How Far Will Economic & Wage Growth Push Housing Demand?

Housing is on solid ground. While the newly enacted tax reform bill creates a complicated set of impact, the underlying trends for the U.S. homebuilding industry are positive, given solid macroeconomic fundamentals and tight existing home inventory. Importantly, disruptions caused by the hurricanes and other natural disasters also seem to have short lived as revealed by recent economic data reports.

Although the December housing data were not impressive, the larger picture is indeed overwhelming. Existing home sales ended the year 2017 with 1.1% gain, the highest since 2006. Building permits increased 4.7% and housing starts rose 2.4% in 2017 from the 2016 figure.

The industry advanced almost 69% in 2017, outperforming the broader market’s (S&P 500) growth of 19.7%. Moreover, January 2018 builders’ confidence reading remained in the 70s, signaling that housing demand should continue to grow this year, courtesy of healthy demand and strong economic growth.

Again, there are signs of increased inclination of home purchases among millennials, a generation that had, to some extent, refrained some from entering the market.

For that matter, there are plenty of reasons to be optimistic about the broader housing sector for both the short and the long term. Below we discuss a few key factors driving the sector and what investors can expect going ahead.

Robust Economic Growth

The nation’s Gross Domestic Product (GDP) grew at a seasonally adjusted annual rate of 2.6% in the fourth quarter of 2017 following gains in the previous two quarters of more than 3%, per the “advance” estimate released by the Bureau of Economic Analysis. This marked the economy’s strongest stretch of growth since the expansion started in mid-2009.

Consumer spending, the main engine of the economy, grew 3.8% over the quarter after a 2.2% gain in the third quarter. Fueled by robust economic growth, Fed policymakers reckon three rate hikes this year, setting the stage for an increase in mortgage rates. Nevertheless, Americans are getting heavier pays now, with wages growing at the quickest pace since the end of the last decade.

President Trump aims to double economic growth through an ambitious stimulus program featuring tax cuts, deregulation and higher infrastructure spending. Although this may face varied obstacles, we expect the plan to help the economy grow at a faster clip in 2018.

This upbeat expectation holds particularly true when one of the nation’s key economic drivers, i.e. construction activity, is gradually strengthening its footprint accompanied by a declining unemployment rate. General unemployment rates in America have stayed at a 17-year low of 4.1% for the fourth straight month, with around 200,000 jobs added in January 2018.

Construction is one of the sectors that has been providing good employment opportunities, along with other sectors like food services and drinking places, health care and manufacturing. Improving economic growth supported by a better employment picture generally boosts housing activity and provides the basis for stronger demand.

Higher Demand, Low Inventory to Boost Price

Steady economic growth along with favorable demographics and the attractiveness of ownership versus rental are driving demand. Per the National Association of Realtors or NAR, existing home sales witnessed 1.1% increase to 5.51 million units, the highest since 2006.

On the other hand, a shortage in buildable lots, skilled labor and available capital for smaller builders are limiting home production, thereby lowering the inventory of homes, both new and existing. The convergence of healthy demand and low inventory levels is giving a boost to prices and is expected to continue doing so for some time.

The supply of December existing homes decreased 11.4% from November and 10.3% from the year-ago period. It has fallen year over year for 31 consecutive months. As such, it will take only 3.2 months to deplete the current supply of homes in the market, according to NAR.

Thanks to low inventory and high demand, median sales price of existing homes increased 5.8% in 2017 from a year earlier. The median sales price of new homes sold in 2017 was $321,100, 4.3% higher than 2016.

We believe prices will continue to scale as demand for homes is likely to grow on high consumer confidence and low unemployment. Improving labor markets, declining unemployment rates and limited home supplies are driving home prices, thereby giving a boost to homebuilders’ top line.

For 2018, National Association of Home Builders or NAHB expects continued growth for home construction and remodeling. The home improvement sector should also remain strong given recent home price gain, increases in homeowner wealth and other lifestyle improvements.

