Looking at the housing market at the beginning of 2019, Brent Anderson didn’t like what he saw. Mortgage interest rates had jumped from the high 3s to flirting with 5% for the first time in a decade. Sales of higher-end move-up homes—the bread and butter of this home building cycle—had suddenly tanked, as potential homeowners felt “buying fatigue” in the face of ever-rising prices. It seemed that the sales spigot, which had only been turned on in fits and starts since the end of the Great Recession, had finally been tapped out.
To top it off, the Federal Reserve had been on a hawkish tightening spree, with at least two more interest rate hikes anticipated for 2019. At the same time, economists were calling for a general economic pullback. With a slower housing market typically being a leading indicator of recession, all signals seemed to be in place for exactly that to happen.
So when Anderson, vice president of investor relations at Scottsdale, Ariz.–based Meritage Homes, considered Question No. 23 of his annual Builder 100 survey—“What is your outlook for housing in your markets for 2019?”—he ticked off “Mostly Negative.”
“We saw a pretty choppy market in the third quarter of 2018, and then in the fourth quarter, it weakened even more,” Anderson recalls. “The market seemed to be getting very soft, very quickly.”
What a difference half a year makes.
“I wouldn’t respond the same to that question today,” Anderson said in July. “Now, the outlook isn’t so scary.”
Instead, coming off of Meritage’s breakout second quarter earnings report—where the company reported a swift sales pace for the entry-level home product it pivoted to in 2017, which produced even better profit margins than its higher-priced, move-up homes—Anderson was all smiles. And who wouldn’t be? Following its report, Meritage’s stock jumped 18% in a single day.
“We knew the results were good, but we didn’t know we’d get that reaction,” Anderson says. Indeed, while existing home sales were still flagging at mid-year, new-home sales had risen 2.2%, compared with 2018, and gained 4.5% in June alone, compared with the same month a year earlier.
Meritage’s turn toward more affordable homes targeted at entry-level home buyers, as well as Anderson’s still cautious, but brightening outlook to the environment ahead, is emblematic of how builders view the evolving home building cycle in the months to come and what they’re doing to prepare for it.
While economists still see a potential slowdown ahead for the economy in general, new-home builders are operating with guarded optimism, bolstered by a strong spring selling season along with promising signs that they’ve finally cracked the code for building—and making a profit from—entry-level homes. But they’re also hyper-focused on staying vigilant for any signs of trouble on the horizon, reading the market, and staying ahead of it.
The ‘Pivot’
Take the recent pullback in prices in 2018 and how builders like Meritage and others reacted to it going into the spring selling season of 2019. With the tailwinds of a newly dovish Fed, which signaled in January it would back off its rate-hiking regime, builders didn’t rely on lower rates alone to save them. Instead, they proactively went to market to lure buyers back in.
“Builders got pretty aggressive in terms of altering their mix to a more affordable product and increasing incentives, or, where needed, even reducing prices on product that wasn’t moving,” says Carl Reichart, home building analyst and managing director at New York–based investment bank and brokerage BTIG. “Builders did not wait around. They entered the spring selling season with deals available, and buyers took advantage of that.”
For Alex Barron, senior research analyst at El Paso, Texas–based Housing Research Center, that reaction to the market illustrates a growing willingness on builders’ parts to be nimble and stay in front of market trends when they see them.
“The Fed pricked the bubble that was developing in new-home prices by raising rates in 2018,” says Barron. “For builders to watch interest rates go up and see their sales start to slow, I think it was a wake-up call. It started feeling like 2006 all over, and it was like, ‘Do we really want to go through this whole cycle of impairments again? Or do we maybe go back to the drawing board and reexamine our core assumptions that we can’t make money at the entry level?’”
One builder that did that kind of soul searching was Meritage. After building its business post–Great Recession focused on the second- or third-time move-up buyer, Meritage began retooling its product offerings in 2017 to stay ahead of the demand curve.
“We made the strategic decision a little over two years ago to focus entirely on entry-level and first-time move-up buyers, rather than try to be everything to everyone,” Anderson says. “We’ve really reengineered the whole business to support those buyers and did a lot of research to redesign the product for them.”
Whereas first-time buyers made up just 24% of Meritage’s customers in 2016, in second quarter 2019, they accounted for more than 52% of the builder’s sales. “This cycle kind of got turned on its head, because the move-up buyers came back first, and entry-level buyers came back after that,” Anderson says. “It may mean we end up building more of this entry-level product for a longer period of time.”
This isn’t to say home builders—or economists—believe we’re out of the economic woods yet. “Certainly, everyone’s talking about when the next recession occurs,” says Robert Dietz, chief economist for the NAHB. “If the laws of the business cycle haven’t been repealed, at some point we’re going to have some kind of downturn.”
Dietz notes that his own economic tables don’t show an actual recession ahead yet, but more of a general slowing or what he calls a “soft patch.” And he emphasizes that in a post–Great Recession world, it’s critical to think about what a recession in today’s market would really look like.
