What Record Home Prices Mean For Homebuilder ETFs

Nearly a decade after hitting their highs, U.S. home prices did it again in 2016. According to the latest reading of the S&P CoreLogic Case-Shiller U.S. National Home Price Index, housing prices in the United States surpassed their previous peak from 2006 in September and October.

Home prices are now 38% above their 2012 lows on a national level and up even more than that in certain cities. Year-over-year, home price growth is about 5.6% currently, a brisk pace, though nowhere near the heady levels of the housing bubble.

Source: S&P Dow Jones Indices

Dearth Of Supply Drives Prices Up

As interesting as the new home price record is, it doesn't tell the whole story. According to some, the fundamentals of the housing market may not be as rosy as the price rise suggests. That's because it's a lack of supply rather than a boom in demand that's spurring the increase.

Sure, 2016's 4% increase in existing home sales isn't bad, but prices wouldn't be rising at the pace they are if supply were more robust. Instead, housing starts―a measure of construction of new homes―is at recessionary levels, hovering at or below the troughs of previous downturns. At the same time, the inventory of existing homes for sale is at record lows when accounting for population growth.
 

Existing Home Sales Inventory (in millions)

Source: National Association of Realtors

"It's very concerning to see that inventory conditions not only show no signs of improving but have actually worsened in recent months from their already-suppressed levels a year ago," said Lawrence Yun, chief economist for the National Association of Realtors.

"Home prices are still outpacing incomes in many metro areas because of the persistent shortage of new and existing homes for sale. Without more supply, the U.S. homeownership rate will remain near 50-year lows," he added.

Inventories Squeezed

Indeed, the consistently low inventory of existing homes for sale has confounded experts. One possible explanation is that would-be sellers looking to "trade up" to new homes simply can't do so with prices so high.

"The more premium home prices rise, the more difficult it is for trade-up homeowners to find a premium home that fits their budget," explained Ralph McLaughlin, chief economist for Trulia. "And if trade-up homeowners can’t find a home that fits their budget, they are less likely to sell their existing home."

Another explanation is that investors―including real estate companies―scooped up many single-family homes during the aftermath of the Great Recession and are now renting them out, further squeezing inventories.

New Construction Hampered

In any case, with prices rising and inventories of existing homes so low, one would expect homebuilders to fill the gap with new homes. Instead, new home construction remains feeble. A shortage of skilled construction workers, difficulty getting financing (especially for small developers), and rising building permit costs are some of the factors curtailing construction activity.

According to a Reuters report, the cost (to the builder) of building a new home is close to 62% of the cost of an average single-family home today, up from 48% 10 years ago.

“The costs don’t really work for the kind of housing that we need, especially for first-time buyers,” Jonathan Smoke, chief economist at Realtor.com, recently told the Wall Street Journal.

Opportunity In Homebuilders

That's perhaps why construction activity hasn't taken off despite the clear need for new homes. But it's also an opportunity for well-financed publicly traded homebuilders, such as those held in the iShares U.S. Home Construction ETF (ITB) and the SPDR Homebuilders ETF (XHB), to pick up the slack.

Analysts expect earnings for the large homebuilders such as D.R. Horton and PulteGroup to grow by double-digit percentages in the coming years. They're also bullish on construction supply and home improvement stocks, which are big components of the aforementioned ETFs.

"If your home price is rising, then you're going to invest back in your house. New kitchens, new faucets, new roofs," said Bob Wetenhall, homebuilding and building products analyst for RBC Capital Markets, in an interview on CNBC.

Homebuilder ETFs soared in 2012 and 2013 when the housing market bottomed out and first began recovering. Since then, their ascent has been more gradual. 

5-Year Returns For XHB, ITB, SPY

As long as the housing market can absorb the recent spike in interest rates, there's a decent chance homebuilder ETFs can flourish in the coming year as an accelerating economy pushes more people to purchase homes and supply remains constrained.

Contact Sumit Roy at [email protected]