The U.S. housing market took a dramatic turn in 2018. At the beginning of the year, homes were selling at a torrid pace and the market could barely keep up. By the end, though, a combination of low inventories, high prices, and rising interest rates started to eat away at the housing boom. It all came to a head this past quarter, as several homebuilders have reported a slowdown in new orders.
As bad as this all sounds in the short term, Lennar's (NYSE:LEN) (NYSE:LEN-B) management seems to think the outlook for the industry is still incredibly strong. Is this a case of a management team that's painting its industry in the most flattering colors possible? Or is management seeing something the rest of the market isn't? Let's consider what Lennar Executive Chairman Stuart Miller said on the company's most recent conference call.
Taking measure of the housing market
Homebuilders have been sending out some mixed signals on the housing market recently. On one hand, you have earnings reports from Lennar and KB Home (NYSE:KBH) that show a noticeable decline in orders. On the other, though, you have LGI Homes (NASDAQ:LGIH) reporting record closings for December and the fourth quarter, as well as guiding for double-digit growth in 2019. These clashing reports don't exactly bring clarity to the state of the housing market.
On Lennar's fourth-quarter earnings conference call, Miller's comments helped explain why these companies could be heading in different directions:
Over the past quarter, market data has clearly indicated that the housing market and recovery has decelerated and seems to indicate a continued slower market ahead. Generally speaking, the increases in new and existing home prices over the past years together with the rapid increase in interest rates, have caused a pause in the housing market and precipitated some price compression. Additionally, labor shortages, trade-driven material price increases, and limited approved land availability have maintained upward pressure on cost.
With recent pressure on both volume and margin, many have become concerned that the housing market has completely stalled. We still do not agree. As rates have started to ease, we have seen traffic pick up. Therefore, we continue to believe the market has taken a natural pause. It will adjust and recalibrate, and demand driven by fundamental economic strength will resume.
What Miller is saying in a roundabout way is that it and some of its peers got caught with too many higher-priced homes. When mortgage rates rise, the customer's buying power declines. While it wasn't immediately evident in Lennar's sales results because of recent acquisitions, management did note that sales slowed down the most in higher-priced markets in California. Similarly, KB Home's West Coast sales were largely responsible for the year-over-year sales decline.
LGI Homes' sales weren't as affected by these issues, because its average price point is considerably lower than those of both Lennar and KB Home. With its average selling prices close to $100,000 lower than those of most other homebuilders, it's likely that potential buyers put off by Lennar's and KB Home's price points turned to LGI.
The market will go on
The housing market may not be as strong as it was a year ago, but that doesn't mean we're immediately headed for a significant slowdown. Miller highlighted some of the reasons investors should remain optimistic that the housing market still has plenty of growth left in it:
We still believe that the housing market is primarily driven by the deficit in housing production that has persisted for over a decade. This production deficit defines an overall housing shortage in the country. Supply of dwellings, both for sale and for rent, [continues] to be short, and underlying demand remained strong though perhaps slower in the short term as the market adjusts to prices and interest rates.
When Miller says the housing market has been in a deficit for over a decade, here's what he means: After the housing collapse back in 2008, housing starts have been well below the historical average.
While housing starts have been historically low, millennials are now at the age when they start to make their first home purchase. Millennials are the second largest age demographic, behind baby boomers, which means there are lots of people looking to enter the market at a time when the housing market has been drawing down inventory for a decade or more.
This situation puts the market in a unique place. On one hand, you have members of a huge age demographic coming to the market for their first home. That should give the market plenty of demand for several years to come. Conversely, first-time buyers are going to be much more price-sensitive. After all, a first-time buyer means no prior home equity to roll into a higher-priced option. It's likely that the market will, as Miller puts it, "recalibrate" as inventories build again and lower home prices make first-time purchases possible.
For some companies, that could mean focusing more on lower price point offerings. Lennar admitted that it will probably sacrifice its margin slightly to maintain market share, so we can reasonably expect its average selling price to decline.
Results aren't great, but it isn't a doomsday scenario
Overall, the housing market doesn't look as bad as Lennar's or KB Home's earnings results suggest. The economy is still growing at a reasonable pace, unemployment is at its lowest in decades, wages are growing, and demographic changes in the U.S. suggests there's a lot of pent-up demand. That demand is going to be much more price sensitive, though, and homebuilders that can adjust to this new buyer are likely to do incredibly well.
For investors, 2019 will be a pivotal year for homebuilders. Those that can keep costs in check and deliver lower-priced offerings are likely to do incredibly well. If not, though, they could be missing the boat on a lucrative market.