THE NATION'S HOME BUILDERS OPERATED IN a very favorable economic and financial market environment in 2004, and home sales and single-family housing starts soared to record levels. But inventories of unsold homes moved up during the year as well, and financial market conditions promise to be less favorable in 2005. Builders must prepare by focusing on the changing environment—higher interest rates, weaker buyer demand, and a higher inventory-to-sales ratio—to make the most of the new year.

Watch Those Inventories Despite robust demand for homes, inventories of unsold new homes climbed substantially in 2004. Although the strong sales pace kept the months' supply figures in a narrow range, the absolute number of unsold homes approached record levels by late in the year.

The 2004 inventory run-up was concentrated in units still under construction; however, the number of unsold completed units moved up slightly, and the inventory of for-sale homes that were permitted but not yet started also rose. Although the current inventory situation doesn't look alarming, it could become more serious if housing demand weakens in 2005.

Interest-Rate Factor There's no question that housing fed off of a historically low interest-rate structure last year. But the Federal Reserve has been systematically raising short-term rates since mid-2004, and more Fed tightening is in store for 2005.

Long-term interest rates fell last summer and fall, despite Fed hikes in short rates, and this disconnect gave housing yet another boost. But Fed action is methodically withdrawing reserves from the financial system, and this process is bound to tighten overall credit-market conditions and put upward pressure on the entire interest-rate structure. The NAHB's forecast shows a percentage-point rise in fixed-rate mortgage yields over the course of 2005 and a 1.5-point rise in one-year ARM yields.

Such moderate increases in interest rates may not seriously damage home buyer demand this year, although some marginal buyers inevitably will be filtered off the edges of the market. Incidentally, higher rates will weaken the powerful rent-to-own dynamic that's been feeding the single-family market for some time.

Fighting Back Builders should be prepared to deal with shrunken home buyer demand in 2005, which means two things need to happen: First, strict controls must be placed on inventory accumulation; second, builders should mine the ARM market for all it's worth. ARMs financed nearly half of all new-home purchases in 2004, with particularly heavy usage in high-priced areas, and a similar share is likely this year, despite some narrowing of the initial ARM interest-rate advantage.

Builders also should be prepared to roll out special sales techniques and incentives that have been successful in the past—a special NAHB survey conducted last November showed heavier usage of Realtors/brokers as well as an increase in sales incentives. The study found that 28 percent of builders were including optional items in their homes at no charge, about 17 percent were paying closing costs or financing points, and some companies had begun to “buy down” mortgage interest rates.

David F. Seiders
Chief Economist, NAHB, Washington, D.C.