For the first time in a while, it looks like homebuilder stocks and lumber are both sending the same message, and that spells trouble for housing and the real estate market broadly.
Homebuilder stocks represent the shares of companies that primarily engage in residential construction. These companies benefit from a booming real estate market, as increased housing demand generally translates to higher revenues and profits.
There’s been an abrupt turnaround in trend here as mortgage rates continue to surge higher. If we use the SPDR S&P Homebuilders ETF (NYSEARCA:XHB) as a proxy, we can see homebuilders hit prior highs and then abruptly weaken. The downtrend may still be intact, and one can argue it probably should be.
Lumber, on the other hand, has gone largely nowhere. It’s also starting to weaken again relative to gold (one of the relationships I reference as a leading indicator of risk-off conditions). The average home has 16,000 board feet of lumber, and there’s a strong correlation between lumber and housing starts because of the long tail of construction. A lack of a pickup here, and some potential near-term weakness, confirms the same kind of sentiment we are now seeing in homebuilder stocks.
This really shouldn’t be a shock. The downturn is largely attributable to rising mortgage rates.
What Rising Mortgage Rates Mean for Housing
The increase in mortgage rates discourages potential homebuyers, leading to a decrease in demand for new homes. High lumber prices in 2021 were a result of a “shock to the system” caused by the Covid-19 pandemic, including supply chain disruptions and unprecedented demand for new homes. With normalization in lumber prices comes a clearer signal of relative momentum.
This is important here as we may be nearing the end of mortgage rate buydowns. In response to rising mortgage rates, homebuilders had been resorting to this strategy to keep revenue going. A mortgage rate buydown is essentially a subsidy provided by the builder to the buyer, reducing the interest rate for a set period, usually 1-3 years. After this period, the mortgage resets to a higher monthly payment. This strategy is used to attract buyers, offering them initial lower payments that eventually reset to higher amounts.
While mortgage rate buydowns may seem like an innovative solution for homebuilders, they can have potentially disastrous consequences for buyers. Once their mortgage resets to a higher payment, buyers may find themselves unable to afford their mortgage, especially if interest rates continue to rise. The popularity of mortgage rate buydowns as resets happen into a potential recession next year could dramatically backfire on go-forward demand for housing.
But wait, what about inventory? There has been a continued shortage of supply in the housing market, causing prices to go higher. As I have noted continuously, this is an easy problem to fix with fear. The moment unemployment sustainably rises and second and third homeowners who rent their properties out suddenly see cash flow dry up, more homes will be available potentially at fire-sale prices. This will spark broader fear and potential contagion nationally.
The Bottom Line
The bottom line here is simple. I’ve been wrong (or perhaps just early) warning about housing for the past year and a half. That doesn’t mean housing will continue to advance going forward though. The stock side is sending a warning, the commodity side with lumber is sending a warning, and only time will tell if narratives around housing inventory justifying high prices are real, or just following past trends that are about to reverse.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