“The problem is, when you use the word ‘recession’ today, people immediately think we’re going to have another Great Recession,” Dietz says. “But that was a once-in-a-multidecade event, marked by the combination of both an economic downturn and an old-school financial panic. When we think about a downturn in the current economy, we’re talking about something like the early 1990s or 2000s, where there were maybe a couple quarters of negative growth and some slow or negative job creation.”
A Stronger Second Half?
Against that backdrop, builders during the summer anticipated a stronger market in the back half of 2019, while still preparing for the pullback they know must eventually come. Having learned hard lessons from the Great Recession, these builders are staying conservative in their outlooks, paying down debt while keeping land in check, and segmenting projects into smaller chunks, rather than the 1,000-lot takedowns of the past. They’re paying more attention to their local businesses, simplifying their products and processes to appeal to today’s price-conscious home buyers, and keeping a close eye on how many spec homes, which they are building again, are in the market at any given time.
Take Pat Neal, president and founder of Sarasota, Fla.–based Neal Communities, which closed 1,148 homes in 2018. He’s anticipating 2019 ending stronger than it began, to build momentum going into 2020. But he currently holds only 2,000 lots—just under two years’ supply—and he’s used proceeds from his sales this year to pay off all of his bank debt, electing instead to sell bonds that won’t reach maturity until 2024.
“I like to say we’re always managing to the next downturn,” Neal explains. “I don’t see any immediate signals, but we need to be prepared for it. I’m managing my embedded expenses, keeping an eye on inventory, ensuring I don’t have debt on land, marshaling my assets, and paying intimate attention to my business every day.”
At Chicago-based Lexington Homes, principal Jeff Benach says he’s focused on building smaller communities instead of the multihundred-unit communities he churned out before the downturn. Part of that is by necessity: Chicagoland still produces only around 6,000 starts a year, but it’s also a more strategic vision.
“We used to do 1,000 units all by ourselves,” Benach says. “We wouldn’t do anything below 100 before. Now, we’re more focused on 50- or 60-unit projects.” He also likes building attached homes, which helps him keep his prices down in the $300s.
At Judd Builders in Asheville, N.C., John Judd Sr. takes a similar approach. Concentrating on attached housing, he says, helps him diversify his risk among multiple buyers while developing just one lot and pouring a single foundation.
“This type of market lends itself more to a duplex or triplex play, rather than one big single-family home where you’ve got all your eggs in one basket, especially on a spec,” says Judd. “Now, you’ve got three people who can qualify for just $300,000, instead of one buyer who has to come up with $1 million.”
Those moves typify builders’ current approach to the changing outlook in the market today. “Post–Great Recession, builders are more cautious,” Dietz notes. “They’re more focused on data. And they’re hyper-aware of movements in the markets and interest rates.”
Waiting for the Market to Turn
At Los Angeles–based KB Home, market factors were definitely on the builder’s mind as 2018’s slowing sales took hold.
“Everyone in the industry in the back half of last year was conveniently calling the slowdown in sales a ‘pause,’ ” says Matt Mandino, KB’s chief operating officer. “Well, that sounded great, but about three months into it, we started wondering, how long does a pause last? By January, we started asking whether this thing was actually going to turn. Fortunately, it did.”
KB’s second-quarter earnings walloped analysts’ estimates, coming in at 51 cents a share versus a consensus projection of 38 cents. While KB has always had its roots in the entry-level market, it had also started to focus on introducing smaller plans to both new and existing communities in 2018, as buyers pulled back from higher-priced, larger homes. “In anticipation of the winds shifting, we wanted to be able to hit a lower price point in all of our communities,” Mandino says. “So, if we had a community where we were offering 1,900- to 2,700-square-foot homes, we would add a 1,700-square-foot plan, too.”
KB also started focusing on more attached or “paired” housing to get homes down in the more affordable price points. “There are markets such as Denver where we rely quite heavily on our duplexes, or paired homes,” Mandino says. “In some cases, those homes might come in at $100,000 less than a similar, single-family detached home nearby.”
Those moves resulted in 55% of KB’s sales coming from entry-level homes in the second quarter of 2019, the highest level the firm has seen in that product range in a decade. And like Anderson at Meritage, Mandino sees the reemergence of the entry-level market and “family-friendly” housing in the suburbs and exurbs as a new wrinkle to the current housing story that, at the very least, could extend the cycle.
“We’re hoping this really opens up for additional buyers who didn’t even think they could get into a new home, who now look at what they’re paying in rent versus what they can purchase for, and realize this is a great time to buy,” Mandino says. “We’re really hoping we see increasing velocity by being able to serve so many families who were priced out of the market until now.”
