Residential real estate shows room for growth
But gathering policy, cost headwinds imply rising risk
The fundamental outlook for the housing sector remains strong even as gathering policy and cost headwinds imply rising risk as the residential investment recovery enters its eighth year. Even so, strong job gains, rising wages, demographics and historically low interest rates are supportive of sustained, if modest, improvement in the industry and are poised to offset current inflationary, financial and policy headwinds.
The major challenge for housing is on the supply side due to regulatory costs, which absorb one out of every four dollars invested in new startups. Meanwhile, a lack of useable lots across the economy, a lack of skilled labor to build new homes and the recent tariff imposed by the Trump administration on soft Canadian lumber are also risks to the outlook.
That said, based on the first three months of data in 2017, we maintain our forecast of housing starts to reach 1.3 million on average this year and for sales of new homes to increase 8.5 percent to about 600,000 at an annualized pace. That would still leave the housing market about 350,000 units below the long-term equilibrium of 1.6 million starts at an annualized pace, which means there is room for growth in coming years as long as policy is aligned with greater residential investment.
Policy risk and cost structure
The recently announced 20 percent tariff on soft Canadian lumber will directly alter the cost structure of residential investment. Imported lumber from Canada accounts for 31 percent of all wood used in residential structures. We estimate that the tariff will add, at a minimum, 1.1 percent or about $3,600 to the median price of a new home ($315,100 as of March).
MIDDLE MARKET INSIGHT: The combination of rising input costs and trade protectionism represent the major risk to middle market firms that feed into and profit from the homebuilder ecosystem.
Equally damaging has been the 9.4 percent increase in the price of soft lumber since the election. The Random Lengths Composite Index for lumber, closely in the industry, is up 22 percent since the beginning of the year on expectations of a White House policy shift on trade. On a year-ago basis, the price for soft lumber is up 12.9 percent.
The rising cost structure due to this change in in policy will generate headwinds for homebuilders that may require price increases of near 2 percent, with most of that cost passed through to consumers, to keep gross margins flat across the industry (framing lumber accounts for about 18 percent of the cost of a single family unit so the increase in prices will impact overall activity and cause further problems with affordability at a time of rising rates).
Single family starts averaged 832,000 per month in the first quarter, the strongest start since 2007. Through the end of the first quarter starts of single family residences (SFRs) are up 9.3 percent on a year-ago basis and multifamily dwellings (MFDs) are up 8.8 percent during the same period. Currently there are 1.085 million units under construction, slightly above the 1.068 million six-month average, with 454,000 SFRs and 631 MFDs under construction. Completions during the first quarter averaged 1.151 million, slightly above the six-month average of 1.38 million at an annualized pace. Just as encouraging is the fact that household formation appears to be growing again at just above a 1.2 million pace through the first quarter.
Given that the major impetus for growth during the housing recovery has been multifamily starts the improvement in single family residence starts is particularly encouraging as it reflects a normalization of the national housing stock. The forward-looking permits data points toward a move in the near term toward 1.26 million at an annualized pace, and we continue to anticipate growing demand linked to solid economic fundamentals which will support a move toward a peak of 1.3 million this year. With vacancy rates in housing increasing to 7 percent, we don’t expect a sustained move in overall investment conditions much above our forecast.
Housing sales, while showing modest gains, are facing constraints that are mainly due to a lack of supply. This has caused an increase in pricing and intensified affordability issues across the economy. In particular, local ordinances have created a regulatory headwind that will be difficult to unwind given the political polarization across much of the nation. The median price of a used home is $278,500 and is up 5.3 percent from a year ago, while the median price of a new home is $315,100, up 1.2 percent. Meanwhile, the most recent Federal Reserve’s senior loan officer survey indicated a net tightening of lending conditions across the economy, while the rate on a conventional mortgage rate stands at 4.31 percent.
Despite those headwinds, existing home sales posted a cycle peak of 5.71 million and were up 5.6 percent through the end of the first quarter. Real residential investment, including brokers’ commissions, was up 13.7 percent in the first quarter and was one of the few bright spots in the growth picture to kick off 2017.