The One Industry with a Hidden “Rate Hike Upside”

The large amount of refinancing and purchase activity that took place during the COVID boom means existing homeowners are unlikely to add supply to the market. Interest rate hikes slowed down one part of the housing market, but they’re creating a tailwind for another…

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Reports of the homebuilding sector’s demise are greatly exaggerated.

The housing sector was a major beneficiary of the COVID-19 pandemic, as people moved to get away from… each other. And meanwhile, working from home became a thing, thanks in part to the growth of cloud computing.

City dwellers seeking the space of suburbia pushed real estate prices higher – as well as the costs of housing inputs, like lumber and metal. Housing makes up almost half the U.S. Bureau of Labor Statistics’ Consumer Price Index (“CPI”), so skyrocketing home costs caused inflation to explode. The Federal Reserve had to intervene to slow price growth.

By raising interest rates from 0% to 5.25% over the last 15 months, the Fed hoped to cool red-hot housing demand and push prices lower – thus easing inflationary pressure. Consequently, home prices and material costs have fallen as the “pull-forward” effect of the scramble for housing diminished.

(If you’re like me – and many Americans – a big portion of your net worth is tied up in your home. So interest rates, which are a big driver of home values, are something that I watch closely.)

Interest rates and housing prices tend to have an inverse relationship. When rates go up, prices usually drop because it costs more to own a home.

But there’s good news… those rate hikes may have slowed down one part of the housing market, but there’s another where we see an opportunity to profit.

As it happens, housing is actually turning out to be a beneficiary – rather than roadkill – of the Fed’s efforts.

And stock investors haven’t caught on… yet.

Housing supply can’t keep up with demand… and, at the same time, material costs are tanking. And as I’ll explain, existing homeowners aren’t adding much supply to the market by selling their houses.

This has created an opportunity for rising margins and market-share gains for newly constructed homes.

And that’s good news for homebuilding stocks…

When “Stay At Home” Turns Into “Buy A Home”

The National Association of Realtors’ (“NAR”) existing home sales report, released monthly, sums up sales and prices for existing single-family homes in the U.S..

As shown below, existing home sales (that is, homes that aren’t newly built by developers) took off in June 2020.

After an initial drop early in the pandemic, the purchase of previously owned homes shot up from a pre-pandemic annual pace of 5.3 million in 2019 to 6.6 million by the end of 2020. That was the highest level since the late 2005 peak of 7.25 million.

Consequently, as shown in the graph below, home values began to rise. According to the NAR, the median sales price averaged $270,000 in 2019. A year later, that number was $294,000, for a gain of roughly 10%.

And in early 2021, prices took off. By May of that year, the price of an existing home was almost $370,000. It had jumped by more than 25% on a year-over-year (“YOY”) basis… the biggest annual gain on record.

There’s another piece to the puzzle. At the onset of the COVID pandemic, the Fed cut interest rates to 0% to stimulate the economy. But as economic activity recovered, the central bank waited too long to raise rates to prevent the economy from overheating. On the housing front, low rates for longer meant money was cheap – which was fuel on the homebuying fire.

Those surges in the prices of existing homes are a big deal. You see, in the 20 years prior to the pandemic, existing homes made up 87% of all housing sales. Hence the upward pressure on inflation growth.

When the Fed started to raise rates, in March 2022, it hoped to cool housing demand and prices, to temper inflation. And the plan is working: in April, the annual rate of existing home sales dropped to 4.3 million, which is the most recent data available.

New Home Sales Surge, Too

The broad strokes of the story of rising demand during COVID was similar for new home sales. Today they account for 33% of total housing sales compared to just 13% prior to the COVID pandemic. In other words, they've almost tripled their market share.

As shown below, 675,000 new homes were purchased in 2019. That was a 10% increase from the year prior and the highest average since the global financial crisis. But then, with the COVID boom, the number surged to an annual pace of just over 1 million, the highest since 2006. .

And just like existing homes, the price of new homes also rose dramatically…

Pre-pandemic, the median price for a new single-family home was about $315,000. By the end of 2020, that number stood at $365,000, or a gain of 11%. And prices kept rising…

As you can see in the above chart, the YOY price gains kept running until August 2021. That month, they were up 24%. The timing was almost identical to the May 2021 peak in existing home price gains.

What drove the acceleration in prices, for both existing and new homes, was the same: Fed policymakers signaling that they were going to start raising interest rates again. So homebuyers looking to take advantage of rock-bottom interest rates needed to move… fast.

The Rate-Lock Boom

Interest rates, of course, define mortgage rates – which drive monthly mortgage payments for homeowners (or for those who aspire to that title). And they’ve been rising.

If you bought a $400,000 house pre-pandemic with 20% down and a 30-year mortgage rate at 3%, your monthly payment is roughly $1,700. Today, if you got the same loan at 7%, you’re shelling out $2,500 every 30 days to pay it off. That’s 47% more.

Over the lifetime of the loan, at 3% you’re paying $165,700 in interest. But at 7%, you’ll shell out $447,200… in addition to repaying the principal. In other words, the total cost is 170% higher.

