Is the Housing Market Cooling Down?

The rally of the housing market seems to have lost some of its momentum in recent months: The growth in housing prices has slowed down, and leading homebuilders' stock have sharply declined in the past several months: Shares of D.R. Horton (DHI 0.10%) have decreased by over 19% between April and September.

Looking forward, will the housing market continue to cool down? If so, what does it mean for leading homebuilders in terms of growth in revenues in the coming quarters?

Is the housing market cooling down?
Home sales aren't growing as fast as they did earlier this year: Based on the U.S Census Bureau's report (link opens PDF), new home sales ranged between 390,000 and 458,000 in the past several months. These figures are higher than last year but didn't grow significantly during 2013. Moreover, in the previous month, home sales reached their lowest level this year. The chart below shows the changes in new home sales and average new home prices. 

Source: U.S. Census Bureau, Department of Housing and Urban Development.

The chart above also leads me the next point: Home prices. The average price of a new home has sharply declined in the past several months. Moreover, based on the latest S&P/Case-Shiller Home Price Index report, prices rose at slower pace compared to previous months: During July, the index slightly increased by 0.6%. In comparison, during June, the index rose by 0.9%.

If home prices don't rise as fast as they did earlier this year, this could suggest the housing market is slowing down.

Another factor to consider is the mortgage market: According to the Mortgage Bankers Association, mortgage applications increased in three out of the last four weeks. The recent rally in mortgage applications coincided with the fall in mortgage rates. But this recent rise in mortgage applications could slow down.

The decision of the FOMC to maintain its asset purchase program, including the $40 billion a month mortgage-backed securities back in September, may have contributed to the latest rise in mortgage applications. Looking forward, the FOMC will eventually cut down its asset purchase program, perhaps next year; this decision is likely to pull down the demand for homes as mortgage rates will potentially rise again.

Despite the potential slowdown in the housing market, homebuilders are still in a sweet spot. The main driver is the high backlogs of leading homebuilders. The sales order backlog represent homes under contract but not yet closed on as of the end of the quarter. A higher backlog is likely to result in higher sales in the coming quarters.

D.R. Horton recorded nearly 10,000 homes in backlog as of the second quarter of 2013 -- a 36% spike compared to the same quarter in 2012. The value of these homes rose by 56%. PulteGroup (PHM -0.18%) also recorded 13% growth in its backlog units and a 25% increase in these homes' value, and its revenue rose by almost 20% in the second quarter.

Lennar (LEN 0.40%) has also experienced a sharp rise in its homes backlog: In the third quarter, its backlog reached 5,958 homes -- a 32% increase. These homes' dollar value jumped by 53%. Moreover, in the past quarter, the company's revenues increased by nearly 46%.

But not all backlogged homes will result in a sale; some may be cancelled. The rate of canceled home sales as percentage of total backlog contracts is a homebuilder's cancellation rate. These companies could experience some slowdown in sales growth if their cancellation rates rise.

A rise in cancellation rates could be due to the following: A decline in existing home sales (buyers aren't able to sell their homes to enter the new home), fewer mortgage loan approvals, higher mortgage rates. A higher cancellation rate could result in a reduction in the high growth in backlog of homes.

D.R. Horton's sales order cancellation rate was 24% in the second quarter of 2013. Based on sales order backlog, prices, and cancellation rate, we could estimate a company's future revenues. Assuming prices will rise by only 10%, and based on D.R. Horton's current cancellation rate, the company's growth in net sales orders could range between 20% and 25% in the coming quarters.

Foolish bottom line
Despite the slowdown in the housing market, as indicated above by the stagnation in home sales, slow growth in home prices, and a potential rally in mortgage rates, homebuilders are likely to pass through this slowdown and maintain their high growth in revenues in the coming quarters.