Are we about to see a renaissance in homebuilding?

Despite all of the gloom out there for the real estate sector, a bright spot is potentially emerging at long last: homebuilding. Over the past couple of weeks, we have seen some encouraging data on that front, which had never really recovered from the 2008 real estate bust, some 15 years ago.

First, we saw an substantial uptick in housing starts, which rose 21.7% month-over-month and 5.7% year-over-year to 1.63 million. Homebuilding had been stuck at depressed levels up until the COVID-19 pandemic which saw a spurt of homebuilding driven by rock-bottom interest rates. This was short-lived and more or less ended with the Fed’s drastic tightening cycle of 2022.

Housing starts were depressed in the aftermath of the bubble due to overbuilding during the bubble years, however shortages of buildable land and skilled labor were headwinds as well. The Millennial Generation tended to prefer urban living, so a lot of housing resources went to luxury apartment construction for younger buyers, not starter homes. The COVID-19 pandemic probably accelerated the inevitable phenomenon of young families exiting the cities to head to the suburbs.

Homebuilder Lennar reported second quarter earnings, which beat Street expectations. CEO Stuart Miller described the current environment as returning to the typical demand we were seeing prior to the Fed’s tightening cycle. The dramatic increase in interest rates caused sticker shock amongst potential buyers. That said, buyers are becoming more accustomed to higher interest rates and accepting this as a new normal that isn’t going to change. As always supply and demand tell the story. From the earnings conference call, Miller said: And even while interest rates and affordability were primary headwinds to demand, the well-documented chronic housing supply shortage has kept inventory levels very low, which has continued to propel customers to stretch their finances for needed housing as incentives and price reductions combined to spark sales activity.”

Homebuilder KB Home said similar things on their earnings conference call: “The long term outlook for the housing market remains healthy. Market dynamics are characterized by low existing home inventory and limited availability of new homes at our price points as well as demographics that are particularly favorable for our business, given that we primarily serve the first time and affordable first move up segments. With respect to demand, buyers are adjusting the higher mortgage rates and the continuation of a more stable rate environment is a positive factor. In addition, with the lack of resell inventory that I mentioned and market price is now starting to increase, buyers are demonstrating a higher sense of urgency than we saw earlier this year.”

Meanwhile new home sales rose 12% month-over-month and 20% year-over-year to a seasonally-adjusted annual rate of 763,000 units. New Home Sales is a notoriously volatile number (note the huge standard deviations around the estimates) but the activity from the homebuilders seems to indicate that homebuilding is rebounding. On the other side of the coin, pending home sales dropped 3% in May and are down 22% on a year-over-year basis. Interestingly, the median price of a new home was down something like 8% on a year-over-year basis.

I have been waiting for homebuilding to pick up post COVID. Despite the exhortations of corporate leaders, work from home is probably here to stay, and one of the biggest frictions of all time - the necessity of co-locating an office with its workers - no longer is a constraint to productivity. Obviously this doesn’t work with some services, but overall commuting costs are going to become less of a driver in home purchases. This is bad news for people who spent $3 million for a 2500 square foot loft in Bed-Stuy, but it will be good news for people who plan to move to the exurbs. Land is much cheaper in these areas, and this should be good for affordable housing.

The upcoming bank earnings season will be interesting to see how many take impairments or charges on their commercial real estate portfolios. Office real estate is getting pounded, with buildings changing hands at less than 50% of their prices a few years ago. Retail is apparently struggling as well, which is surprising given that retail construction collapsed during the 2008 financial crisis and hasn’t really recovered yet. I found this slide from retail REIT Kimco Realty’s first quarter earnings presentation interesting:

Retail development and store closures are at multi-year lows. Seems strange to think that retail commercial real estate is struggling, but perhaps the issue is rolling over debt. That is going to be the problem for office properties - nobody will be willing to roll over maturing debt when cap rates are at or below current interest rates.

If the pain in commercial real estate is worse than people are forecasting that could be the straw that breaks the camel’s back on this Fed tightening cycle. With inflation falling, real interest rates are rising even if the Fed does nothing. While it is always tempting to think this time is different, tightening cycles of this magnitude usually cause deep recessions.

Finally, a happy 4th of July for everyone out there.