So, it makes sense that when the Fed indicated that interest rates were about to rise, people bought houses.

According to home-search website Redfin, 85% of all U.S. homeowners have a mortgage rate of less than 5%. And, according to residential property data provider Black Knight, just over 64% of all households have a mortgage rate under 4%.

The big headwind for home sales now is… who wants to trade a sub-4% or 5% mortgage in favor of a 7% interest rate? No one! Unless rates drop sharply or people are forced to leave their homes for work-related reasons or an adverse event, the supply of existing homes will remain constrained for the foreseeable future.

That’s a tailwind for homebuilders.

It’s No Longer “Location, Location, Location”

There’s an old saying in real estate… the three most important factors in buying property are “location, location, location.” That might be true when the supply/demand picture is stable, but when no one can find a home, location matters less.

According to the U.S. Census Bureau, 17.4 million new households (defined as two or more people sharing a living space) were formed from the end of 2009, through the end of 2022 – for growth of 16%. That’s a lot of new families that need a place to live.

But over that period, only 9.4 million new homes were built – suggesting a deficit of around 8 million homes. If we divide that by the roughly 720,000 homes built per year over the span, there’s about 11 years’ worth of demand. That’s going to underpin new home prices for a long time.

If we look again at the pace of new home sales, we can see they’re already recovering…

In July 2022, the number of new homes sold had slipped all the way back to an annualized rate of 540,000. By April 2023, that increased to 683,000. That’s the strongest number since just before the Fed started raising interest rates in March 2022.

As we said before, new home sales as a percent of overall house sales have almost tripled. That’s a direct consequence of the Fed’s actions.

In other words, the central bank’s rate hikes have spared the homebuilding sector. No one’s dumping their 4% or 5% mortgage to lock in at 7%. So, the supply of existing homes isn’t growing. People instead are buying new homes.

That’s not to say that the prices of new homes aren’t falling: In fact, prices fell 8.2% YOY in April. But let’s keep it in perspective… the average price for a new single-family home is $421,000 compared to $330,000 at the end of 2019. Prices have slipped from the peak but are still high.

And for us, there’s a more important part of the equation to consider: Building costs have dropped… and that means improving margins.

Wood And Metal Cost Less – Boosting Homebuilders’ Margins

According to the National Association of Homebuilders’ (“NAHB”) most recent Cost of Constructing a Home survey, it cost roughly $392,000 to build a house in 2022. We want to focus on construction costs (labor included) because they’re the bulk of the expense at 61%. They involve two main inputs… wood and metal.

According to data from the Chicago Mercantile Exchange (CME), lumber prices have plummeted…

As you can see in the above chart, the cost to buy lumber exploded as COVID-related housing demand took off. The price jumped from the low of $264 per thousand board feet in April 2020 to a peak of $1,686 in May 2021. That’s a change of 640%....

Yet it’s what happened in the last year that really matters. In May 2022, lumber prices hovered around $920. But today, they’re closer to $340. That means the single biggest cost input into building a house has fallen by 63%, to return to pre-pandemic levels… while house prices are still up 28% from that time.

Tin, which is mixed with other metals in nuts, bolts, nails, rebar, and I-beams, is another important input. And prices of tin are also down sharply...

London Metal Exchange (“LME”) figures show that tin currently costs around $25,000 per metric ton. That compares to the post-pandemic peak of just over $50,000 and the pre-pandemic price of around $19,000. And the change relative to a year ago is also sharp…

According to the LME, spot tin prices have dropped 29% since the same month last year. When we consider that compared to the 8% slide in new home prices, it means builders’ margin opportunity is growing. Prices charged to homebuyers have fallen a lot less than the actual cost of building houses.

How To Invest

Putting it all together… simple demographics highlight why housing demand is strong. Meanwhile, owners of existing homes aren’t interested in selling – and thus taking on more expensive mortgages when they buy elsewhere.

That means that unless there’s a complete economic calamity, the housing supply/demand equation will continue to favor the builders. The dynamic will help to underpin new home prices for the foreseeable future. And falling costs will boost margins.

One way to invest in this trend is to consider the SPDR S&P Homebuilders Fund (NYSE: XHB)

This ETF aims to replicate the performance of the S&P Homebuilders Select Industry Index. It invests in equities, 93% of which are in the U.S. Its holdings are diversified across the housing industry, including the building materials, home builder, and retail sectors. It holds industry bellwethers such as PulteGroup (PHM), Owens Corning (OC), and NVR (NVR), among others. It trades over 3.1 million shares a day, so it should be easy to get in and out of.

If you’re a Big Secret subscriber, you may remember that we recently recommended a capital efficient homebuilder with a unique “asset-light” business model –  it’s increased revenue by an average of 65% per year over the last three years. And, remarkably, it achieved this meteoric growth with no upfront capital, while generating positive earnings every year along the way. Read more here.

Scott Garliss

Porter & Co.
Stevenson, MD

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