April, first-time buyers comprised 33% of sales, which is down from 34% a year ago but up from 30% in March.

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. Lennar, PulteGroup and Toll Brothers carry a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Fed’s Hawkish Stance, Rising Interest Rates & Volatile Mortgage Rates

Minutes from the meeting, which ended May 2 and were released on May 23, reveal that Fed officials are on track to raise rates again in June. Officials at the Federal Open Market Committee concluded the May 2 meeting with a unanimous decision to keep the Fed’s benchmark interest rate unchanged, in the range of 1.5% to 1.75%.

The Fed last raised interest rates in March, by a quarter of a percentage point. The target range for benchmark short-term interest rate stands between 1.5% and 1.75%. This was the sixth-rate hike undertaken by the Fed since 2015.

The Fed expects to increase interest rates two more times in 2018. Fed officials now project a median federal funds rate of 2.9% by the end of 2019, which indicates three rate hikes in 2019 against two predicted in the last Fed meeting in December 2017. They expect the rate to move up to 3.4% in 2020 from the previous expectation of 3.1%.

Meanwhile, mortgage rates, which loosely follow the yield on the 10-year Treasury, started the year at around 4% but began rising thereafter. Mortgage rates are surging in proportion to U.S. government bond yields in anticipation of higher rates of inflation and further monetary tightening by the Fed.

The 30-year, fixed-rate mortgage rose to an average interest rate of 4.61% for the week ended May 17, 2018, the highest level since May 2011, according to mortgage finance agency Freddie Mac.

The rise in interest rates comes at a time when values of homes are marching up with higher demand and lesser supply. The situation could be detrimental to first-time buyers, raising affordability issues. This is evident from the latest report of Mortgage Bankers Association, unveiling the seasonally adjusted weekly survey for the week ending May 18, 2018.

The report stated that total mortgage applications fell by 2.6% from a week earlier. Purchase applications for new loans fell 2% from the previous week, while refinance applications plunged 4%, the MBA reported. The refinance index is currently at its lowest level since December 2000.

Speculation of further rate hikes is niggling investors in this space. Although we see limited impact on housing demand from the upcoming rise 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 the balance of 2018 or thereafter. High mortgage rates dilute 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, along with shortage of buildable lots and skilled labor are creating upward pressure on home prices and hindering a stronger housing recovery.

April’s median sales price of existing homes grew 5.3% from the comparable period a year ago to $257,900, marking the 74th straight month of year-over-year gains. In 2017, prices increased 5.8%, rising for the sixth straight year. Additionally, the median sales price of new homes sold in April was $312,400, 0.4% higher than a year ago.

Overall, rising prices may keep home buyers at bay with many postponing their search for the time being.

Sales Continue to Falter

Most recent data showed that sales of new U.S. single-family homes dropped in April after gaining in March. In fact, new home sales faltered in three of the last four months this year, suggesting the travails of the housing market in winning back momentum. Housing starts and building permits also fell 3.7% and 1.8%, respectively, in the month.

Sales of newly constructed single-family homes, accounting roughly 10% of all U.S. home sales, dropped 1.5% in April from the prior month to a seasonally adjusted annual rate of 662,000 units, as per data released on May 23 by the Commerce Department. Meanwhile, sales data for the prior three months was also revised down. The revisions revealed that sales in the first three months of the year were not as strong as earlier reported.

Moreover, existing-home sales faltered in April on both a monthly and annualized basis, according to the National Association of Realtors, after moving upward for two straight months.

Total existing-home sales decreased 2.5% to a seasonally adjusted annual rate of 5.46 million in April from 5.60 million in March. With last month’s decline, sales are now 1.4% below a year ago and have fallen year-over-year for two straight months.

We would prefer to avoid M/I Homes, Inc. (MHO - Free Report) stock for the time being, given its unfavorable Zacks Rank #4 (Sell).

Bottom Line

In “Builders’ Confidence, Economic Growth Raise Hopes for Housing” 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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