Housing Supply Isn’t So Short. What That Means for the Housing Market–and the Economy (March 5, 2023)

Official data may not accurately reflect the true state of the U.S. housing market.

By Lisa Beilfuss
March 5, 2023

Economic turns often hinge on housing. Investors should be wary of assumptions that the housing market has bottomed.

Housing optimism is spurring renewed hope that the U.S. economy will dash a recession, even after 2022 brought the most aggressive rate hikes in history and even though the Federal Reserve’s tightening campaign appears far from over. The sector makes up nearly a fifth of gross domestic product. More people own homes than have stock-market exposure, meaning households’ willingness to spend is deeply connected to property values. Consider as well that Americans are borrowing against home equity at the fastest pace in more than a decade.

Recent indicators support growing optimism that the worst is over for residential real estate. Sales of new domestic single-family homes rose 7.2% in January, the fourth straight increase to the highest level in almost a year. The NAHB housing market index, based on a survey of builder sentiment, jumped in February to the best level since September 2022. Even a drop in existing-home sales to the lowest level in 12 years was well received as some analysts said a slowdown in the pace of decline means that a bottom is near.

But there are several reasons why investors should remain skeptical that housing is turning a corner. That isn’t to predict housing armageddon. There are some factors, such as the level of M2 money supply still 38% above pre-pandemic levels, that support a higher floor than might otherwise be the case. The point is that the worst probably isn’t close to over for real estate, which upends some broader, positive assumptions about the strength of the U.S. economy and financial markets.

The first two reasons to question housing optimism are straightforward. First, monetary policy works with a lag. Michael Kantrowitz, chief investment strategist at Piper Sandler, says it is naive to expect any kind of economic or market bottom now given that the first hike in this cycle was not quite a year ago.

“This is the nastiest tightening cycle we’ve ever seen, and it takes 15 to 18 months to show up,” says Kantrowitz. Already-implemented Fed policy may only be starting to spur layoffs and broader contraction, and that is to say nothing of the risk the Fed tightens more and holds rates higher for longer than anticipated. Housing will worsen as long as either mortgage rates rise or employment deteriorates, Kantrowitz says.

Second, the falling mortgage rates that boosted recent housing activity have reversed and aren’t yet hitting the data.

The third reason to doubt an imminent housing bottom runs contrary to the conventional wisdom underlying most housing-market analysis: Housing supply may not be as short of demand as presumed.

Investors tend to focus on existing homes because they represent a bigger share of the overall market. Supply of previously owned homes is all but frozen as 99% of current mortgages have interest rates below current market rates, according to Goldman Sachs. Months supply of existing homes, or the number of months it would take for current inventory to sell at the current sales pace, is at an historically low 2.9. Months supply for new homes stands at 7.9, resulting in an unusually large gap between the supply of existing and new homes.

Oversupply in one area doesn’t neatly solve undersupply in another. And new homes aren’t perfect substitutes for existing homes because new construction is often more expensive and in less-appealing areas. But housing under construction remains near record levels, and some analysts say new homes are close enough substitutes for existing homes–especially given the dearth of previously owned homes for sale. What is more, new-home supply may be much higher than data show, threatening a real-estate price shock as builder price cuts weigh on existing-home prices.

Melody Wright has been in the housing business since 2006 and now runs a mortgage strategy and fintech company. Suspicious of dovetailing narratives that housing supply remains scant and real estate is bottoming, she hit the road. “I needed to know for myself,” Wright told Praxis on day nine of her roadtrip to survey new-home communities and construction sites in and around Nashville, Tenn., Austin, Texas, Tampa and Jacksonville, Fla., and Charlotte, N.C.

She described development upon development with little to no occupancy or potential-buyer traffic. In one stretch near Round Rock, Texas, about 20 miles north of Austin, she counted seven new developments within a span of a mile where the price per square foot was around $279, 26% above the national average.

“They park construction trucks and cars from the workers and pull the new garbage cans to the road to make it look like the homes are occupied,” Wright said, referring to developers’ attempts to demonstrate signs of life. She told of coming-soon signs across exurbs and megasites promising in 2022 gas stations and grocery stores that don’t exist and of sheriffs policing empty sites.

“The emptiness, the desolation, it is wild,” she says of sites across the states she surveyed. “Bubble is too light a word to describe this oncoming storm.”

Homebuilders are already reporting faltering deals. KB Home (KBH), for example, said customers backed out of 68% of signed contracts in the fourth quarter. A sales representative for one of the country’s biggest builders warns the situation is more dire. In recent months, sales reps have mostly written unqualified contracts they know won’t close for fear of missing quotas and being fired, the person says.

“Builders are inflating the numbers,” says the person, meaning inventory is likely higher than reflected because many deals won’t close. “Most new sales are worthless.”

Housing analyst Ivy Zelman, co-founder of Zelman & Associates, has warned that new-home construction is ahead of demand and that estimates of a housing-supply deficit are overblown. The problem, she said in a 2021 interview with The Real Deal, is that demand isn’t insatiable but a mirage. The market moved too fast to accurately track it, in part because historically low mortgage rates and the Fed’s massive bond-buying program supercharged record investor purchases of single-family homes.

Investors bought about a quarter of properties sold during the pandemic boom, up from an average of about 15% in the prior decade. Small investors, as opposed to institutions, comprise the vast majority of the investor category. Many bought properties without physically seeing them, aided by online real-estate investing platforms and debt service coverage ratio, or DSCR, loans.

The DSCR market is small. But banks are securitizing the loans, and the niche speaks to forces that Fed tightening has yet to unwind. Such loans don’t require income verification and are instead based on an estimate of a property’s cash flow. Mortgage broker Gaetano Ciambriello says DSCR loans boomed in popularity during recent years. He adds that customers who have used DSCR loans typically can’t qualify for conventional loans and often take on multiple so-called landlord loans.

Should a property lose value and the DSCR ratio fall below 1, meaning cash flow fails to meet debt-service obligations, a borrower faces default unless it raises the tenant’s rent, refinances, or does both. The former can be tough in a broad downturn, while the latter option requires falling rates and usually involves a prepayment penalty.

The housing market is made up of many moving pieces. An examination of them makes it hard to view the notion that real estate is sustainably recovering as something other than wishful thinking dotted by blind spots. The question isn’t if housing–and thus the economy–will fall from here, but how far and for how long.