Chaos has subsumed the housing market in 2022. Mortgage rates have shot up at a record pace, recently hitting an average of 7% across the United States. These rate increases have made it increasingly difficult for people to afford a home, which has gotten investors nervous about the prospects of the housing industry over the next few years. The iShares U.S. Home Construction Exchange Traded Fund (ITB 0.79%) is down 38% this year, almost double the 22.8% drop in the S&P 500 over the same time period.
With the homebuilding sector trailing the market in 2022, is now the time to buy the dip on some homebuilding stocks? Let's investigate.
The good: Short supply and demographics
Let's go through some reasons why the housing market -- and specifically the homebuilding industry -- will likely do fine over the next few years. From my point of view, it comes down to two factors: A supply shortage and demographics.
A national report last year estimated the U.S. was short 3.8 million housing units, which could take over a decade to remedy. This shortage can provide steady demand for homebuilders as the country works hard to close this supply gap.
Many states have goals to build a certain number of housing units as well. This political support could give homebuilders a boost in demand, regardless of where the economy heads in the short term.
On top of the current supply shortage, the age demographics of the United States look promising to drive housing demand for the next 10 years. The millennial age cohort of 25-40 is the largest in the country. Early adulthood is the prime homebuying period for most people, so this influx of aging millennials should create tons of homebuying demand.
The bad: Affordability and price declines
Let's get to the ugly stuff, which is the extreme rise in mortgage payments over the last year. In 2020 and 2021, with the Federal Reserve keeping interest rates at zero, mortgage rates fell to all-time lows. This made it easier for people to buy homes, even with the average home price going through the roof.
The majority of a home purchase is fueled by debt, so if the interest rate on that debt is low, it can be quite affordable to buy a home even if the sticker price looks high.
That all changed in 2022 when the Federal Reserve started aggressively raising interest rates. Mortgage rates have gone up, hitting a multi-decade high of 7% in September. According to Redfin, this has caused the average monthly mortgage payment to climb 50% year over year to $2,547, an all-time high.
A 50% rise in monthly mortgage payments is extreme and is likely pricing out many potential homebuyers at the moment. Redfin is seeing this in its data, with an estimated 17% of home deals called off in September, an all-time high (excluding March 2020). The number of homes sold dropped 25% in September as well.
In order to get supply and demand back into equilibrium, housing prices will likely have to fall by a significant amount across the U.S. This could negatively affect homebuilders profit margins over the next few years, thereby decreasing the earnings power of these businesses. If material and labor costs stay the same or rise, but homebuilders have to sell units at a 20% discount, profit margins are going to get crushed in the near term.
So buy or sell?
Right now, I think it is best to avoid the homebuilding sector and stick to industries not as affected by interest rates or inflation. However, if you want to take the plunge and buy a homebuilding stock, it's best to find one that's high-quality and run by an intelligent management team. One on my watchlist is NVR (NVR 1.58%), an asset-light homebuilder with a clean balance sheet and a track record of conservative growth.
The stock is up almost 40,000% since going public a few decades ago. Even if the housing market gets crushed over the next few years, NVR will likely come out clean on the other side.