A housing crash is not a foregone conclusion
By Alex Barron
At the beginning of 2022, the outlook for the U.S. housing market seemed very positive. On the supply side, we had all-time low inventory in the resale market. In the new home market, supply chain issues prevented builders from completing more than 80,000 homes per month. There was virtually no finished spec inventory. On the demand side, demand seemed to be almost “infinite.” Most communities around the country had long waitlists of anywhere from 30-150 people.
Builders were releasing only two homes every two weeks for sale to the highest bidders. With each release they would raise the prices $5,000-$10,000. Over the last two years, home prices rose $100,000-$300,000. Mortgage rates were at 3%, the same level they had been since the onset of the pandemic. What could possibly go wrong with this scenario?
As it turns out, the market started to worry about inflation. The Fed had insisted inflation was transitory and now appeared to be behind the curve. At first there was debate on how often and how much they would need to raise interest rates and when this process would start. The Fed raised rates 25 bps in March 2022. Then again 50 bps in May 2022. Now they are expected to raise again 50-75 bps at the June meeting and every future meeting for the rest of 2022.
The 30-year mortgage rate has increased to 5.5%. The combination of rapidly rising home prices and aggressive interest rate increases has resulted in average new home payments going up about 80% YOY. Many are concerned that housing has become unaffordable.
From January to April, it didn’t seem that housing could crash. Long waitlists of buyers with plenty of equity and healthy finances were eager to buy homes. What few understood was that the majority of these buyers were seeking to move from an expensive state to a more affordable state. This desire had only accelerated due to the inflation everyone was feeling.
At first, it was not apparent when this demand would ever end. The demand was very strong and builders were limiting their sales pace to four to five homes per community per month. Build times had extended out from the typical four to six months to now 9-15 months.
After the supply chain issues began a year ago, many builders chose to switch their business model from build-to-order to spec building. Some who were already spec builders chose to start the home on spec, but did not release it for sale until it was very close to completion. The goal was to lock in the costs, raise the price and maximize the margins. This strategy worked as gross margins went from the low 20% range to the high 20% range and some builders even achieved 30% gross margins. But this is a risky strategy predicated on having a long list of potential buyers.
In May 2022, mortgage rates went above 5.0% and something began to change. All of a sudden, the traffic slowed down. The number of sales began to slow down. Meanwhile, the number of cancellations began to rise as many buyers in the backlog suddenly realized that they could no longer afford the home they had signed up to buy in 2021. By the time the home was to be delivered with the increase in mortgage rates, the home payment was no longer feasible and they no longer qualified or could afford it.
In June 2022, we are beginning to see a few builders cut their prices. This is a bad idea, reminiscent of how the housing crash started in 2005.
We believe a housing crash 2.0 is not a foregone conclusion. Our recommendation is that builders should NOT cut prices. Why? Because this undermines buyer confidence and home equity. It also triggers further cancellations. We believe builders should start very few homes, if any on spec, for the rest of the year. Instead, they should go back to building build-to-order homes. This would prevent an oversupply of completed spec homes by year end. If they can do these two things, I believe we can avoid another housing crash 2.0. But if builders decide to try to push specs via price cuts, then all bets are off.