Homebuilders' Long-Term Foundation Could Be Built on Shaky Ground

The latest housing numbers don't tell the entire story about the future landscape for homebuilders in the next year or so.

Jan 3, 2014 at 10:23AM

The new home sales numbers for September and October came out the first week in December. The raw numbers say that the housing market is on a roll and still gaining steam. This is great news for homebuilders like Toll Brothers (NYSE:TOL), Hovnanian Enterprises (NYSE:HOV), and PulteGroup (NYSE:PHM), right?

Well, maybe not. If you dig a little deeper into this and past reports, and take a look at what the Federal Reserve released that same day, there's a different story of where this market may be heading.


The story behind the story
The Census Bureau estimated that the month of October saw new home sales run at an annual rate of 444,000 -- that decisively beats September's rate of 354,000 and is a rise of 25% on a month-to-month basis.

It was the most dramatic uptick in more than 30 years. This was the follow-up to a September that saw these same contract numbers drop 6.6% from August.

Sounds good. Housing is on the right track. But that's just taking those headlines on face value. As with all reports and numbers, you need to dig a little deeper. If you do, you'll find these three things:

1. Cancellation rates among homebuilders is a growing concern.

There's been an unsettling trend with the Census Bureau estimates of new home sales since July. They have a lot of significant downside revisions that can be attributable in part to rising cancellation rates.

The numbers mentioned above are based purely on signed contracts, not closings. Some homes have not been built, and completion could be months away. For those buyers just starting the process, it's most likely they couldn't lock in a rate. And rates have risen. So some of these contracts will not come to fruition because of financing, and it seems to be a growing trend over the past few months

We can see the most significant revisions starting in August, where the original seasonally adjusted annual rate came in at 421,000. That was revised down to 379,000 units, and finally further down to 354,000.

2. The trend in declining mortgage purchase applications tells us that traditional buyers can't afford homes.

We may have reached a point where the Fed's easing policies are no longer an enticement to buy a home. Higher mortgage rates spell disaster to a real estate sector that's been buoyed by policies to keep them historically low.

Over the last five years, we've been feeling a real loss in purchasing power. In September, another Censes Bureau Population report: "Income, Poverty and Health Insurance Coverage in the United States: 2012" reported that median household income dropped to $51,017. That's the lowest it's been since -- adjusted for inflation -- 1995.

3. The October new home sales gain came courtesy of a decrease in median prices.

If you look at the second page of the Census Bureau new home sales report, it shows us that median new home prices dropped 4.5% from September to October from $257,400 to $245,800. If this was just a one-month anomaly, we shouldn't be that worried. However, since the 2013 high in April of $279,300, that's a decline in price of 12% over that six-month period. It looks like builders are cutting prices to get sales. But how low can they go until a lack of profitability tells them enough is enough?



Why? Well, investors took a closer look at the numbers, but also saw another report from the Federal Reserve, the Beige Book. The report is distributed eight times a year and gives a subjective overview of the economy.

The December 4th edition was interpreted negatively for homebuilders. It actually said the economy was improving. This seems counterintuitive at first glance, but it was a sign that the Fed could soon taper back asset purchases.

The lower demand for mortgage-backed securities translates into higher mortgage rates going forward. The Beige Book report incited a homebuilder stock sell-off that weighed more than any housing sales numbers.

Tapering starts the beginning of tenuous times
On December 18, Fed Chairmen Ben Bernanke announced that there would be a $10 billion decrease in the rate of asset purchases. It's a mild taper, but higher rates are coming, and that's not a good look for a real estate market artificially propped up by the government.

And here's the takeaway. Without QE, the housing market will have to depend on falling household incomes, rising mortgage rates, and more stringent mortgage regulations in the very near future. And with these traditional market forces driving said market, you should be wary of the homebuilder industry as a whole.

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