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Industry Outlook

Though Brexit-related uncertainties and global economic pressure are not expected to have any major impact on U.S. homebuilding activity, there are other factors that can pull it back. As per the latest Q3 data released by the Commerce Department on Oct 28, 2016, the U.S. economy registered its fastest growth in two years. However, the drop in spending on residential construction is alarming.

Again, land and labor shortages have become valid concerns, and so are tedious underwriting standards. And you can’t evade competition that can at times get fierce and ignore cost inflation.

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.

Soft Housing Data

The housing sector remained a soft spot in Q3. Residential fixed investment declined for the second straight quarter, falling at a 6.2% annual rate over the summer following a 7.7% drop in the spring, and had a negative impact of 0.24% in the overall GDP growth rate in Q3.

Residential fixed investment had been a stable contributor to growth, but it has been weakened by volatility in housing starts in the first half of 2016.

Interest Rate Hike in the Cards?

One factor that could be hurting investors’ sentiments is the possibility of an interest rate hike.

Solid Q3 growth numbers clear the way for the Federal Reserve or Fed to raise interest rates at the end of 2016. The Fed is expected to hike interest rates when it meets in December; which could be the first increase in a year. The Fed has not raised rates this year even after signaling four rate hikes in 2016 last December.

That number has since been scaled down to two this year, with another three hikes scheduled for 2017, owing to a global slowdown, financial market volatility and tepid U.S. inflation. Sluggish growth along with a tepid jobs report in May have also held the Fed back from raising rates earlier in 2016.

It is to be noted in this regard that a rate hike could make mortgages more expensive.

Labor/Land Shortages

Several years of production deficits during the housing downturn resulted in a limited supply of both rental and new homes in the country. At present, a shortage of buildable lots, skilled labor and available capital for smaller builders are limiting home production, thereby lowering the inventory of homes, both new and existing.

The labor market has tightened with limited availability arresting the rapid growth in housing production. Labor supply is expected to remain tight through the rest of the year. Also, capital constraints for land and land development have left entitled lands in short supply while increasing demand has driven land prices higher. Moreover, the regulatory environment for mortgages remains challenging.

Total housing inventory of existing homes was 6.8% lower at the end of September than a year ago, per data released by the National Association of Realtors in October.New home inventory for sale was 204,000 units at the end of September, a 4.5-month supply at the current sales pace, which is down from 4.6 months in August.

Rising Labor, Land and Material Costs

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, going ahead. This is eating into homebuilders’ margins considering that home price increases are moderating.

Rising land and labor costs -- mainly the latter -- have hurt gross margins of the likes of Lennar Corporation (LEN - Free Report) , KB Home (KBH - Free Report) and D.R. Horton, Inc. (DHI - Free Report) in the past few quarters.

Slowing Sales Trends in Texas/Houston

Texas’ economy is dependent on the oil complex and the volatility in the energy sectorhas in the recent past hurt the region’s overall economic growth and, in turn, home sales. Though Texas’ markets like Dallas and San Antonio are doing well, Houston suffered in particular, mainly at higher price points, in the wake of the oil price slide. However, lower-end demand remained more or less steady in Houston.

Pulte Group, Inc.’s (PHM - Free Report) Texas segment accounts for around 14% of its homebuilding revenues as of Sep 30, 2016. Orders declined 9% in this market in 2015.Again, Houston accounts for around 9% of Lennar’s homebuilding revenues. The company’s orders declined 12% in the Houston segment in fiscal 2015 and 7.5% in the first nine months of 2016 due to lower demand.

Interestingly, Pulte management said at the first as well as second-quarter conference call that demand trends in Houston improved as they moved through the quarter. Meritage Homes Corporation (MTH - Free Report) , a smaller homebuilder, also said that its sales in Houston exceeded expectations in the first as well as second quarter. With oil prices on the rise again, demand trends could improve in Houston.

Bottom Line

In US GDP Solid: Housing to Gain More Strength? 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?