Anyone who has bought or considered buying a house over the past year has probably experienced firsthand how difficult it is to find any availability in their price range. It seems like there are fewer and fewer homes, both new and old, hitting the markets as of late, especially near the national average “starter home” price point of around $300,000.
The logical solution to this would be to build more homes. Not only would this result in higher profits for homebuilders in the short term, but it would also slow down the explosive growth of housing prices, thus making it less likely for people to be priced out of the market and forced to move in with relatives or roommates rather than buying places of their own.
However, this doesn’t appear to be what homebuilders have been doing. From January 2012 to June 2021, around 12.3 million American households were formed, but only 7 million new single-family homes were built over that same period of time. According to recent research from Realtor.com, the U.S. is now short approximately 5.24 million homes, an increase of 1.4 million compared to compared to the 2019 gap.
Why haven’t U.S. homebuilders been keeping up with housing demand, and what does that mean for homebuilders, real estate companies and housing prices? Let’s take a look at several long-term trends in homebuilding to see if we can find answers to these questions.
Labor and materials
As with any case of demand growing faster than supply, the bulk of the issue stems from insufficient supply chains. Even if homebuilders want to build more homes, they are not able to due to the scarcity of labor and raw materials.
Home construction has been suffering from a labor shortage since well before 2020, but the Covid-19 pandemic exacerbated the issue. The construction industry was shut down for only a few months last year before being deemed essential and allowed to return to work, but construction companies have only recouped about 80% of their workforces since then.
Wages aren’t the problem. The labor shortage in construction has been bad enough that companies have been regularly poaching workers from other construction companies by offering higher wages, and even entry-level wages have risen by as much as 40% over the past year.
The problem lies with the fact that fewer and fewer people want to do construction work. It’s tough labor that not everyone is physically capable of, and with shop classes being phased out of school curriculums across the country in favor of things like tech education, young people are not being introduced to the basic skills that would spark an interest in construction work.
New jobs in construction are expected to amount to 1 million over the next two years according to Associated Builders and Contractors, and the million-dollar question is whether the industry will even be able to attract that many new workers. Companies are increasingly turning to technology to make up the gap, including drones, robotics and additive manufacturing, and while these jobs are more attractive to younger generations and more in line with the skillsets they are taught in school, it is unclear how much they will be able to make up for the shortage of on-site workers.
In addition to the labor shortage, homebuilders are also facing a materials shortage. In the short term, supply chain disruptions have pushed the prices of materials such as lumber higher, and in the long term, issues such as deforestation, climate change and increasing population density will likely widen the gap between available materials and demand for new housing.
Quality and gentrification
Due to labor and materials shortages, some homebuilders have lowered their guidance for home closings. If they can’t increase profits by building more homes or reducing production costs, there’s really only one thing to do, and that’s to build homes that will fetch a higher price.
The process of demand shock causing price and quality to rise is a form of gentrification. If a company must pick and choose which customers to cater to, it will choose to cater to the wealthiest buyers, since they have the money to pay a higher price. To illustrate this, homes with a median value of $300,000, which is considered relatively affordable on average, represented 32% of builder sales in the first half of 2021, a significant decrease from 43% during the same period in 2018.
Increasing the quality of an existing home is an even more cost-efficient method of gentrification than building more expensive new homes, and as the gap between housing demand and supply widens, it is becoming more common for investors to snap up cheaper properties, update them and sell them at a premium.
This bodes well for certain real estate and real estate investment trust stocks. While these stocks tend to be a more mixed bag compared to the stocks of homebuilding companies, since homebuilders have little real pricing power and are forced to compete on more or less equal footing, real estate companies will likely benefit from an increase in demand for homes and residential rental properties that are not new constructions.
The more people are priced out of the new home market, the more will enter the market for the resale of older real estate, and the more will turn to rentals instead. This will drive the prices of these places up, and if they find themselves with more demand than supply, landlords can simply increase prices so that those with lower income are automatically disqualified.
Of course, this works better for real estate companies that help sell property outright than it does for companies that rent out their properties, as landlords normally operate on high leverage due to the cost of buying property. In order to grow faster than the rate at which their properties naturally appreciate in value, they need to acquire more real estate, and if this new real estate is purchased at a higher price, it will become even more difficult to turn a profit. Combine this with the potential for interest rate increases in the future and the amount of rent landlords would need to charge in order to remain solvent could rise even faster than what the scarcity-driven market can support.
Interest rates and credit
One major driver of rising home prices that is often overlooked is interest rates. On the surface level, most people are aware that a lower interest rate allows people to qualify for larger home loans. However, the gradual trend of interest rates being lowered over the past few decades has also helped push home prices higher.
Going forward, it’s likely that the “ever-decreasing mortgage rate” tailwind will likely all but disappear from the housing market, knocking out one factor driving price increases. The only way for interest rates to continue to go lower would be if the Federal Reserve pushed the base rate into negative territory, which certainly isn’t outside of the realm of possibility, but it would bring a whole host of changes to the market that are outside the scope of this discussion.
On the other hand, if the Fed begins to raise interest rates again, it will cause mortgage rates to increase as well, reducing the prices that people are able to pay to purchase new homes. While the central bank has decided to keep the base rate at zero for the time being, that might not be the case forever, especially if inflation gets out of control.
A decline in purchasing power across the board combined with a worsening supply shortage would be a recipe for disaster in terms of housing availability. In such a situation, many of the lowest-valued homes that are still in plentiful supply due to people not wanting to live in them could see a sharp price increase.
Conclusion
Homebuilding and real estate are industries that want to grow. They have the demand, and they have the attention of investors looking to make a significant profit. However, they lack sufficient resources to meet demand, which limits their upside potential.
Add in the fact that housing prices in the U.S. have increased a whopping 70% over the past decade compared to a measly 30% gain in the median income over the same period of time, as well as the fact that there is no longer much room for declining mortgage rates to increase consumer purchasing power, and we have a recipe for a potential housing crisis on the horizon. At the very least, it seems that many homebuilding and real estate stocks could reach a price ceiling soon as their growth flattens.