Millennials Take Interest

Millennials — those born after 1980 — are anticipated to continue to make up a large and growing portion of the buyer section, although many disagree with this view. This is due to the fact that millennials occupy the largest adult generation and make up the greatest percentage of the workforce.

First-time buyers comprised 32% of sales in December 2017, which is up from 29% in November and unchanged from a year ago. NAR’s 2017 Profile of Home Buyers and Sellers, released in late 2017, revealed that the annual share of first-time buyers was 34%.

Boosting Land Bank Amid Rising Costs

U.S. homebuilders have been seeking various ways to increase their land holding amid rising land acquisition costs and a tight labor market that hinder efforts to tap the recovery in the housing market.

Again, limited capital for land development has left entitled lands in short supply, while growing demand drives land prices. The labor market has also tightened with limited availability of labor, arresting the rapid growth in housing production.

Land development and homebuilding are correlated but fundamentally different operations. Prominent homebuilders are buying out major land developers that will help them address the ongoing issues.

In Oct 2017, Lennar Corp. (LEN) agreed to take over CalAtlantic Group Inc. (CAA) in a $9.3 billion deal (including debt), which will create one of the country’s top three home builders in 24 of the top 30 U.S. markets. CalAtlantic investors would own approximately 26% of the combined entity upon the deal's expected closing in February 2018. The combined company will have a footprint touching approximately 50% of the U.S. population and the combined entity is expected to generate meaningful cost savings.

The deal is expected to generate roughly $250 million in annual cost savings, with about $75 million in savings expected in fiscal 2018. The savings include lower overhead costs and elimination of duplicative corporate expenses. Earlier, in February 2017, Lennar acquired Florida-based homebuilder WCI Communities Inc., a premier lifestyle community developer and luxury homebuilder of single and multi-family homes, to enhance its land holdings.

Again, in Oct 2017, D.R. Horton, Inc. (DHI) acquired 75% share of Forestar Group Inc. (FOR), a residential and mixed-use real estate development company, for about $520 million in cash. This buyout will give a meaningful percentage boost to D.R. Horton’s current holdings of 252,000 lots (owned and under control), as of June 2017. The company is on track to close 45,800 to 46,200 homes in fiscal 2017.

The deal would add to D.R. Horton's fiscal 2018 earnings. The Forestar integration is in sync with D.R. Horton’s long-term strategy of developing strong relationship with land developers across the country and growing the optioned portion of its land and lot position to enhance both operational efficiency and returns.

How to Play the Industry

Major homebuilders are well poised on the positive fundamentals of the housing market. Particularly, given the cheap valuation compared with the broader market, this is perhaps the right time to pick a few stocks from the Zacks Homebuilding Industry.

We recommend those that are witnessing positive estimate revisions and carry a Zacks Rank #1 (Strong Buy) or 2 (Buy): CalAtlantic, Century Communities, Inc. (CCS), M.D.C. Holdings, Inc. (MDC), D.R. Horton, Taylor Morrison Home Corporation (TMHC), KB Home (KBH), Lennar, M/I Homes, Inc. (MHO), Meritage Homes Corporation (MTH), NVR Inc. (NVR), Persimmon (LON:PSN) Plc (PSMMY) and TRI Pointe Group, Inc. (TPH).

CalAtlantic, Century Communities, M.D.C. Holdings, D.R. Horton and Taylor Morrison sport a Zacks Rank #1, while the rest carry a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.

Conclusion

Though homebuilders admit to rising labor shortage and land/labor costs, they remain optimistic about a measured recovery this year in tandem with steady economic growth.

The housing industry is cyclical and is affected by consumer confidence levels, prevailing economic conditions and interest rates. Although rising interest and mortgage rates, land and labor shortages, and rising material prices raise concerns, the 2018 outlook for homebuilding seems to be solid given strong economic growth and labor market. Investors could also take advantage of the homebuilding-sector opportunities in the near term.

Check out our latest Housing Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.