Builders need to see several months into the future to make any sort of profit. The elongated time it takes from start to completion means forecasting future home sales is essential, and some alarming trends are becoming more defined by the day.

Nationally, new home sales continue to decline in 2022, with new single family residential (SFR) sales down 27% from a year ago as of April 2022, according to the National Association of Homebuilders (NAHB).

Looking forward to future new home sales, the number of mortgage applications for new homes is down 11% from a year earlier as of April 2022, and down 14% from the prior month, according to the Mortgage Bankers Association (MBA).

Further, the supply of new homes has increased 40% over the past year to 9 months’ supply as of April 2022. Just 9% of this supply is ready to occupy, with the majority still in the process of being built.

New home sales have declined steadily since the end of 2021 and are now at their slowest pace since May 2020 when homebuyers were at their most cautious during the outset of the pandemic. This decline is a significant contrast from most years when home sales are ramping up during the first half of the year.

Reading the warning signs, builder confidence in the multi-family market declined in the first quarter (Q1) of 2022, with most builders believing production conditions will decline, according to the NAHB.

Builder confidence for future sales of new SFRs is still majority-positive, but at its lowest level since bouncing back from the lows of the 2020 recession, according to the NAHB.

The NAHB survey shows builders are still optimistic about high demand for multi-family housing. But this demand continues to be tempered by rising interest rates, high building costs, building material shortages and labor shortages. With the cost of housing continuing to rise, even today’s high demand may fall short.

Warning signs for the recession to come

The NAHB Chief Economist calls the recent, dramatic drop in new home sales a “clear recession warning.”

New residential construction tends to decline in advance of a yield spread inversion, the time-tested indicator of a future recession. The yield spread is a weathervane for economic conditions as interpreted by bond market investors and Federal Reserve (Fed) economists. When the yield spread goes negative, a recession is imminent within the following 12 months.

As of May 2022, the yield spread remains in positive territory. But signs point to an inversion arriving in Q3 2022, with a recession following soon after. The declining level of new homes sales experienced since Q4 2021 confirms this forecast.

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Here in California, the severe housing shortage has pushed state legislators to encourage more building. This has been conducted through offering builders:

  • incentives for building low- and mid-tier housing;
  • fewer barriers like stringent parking requirements for transit-rich housing;
  • looser zoning restrictions for accessory dwelling units (ADUs); and
  • reduced or no impact fees for low- and mid-tier housing.

Heightened by these legislative incentives and high demand for housing, residential construction starts are 23% above a year earlier as of April 2022. However, the pace of increase is quickly falling.

California builders are acting with more caution following 2021’s expiration of the foreclosure and eviction moratoriums, which have begun to release a buildup of inventory onto the home sale and rental markets. Persistent job losses are also a concern to builders, as incomes are unable to support the rapid pace of home price increases experienced in 2021-2022.

But the loudest alarm bell sounding in builders’ ears is the impact from rising interest rates.

The Fed’s actions to cool the economy are the main factor behind the rapid rate increase in 2022. As of April 2022, the average 30-year FRM rate has increased such that the amount of mortgage money available to a typical homebuyer had fallen nearly 25% from December 2020, when rates were at an historic low. Further, the Fed intends to continue its rate increases throughout 2022.

This steep buyer purchasing power reduction has forced today’s homebuyers to take a step back from the market, canceling escrows and building contracts on homes for which they no longer qualify. Builders are very aware of this reality and are scaling back as quickly as possible.

Combined, these factors will hold back residential construction starts from reaching their full potential until the recovery from the next recession, with home prices expected to bottom around 2025 and the recovery to pick up steam around 2027.

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