Are we seeing a new home surplus?

Nov 10, 2021 - 5 Min read
Peter Miller
Real Estate Expert

Why are home prices going up? The common wisdom suggests that lots of demand coupled with a lack of supply are at the heart of recent price increases, but what if demand is less robust than widely believed? And what if supply is likely to grow? It could mean a very different year in 2022 for real estate investors as well as homebuyers in general.

There is surely an argument to be made that new home sales are doing well. Lawrence Yun, chief economist with the National Association of Realtors (NAR), said in October that “new home construction fell modestly, 1.6% in September from the prior month, but the year-to-date activity is solidly higher by 17% compared to 2020 and by 23% compared to the pre-pandemic year of 2019. More housing inventory will therefore steadily emerge.”

But, as they say on Wall Street, “past performance is no guarantee of future results,” a concept that surely applies to the pandemic economy. Can the new home market be slowing?

That may be the case. Dennis McGill, Director of Research at Zelman & Associates, says we now have more new homes in the pipeline than at anytime in decades. Meanwhile, the demand surge seen earlier in the pandemic may be moderating, thus leading to oversupply.

A tale of two markets

We essentially have two housing markets, one for existing homes and one for new construction.

The supply-and-demand trends that work for one market may be different for the other. Complicating matters is the reality that for nearly two years we’ve been in the midst of a pandemic economy, a time of massive government spending, huge employment shifts, and a financial environment that’s unlikely to be continued or repeated.

The price gap

One of the core differences between new construction and existing homes is price. The typical new home sold for $408,800 in September according to government research while the National Association of Realtors reports that the median price for an existing home was $352,800 during the same month. That’s a $56,000 difference, a huge gap for many potential house-hunters.

While the existing home inventory is well-below the preferred six-month mark, the inventory situation with new homes is more comfortable. Figures from CalculatedRisk.com show that in September, “the inventory of new homes under construction is at 3.6 months — slightly above the normal level.

“However,” adds the site, “a record 106 thousand homes have not been started — about 1.6 months of supply — almost double the normal level.”

The pandemic effect

“In the first quarter of 2018,” says Rose Quint with the National Association of Home Builders, “only 15% of prospective buyers were looking for a newly built home. The onset of COVID-19 propelled that share up to 42% by the final quarter of 2020, but strong gains in new home prices have driven it down for the last three quarters, reaching 32% in the third quarter of 2021.”

For real estate investors and property owners in general, the new normal, or at least what’s “normal’ for the moment, creates both opportunities and risks. The opportunity is that we now have unusual price gains and quick sales, while the risk is that new home demand may lessen as a result of growing costs and rising mortgage rates.

Mortgage rates

Among all the one-time conditions and events seen during the past year, record-low mortgage rates surely stand out in the housing sector. In the first week of 2021 the average 30-year mortgage rate was 2.65%, according to Freddie Mac, the lowest interest level seen since it began collecting weekly data in 1971. In contrast, by late October the typical interest rate for mortgages had reached 3.14%

The general thinking is that mortgage rates will rise in 2022, perhaps reaching 4% by year-end, according to the Mortgage Bankers Association. By long-term historic norms, 4% is a remarkable bargain, but compared with 2021 it’s simply a bigger monthly cost.

Market constraints

It might seem that with so much overall demand, we can easily sell more and more new homes, but that’s not the case.

To build new homes you need a skilled workforce and even with good pay the industry is not attracting a sufficient number of workers. In August, the latest month for which we have statistics, the government reports that there were 344,000 unfilled construction jobs.

Builders are looking for ways to get around the labor shortage. Lennar, for example, will erect a community of 100 3D-printed homes next year in an effort to overcome labor and materials shortages. Habitat for Humanity Central Arizona built its first 3-D house earlier this year in Tempe. St. Louis-based MiTek, a company owned by Berkshire Hathaway, is using software to create modular homes. It wants to “innovate at every step of the process and, half a century after it was first touted as the next great thing, finally make modular mainstream.”

While efforts to construct with new systems and technologies hold much promise, the need for additional units in large quantities is now. The “underbuilding” shortage amounts to 5.5 million units during the past 20 years, according to the National Association of Realtors, an average of 275,000 missing units every year.

But, even if more homes are built, not all new construction will reduce ownership demand. A large and growing portion of the new construction market — everything from individual units to entire communities — is going to investors in the form of build-to-rent (BTR) properties. According to The New York Times, BTR construction now represents 6% of the marketplace and will likely reach 12% in the coming decade.

A particular problem is the lack of new homes for entry-level buyers. Sam Khater, Freddie Mac’s chief economist, says that “in the span of five decades, entry level construction fell from 418,000 units per year in the late 1970s to 65,000 in 2020.” 

But, interestingly, we may see an increasing number of smaller units going forward as efforts to end single-family zoning gather steam and accessory development units (ADUs) become more common.

“Economic research shows that relaxing the zoning rules and other regulatory constraints that have impeded home building for decades would boost supply and lower prices and rents,” explains The Housing Shortage: Prices, Rents, and Deregulation, an October report from economist Ronnie Walker at Goldman Sachs.

California and Oregon have already moved to limit single-family zoning restrictions, while New Hampshire allows accessory development units in much of the state. The White House is making zoning reform a major priority, explaining that “exclusionary zoning laws place restrictions on the types of homes that can be built in a particular neighborhood. Common examples include minimum lot size requirements, minimum square footage requirements, prohibitions on multi-family homes, and limits on the height of buildings.”

“Between pricing, zoning, worker shortages, and sales to real estate investors, new construction has a limited ability to resolve the immediate inventory problem,” said Rick Sharga, Executive Vice President with RealtyTrac, “However, if new homes with less square footage and lower prices become increasingly available, there’s a clear path to additional new construction and with it reduced inventory concerns.”

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