OC Homebuilders see flat pricing as best-case scenario
Analysts working for homebuilders see a flat market with weak sales as the likely future for OC Homebuilders.
At first low MLS inventory was a boon to homebuilders, but housing market manipulations give homebuilders false signals, so Orange County homebuilders oversupplied the market, and as it turned out, reflating the housing bubble hurts homebuilders, rather than helps them.
It wasn’t until early 2013 that homebuilding bounced off its five-year long malaise at 60-year lows. Homebuilding is still 40% below the average of the last 60 years, and with high prices and weak job growth, some are wondering when the industry will ever recover.
Homebuilder’s demand comes from financially stable households with sufficient savings, good credit, and a desire to own a house. Unfortunately, over the last several years, household formation has been low, potential buyers lack savings, many have bad credit, and Millennials in particular are content to rent. That isn’t an environment conducive to explosive growth in homebuilding. Wages rose in nominal terms over the last several years, but when adjusted for inflation, wages have actually declined since 2000.
When lenders evaluate a borrowers ability to repay a loan, they look at two important financial ratios: front-end DTI and back-end DTI. The front-end DTI is the percentage of income a borrower spends each month only on housing costs: principal, interest, taxes, insurance, and HOAs or other costs. This is typically limited to 31% of total income, but this standard has been both higher and lower at different times. The more important ratio is the back-end DTI, the total amount of debt service of all kinds as a percentage of borrower income. The back-end DTI encompasses the front-end DTI of housing debt, plus it adds all other financial obligations a borrower might have — including student loan debt.
As lenders loaded up borrowers with credit cards, student loans, and car payments, lenders kept adding to the total debt burden as a percentage of borrower income. As long as debt is unlimited — as long as lenders let borrowers go Ponzi — everything works fine.
To this day, the competition to enslave borrowers by capturing larger and larger portions of their income goes on unabated, well . . . almost unabated. The new mortgage regulations will prevent future housing bubbles, and they will ultimately force lenders to limit other forms of debt — if they ever want to underwrite another mortgage. The new qualified mortgage regulations cap debt-to-income ratios at 43% of gross income. If lenders burden borrowers with more than 12% of their income going toward other debt service (43% -12% = 31%), then any additional debt subtracts from what’s available to support a borrower’s front-end ratio, which supports a housing payment.
Another difficult problem facing home sales is the lack of sufficient down payment savings. The recession wiped out many people, and the tepid wage growth further held them back. To make these conditions even worse, rents have risen faster than wages, preventing people from saving what little income they have.
Back in 2009 I wrote a post asking Will the market perish in fire or in ice? Well, since our banking system couldn’t survive a “fire” scenario, the federal reserve with collusion among politicians and bureaucrats engineered a series of bailouts to ensure the market would suffer a long deep freeze, which it has.
I didn’t foresee the steep reflation rally of 2012, but then again, nobody else did either. The problem the the ice scenario is that long-term growth is sacrificed in favor of avoiding short-term pain. The majority of the debt from the credit orgy of the early 00s was never expunged. This lingering debt held back the recovery as evidenced by a “recovery” without a single year of 3%+ growth.
Homebuilding usually leads the economy out of recession. The Great Recession did not end with a building boom largely because of overbuilding during the housing bubble. A false price signal triggered excessive homebuilding, and it took five years to work off the inventories.
The collapse of the housing bubble saw new home sales and construction fall to the lowest levels ever recorded — and those records go back to the 1960s. To make matters worse, rather than experiencing a sudden drop and a “V” bottom leading to a new boom, new home sales flat-lined at record lows for five straight years. This basically wiped out the homebuilding industry.
A few years ago, I heard the Riverside County manager of KB Home quip, “I’m building 10% of the homes with 10% of the staff I had in 2006.” That’s no exaggeration.
From early 2009 to early 2015 the stock market had a long bull run. Even though the market was overvalued, everyone convinced themselves it would continue rising, so most kept buying stocks. Now that the market is enduring a deep correction, the fallacies of “strong fundamental support” and other false truisms are exposed as frauds. The same is probably true of the housing market.
For the last several years, everyone (including myself) believed higher mortgage rates were right around the corner. With rates back down near record lows, everyone has been consistently wrong for quite a while. This has lulled everyone into a complacency typical of long bull runs. Nobody wants to believe rising mortgage rates will hurt the market, but the math is inescapable.
But until the inevitable actually comes to pass, it hasn’t happened. And like those who bought stocks right up to the peak, everyone will keep buying until suddenly nobody can afford to buy anymore.
If mortgage rates do go up, we all know it will cause major affordability problems.
In the chart below, notice the gap where “rates rise faster than income.” This is an affordability gap that will drag down sales and serve as an anchor dragging down prices as well.
Does the chart above look familiar? It uses a different value benchmark, but the analysis is the same as mine.
The end result of all this analysis is that home prices, particularly new home prices, are likely to remain flat and experience low sales volumes due to a lack of affordability. That’s the best case scenario.
Worst case, sales volumes could fall off a cliff taking house prices with them.