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Why Are Home Sales Slowing?

Brian Bernard, CFA, CPA

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Brian Bernard: So far, in 2018, housing demand has slowed relative to last year. While rising home prices and higher mortgage rates have made homeownership a less compelling investment for some and might have completely priced out others from the housing market, especially in high-price markets like in California, we do think that there's other factors involved. We think a tight supply of existing home sales, which is particularly acute with more affordable homes, has really driven that year-over-year decline in existing home sales. Now, it's generally believed that that market is balanced when there's six months' supply of existing homes for sales; as you can see, we are at four months. So, we are undersupplied.

And then, just to touch briefly on the new construction, so that's the starts, the sales, we're up year-over-year but that has slowed. Aside from demand some things that could be slowing it, too, is: there's a tight supply of labor. It's taking longer to build homes and it's taking longer to get entitlements from municipalities. But the hot topic is affordability. And the question is, with the rising mortgage rates and the high home prices, have we hit a breaking point? We don't think so.

We like this chart here to show affordability. So, it is the median mortgage payment to gross income. We think that's a good way to assess affordability. Now, it's not going to be indicative of all housing markets, but it's good for a national level and that's below long-term average. So, we are still good there. Affordability is good by that metric. The fact of the matter is, mortgage rates are rising, but they are still historically low. We're seeing wage growth that's offsetting the higher home prices, and we continue to expect more wage growth and we do expect homebuilders to put out more lower-priced products. So, affordability should stay in check over next decade.

Now, we are bullish on our long-term housing outlook. Why? We do think we are going to see some demographic tailwind from the millennials. As you can see, the millennials, that's a quarter of the population, hitting that prime age for homeownership. Now, the question is, do these guys even want to buy homes. You will see that a lot in the media. But we've done a lot of work, reviewed a lot of surveys, and the fact of the matter is, is that we think that that this generation still aspires to own homes.

In terms of our housing forecast, starts is the blue line, is the historical and our forecasted. Now, we did take a step back, took a fresh look at our underlying assumptions and took into consideration some of the fresh data that's been a little bit weaker than we expected. We did reduce our long-term forecast. We now expect 15 million starts between now and 2027, peaking at 1.6 million. That's about a 10% reduction over our prior forecast. But that's by no means a bearish call. We still expect seven more years of strong residential construction.

Now, we don't think that this is an overly optimistic forecast either. I want to point to this slide, homeownership rates. Now, looking at this younger age cohort, the millennials, so we are showing--this is the historical 2017 and our projection--we are showing some modest improvement there. That's what's driving a lot of demand. But when you look at the overall population, we are projecting 65% homeownership rate. That's well below the long-term average. So, we still think we are being conservative.

Getting back to the forecast here, we do have a couple of scenarios for you. The bull case, that's the green line, that's getting back to about 1.9 million starts. That's getting close to the peak. What do we need to get there? We need strong wage growth. We need loser credit standards, because it is difficult to get mortgages for some. We really need homebuilders to really start pushing out those entry-level homes.

Now, on the flip side, the red line is the bear case scenario. That's saying, hey, we are at about 1.3 million starts, that's as good as it gets. Affordability is going to worsen. Credit standards might get worse. Homebuilders aren't going to build anymore. That's really the assumptions there. Just what you are seeing with the homebuilder stocks and whatnot, we think more of the consensus is more leaning toward this path. But based on all of our work, we are still confident that yellow line, the base case, is the most reasonable outlook. If that's the case, if we get back to 1.6 million starts, that's good for the U.S. homebuilders, that's good for the U.S. building product companies, and a lot of those stocks have been beaten down.