Prospective homebuyers and investors alike have been watching the U.S. housing market’s meteoric rise over the past couple of years, with homebuyers hoping price increases would cool off soon and investors rejoicing in the opposite.
Amid record low interest rates and low inventory driven by more than a decade of underbuilding, for a while it seemed like nothing could stop the red-hot housing market. However, with interest rates on the rise again and sellers fighting back against marking down their prices, demand is finally beginning to fall off.
Whether there have been price decreases or simply a deceleration in price increases depends on the area; for example, Dallas home prices increased 15% year over year in July while Boise, Idaho saw 70% of home sellers drop their asking prices that same month.
Nevertheless, the market is cooling down overall, as demonstrated by existing home sales for the 12 months ended in July declining to the lowest level since November 2015 (excluding the market freeze in early 2020). Homebuilders are also scaling down their operations as more buyers back out of deals. D.R. Horton (DHI, Financial), the largest homebuilder in the U.S., said that its cancellation rate jumped to 24% in its fiscal third quarter, which ended June 30.
In light of the housing market slowdown, let’s take a look at how various classes of stocks related to the housing market could perform going forward.
Homebuilders
Homebuilders like D.R. Horton are well-known examples of cyclical stocks, though their cycles tend to be longer than commodities like steel. In general, we can expect homebuilders to suffer when the economy is not doing well.
However, there are two factors that have propped up the homebuilding industry and contributed to long-term profits for shareholders: declining interest rates over the past four decades and chronic underbuilding.
The unstoppable tide of ever-decreasing interest rates has supported faster home price increases, as any small interest rate drop provides a significant discount for a 30-year mortgage payment. Meanwhile, underbuilding ensures there will be greater competition for properties and more people (and thus more income) per household on average.
Below is a chart comparing the share prices of three major U.S. homebuilders: D.R. Horton, Lennar Corp. (LEN, Financial) and Toll Brothers Inc. (TOL, Financial). As we can see, despite a peak and trough surrounding the financial crisis, there has been a general long-term uptrend:
Interest rates are unlikely to decrease forever, especially now that the Federal Reserve has already hit and bounced off the 0% mark. We might see some minor decreases again once inflation stabilizes, but they will not be able to provide nearly as much impetus as the decreases of the past few decades.
Underbuilding, on the other hand, is likely to continue and could even accelerate. If homebuilders continue to see high cancellations as the economic situation worsens, they could begin to slow down the pace at which they build new homes, not wanting to risk building a bunch of houses only to be forced to sell them at unsustainable discounts.
It seems likely that homebuilders might suffer a short-term setback if cancellations remain elevated or worsen. With new housing starts in 2022 up 42.3% compared to the 120-month average according to data from the U.S. Census Bureau, there might be a lag before the full pain sets in, as even discounted houses will still bring in cash until builders begin to decrease housing starts. On the other hand, the long-term outlook remains positive.
Real estate tech
The biggest losers of this housing market slowdown have been and probably will continue to be real estate technology stocks. These stocks are seeing their share prices tank due to the double whammy of declining business and falling tech stock valuations.
For example, real estate information aggregator and advertiser Zillow Group Inc. (ZG, Financial) saw business spike even more than the housing market as more people were using its resources to search for available properties online. There was also a lot of excitement surrounding the company’s moonshot algorithm-driven home-flipping business, which turned out to be a dud due to the inability to account for things such as desirability of location and cost of renovations. After peaking at over $190 per share in February 2021, Zillow stock is back around Covid-crash lows at $33.
Opendoor Technologies Inc. (OPEN, Financial) is a newly-public company that uses a proprietary algorithm to trade houses for profit. A common misconception is that it is a home-flipper, but Opendoor does not flip homes, instead relying on selling fees, home mortgage interest and trying to buy houses at a discount for resale at market value. This as-yet-unprofitable company is not likely to turn profitable anytime soon if housing prices or sales volume decrease.
Stocks like these will likely need a catalyst such as a flourishing economy, a hot housing market or actually becoming profitable in order to recover.
REITs
One class of real estate stocks that tends to hold up well even in recessionary conditions and housing market slowdowns is real estate investment trusts. That is because REITs rely on rent money as their main source of income, and by law, they must pay out 90% of their taxable income as dividends to investors.
Additionally, REITs are broadly considered to be good protection against inflation, since the value of real estate holds up well in the long term. While homebuilders and traders might sometimes be forced to sell at a loss due to the need for cash or the risks of holding on to unoccupied property for extended periods of time, the rental income that REITs collect is usually more stable and reliable.
Rent prices also have not increased as rapidly as housing prices over the past couple of years, especially when we factor in the impact of interest rate increases on mortgages. Thus, there is a bit of wiggle room for financially distressed consumers to sell their homes and become renters if needed.
The below chart shows how the share prices of three REITs, Realty Income Corp. (O, Financial), Annaly Capital Management Inc. (NLY, Financial) and American Campus Communities Inc. (ACC, Financial) performed during the 2006 to 2011 time period surrounding the last housing market crash.
Takeaway
Several signs are pointing to a housing market slowdown. While we have no way to know ahead of time how bad it will get, it is unlikely to be as severe as 2008 due to factors such as underbuilding, the long-term decline of interest rates and inflation (which has brought up not only housing prices but also wages for workers in some industries).
Homebuilders could be risky at the moment due to the combination of increasing cancellation rates and accelerated housing starts. Housing-related technology stocks are suffering both from the housing market slowdown and the decline of investor enthusiasm for tech stocks. REITs remain one of the safer classes of real estate investments due to the predictability and stability of rental income and solid dividend yields, even if they are not usually good for outperforming on the capital gains front.
