Builders still going Crazy: 2 Million Units under Construction

The US Census Bureau just released new home building data. And boy, this data was a doozy. The report showed that home builders across America currently have a record 2.0 million units actively under construction or permitted.

These units will get dumped onto the US Housing Market in 2023 and 2024 just as the economic recession worsens. Putting downward pressure on both home prices and rents.

Despite these headwinds, single-family builders are reporting improved sentiment and feeling more optimistic about the future. Their stock prices have surged. However, I don't think those good feelings are going to last for long.

That's because the data is clear: America is exiting a long housing expansion and is now entering a protracted downturn. It will take years before builders are able to clear out all the units in their construction backlog.

A LOT of Houses and Apartments are about to be Delivered

The building backlog is comprised of 1.7 million units actively under construction plus another 300k permitted and waiting to to break ground.

Which combined at 2 million is the second-largest construction backlog ever. Just barely falling below the previous peak that occurred in 1973 and smashing the other peaks that occurred in 1978, 1986, and 2006.

What's amazing is that building backlog has stayed stubbornly high, even as the housing downturn has started. That's because 2+ years of materials and labor shortages caused lots of projects to be paused or severely delayed. And only now are builders starting to catch up.

You can see this "catch-up" by comparing housing permits v housing completions.

At the peak of the Housing Bubble last summer, builders pulled nearly 1.8 million permits over the previous 12 month period while only completing 1.3 million. This gap between permits and completions, which lasted nearly two years, is what kept the construction backlog growing.

Now the trend is reversing. New permits are collapsing fast while completions are rising. A trend that will likely continue throughout the rest of 2023 and well into 2024 as builders clear out all of the excess inventory they have in backlog.

The Homebuilder Cycle drives Recessions

This historical data on homebuilding makes one thing clear: builder behavior predicts recessions.

Builders start by heavily ramping up construction during periods of economic expansion. After all, more money and more jobs means more people who want to buy homes and rent apartments.

But when interest rates go up and the economy starts to slow, builders get caught. They suddenly have a big pipeline of construction in a declining demand environment. As a result, they cut back hard on new developments.

Historically that cut back lasts anywhere from three to six years. And results in a 55% reduction in their building backlog. This builder "deleveraging" tends to occur as the economy falls into deep recession.

We are likely now in the beginning stages of another protracted decline in builder activity. Home builder backlog peaked in America in October 2022, only seven months ago. Suggesting we have another three, four, maybe even five years of builders cutting back so they can work through the backlog.

We likely won't see a bottom for building activity until at least 2025 or 2026. This bottom in building activity will likely also correspond with a bottom in the broader economic cycle. As manufacturers and retailers go through a similar deleveraging process. Suggesting that this downturn has a long way to go.

Big differences between Houses v. Apartments

This deleveraging process for builders is already well underway. Particularly for single-family homes.

The builder backlog in single-family has dropped down to 830k, a 15% reduction from peak in the middle of 2022. This is occurring because builders have pulled back hard on the permitting of single-family houses over the last year.

Meanwhile, builders of apartments and condos are not yet in the deleveraging phase. The backlog of multi-unit structures has kept growing, surpassing 1.1 million units under construction and permitted in the most recent data. Near an all-time high.

These diverging trends indicate that we will begin to see a slowdown of newly completed single-family homes occur sometime in 2024. While we will likely continue seeing new apartments and condos completed well into 2025.

Expect heavy downward pressure on rental rates as result, particularly in the luxury apartment segment of the market. Declining rent growth is something that should eventually translate into lower home prices.

Home Builder Sentiment is Improving?

An interesting wrinkle in the home builder story is that, despite the large backlogs and waning demand, single-family builders are starting to feel more optimistic in 2023.

This is confirmed by the NAHB Builder Survey. Which tracks the sentiment of single-family builders each month. The May survey just came out and showed that builder sentiment improved to an index level of 50. With reported home buyer traffic at builder sites rebounding to an index level of 33.

These figures are a big improvement off the lows experienced at the end of 2022. However, they are still poor. Registering 30% below pre-pandemic norms for each.

The main driver of the improved builder sentiment is a lack of inventory on the resale housing market.

Depressed seller listings of existing homes has made for a historically tight inventory environment in 2023. Which is now throwing a life-line to homebuilders as newly built homes now account for 33% of all the listings on the market in 2023. That's a record high share and more than double the long-term average of 14%.

Higher market share of inventory has allowed single-family builders to maintain decent sales volume even though aggregate homebuyer demand is at the lowest levels in 20 years. The result has been surging home builder stock prices and renewed optimism on the state of the housing market.

Except there's a problem: Low Inventory Won't Last

Single-family builders right now are benefitting from a very unique situation, where multiple years of foreclosure bans and suppressed interest rates have created a constrained inventory situation in the resale housing market.

However, this situation won't last. Especially as the recession gets worse. Distressed selling will eventually increase, and builders will all of a sudden have a lot more competition from the resale market.

And many of these distressed listings will come from home building communities. That's because over 90% of new home sales are financed with a mortgage. Mortgages that were issued at sky-high valuations over the last several years. Creating a recipe for widespread mortgage defaults and foreclosures in builder communities.

Especially for a builder like DR Horton. They aggressively sell to lower-income families who use government backed, low downpayment mortgages to purchase their homes. Nearly 50% of DR's sales are financed by FHA or VA loans.

One has to wonder - what will a wave of mortgage defaults in builder communities due to the builder's pricing power on selling new homes in those communities?

It probably won't be good.

We're exiting an 11-year Housing Expansion. The downturn is just getting started.

Finally - I think it's important to maintain perspective. We're exiting an 11-year housing expansion that occurred from 2011 to 2022. One of the longest housing expansions in US history.

That long expansion resulted in a massive backlog of houses and apartments under construction. A backlog that is just now starting to deleverage itself. It will take multiple years to clear out this backlog, and a result, builders will likely continue to pull fewer permits. And the economy will likely tip further into recession as other corners of the economy (manufacturers, retailers) also pull back.

Homebuyers and renters should continue to expect more new inventory over the next year. And more downward pressure on prices and rents coming from that new inventory.

In the interim - single-family builders might catch some tailwinds from the constrained inventory environment on the resale market. But don't bet on that lasting for long.

-Nick