But while he clearly saw potential in the market in 2019, like other builders, he hasn’t forgotten the lessons of the past. Going forward, KB is approaching its land development in the same way it might open different phases of a new community, with smaller deals that develop one section at a time. And while building for entry-level means the firm has necessarily sought land farther out from the urban core, it’s not venturing into the hinterlands, the hallmark of builders who expanded into far-flung territories just before the last crash.
“We’re not buying 2,000 lots a half-hour from the nearest grocery store,” Mandino says. “We’re doing many more deals in the 100- to 150-lot range versus the 500-plus lot deals of the past. We feel this is a good environment to operate in. But it can change quickly, and we need to make sure as an organization we can adjust. We’re taking a very disciplined approach to it.”
That one-step-at-a-time approach can be seen with other builders, too. On PulteGroup’s second-quarter earnings call, executives emphasized how the builder, which at one point had as much as seven years of land on its books post-recession, was at just three years of owned lots today, while using options to control additional dirt.
“We continue to make excellent progress against our goals of three years owned and three years optioned,” said PulteGroup CEO Ryan Marshall on the call, during which he also emphasized the builder’s goals of growing its entry-level sales to 35% of its mix from 29% currently. It reported building 26% of its homes on spec, while keeping an eye on its land holdings to bolster its balance sheet. “Our field teams have just done an outstanding job in working on a local level on a transaction-by-transaction basis to really secure lots that are helping us to turn our assets faster and to minimize the risk that’s associated with having too much land on the balance sheet,” Marshall said.
Recalibrating Toward Entry Level
Home builders’ distinct new emphasis on entry-level offerings in 2019 has drawn attention back to the potential resiliency of the housing sector. In fact, with a consistent undersupply of homes—numbers range from a shortfall of 1.3 to 2.5 million units nationally—observers say conditions could be right for housing to act as an economic stimulator for the broader economy, instead of just being a beneficiary of it.
“If we’re undersupplied the way I and others estimate it, it would stand to reason that housing might actually be a domain of growth for the economy,” says Brad Dillman, chief economist at Atlanta-based multifamily owner, builder, and operator Cortland, who previously served as director of economic research at PulteGroup. “There could be more runway ahead, or at least the downside may not be as stark as some people think.”
Even economists who do see a recession ahead say there will likely be a disconnect between the general slowing of the economy and what’s happening in the housing market.
“This will not be a housing-led recession,” says Mark Boud, chief economist at housing data analysis firm Metrostudy, which is owned by BUILDER’s parent company. Boud is calling for a recession in the broader economy to start in the later half of 2021—the same year he sees a peak in the current housing cycle—and cites the rising federal debt as his biggest long-term concern. But he also pushed the time of that recession out by two quarters after 2019’s second quarter; at the end of 2018, Metrostudy projected a recession beginning in 2020–21. Now, it’s saying it will come in 2021–22, and Boud has described it as a “soft landing.”
“This next recession we don’t feel will be nearly as deep as the previous recession,” Boud says. “Nonetheless, it’s a recession, and during recessions, demand for housing tends to fall.”
Others still see more pressing signs of trouble ahead. With housing slowdowns typically being a leading indicator of recession in the general economy, some economists say the pullback in prices and sales in 2018 is already signaling a broader downturn.
William Emmons, lead economist for the St. Louis Federal Reserve Bank’s Center for Household Financial Stability, sees recessionary signals taking hold by the end of 2019 or early 2020. He bases his outlook on four measures of housing health: mortgage rates; existing home sales; house prices; and contribution of residential investment to GDP growth.
At the end of 2018, he wrote on the St. Louis Fed’s website that those measures signaled recession in the fourth quarter of 2019. In June 2019, he updated his post to say things only looked worse, but he didn’t include second quarter results in his analysis. “All four of the housing indicators highlighted late last year are more concerning now, according to data through the first quarter of 2019.”
A New Housing Cycle?
And yet, with the emphasis on less expensive plans, and builders’ newfound ability to produce entry-level homes profitably, other observers see 2019’s spring pivot as a sign that a fundamental change has occurred in the housing market, one that takes it back to its roots of selling affordably priced homes to first-time buyers.
With the peak of the 80-million-strong millennial generation now reaching its 30s and finally showing a willingness to buy homes in the suburbs, 2019’s early returns could signal a back-to-the-future swing for home builders, where they finally start producing the volume of homes seen prior to the Great Recession.
“What builders have found out is that the sales pace of these entry-level communities is tremendous,” says Barron. “They’re selling 10, 15, 20 homes a month versus the two or three sales that they were getting in their move-up communities. This could get us back up to the kind of volumes we used to see in previous cycles.”
After crisscrossing the country during the spring selling season in 2019 to see activity in builders’ communities firsthand, Barron put out a research note in July declaring the old cycle dead, with a new one just begun.
“Based on our field visits, and looking at 50 years of housing data, we concluded that the last housing cycle that began in 2011 actually ended in 2018,” Barron says. “Everything points to a new cycle, marked by entry-level homes, that began in January of this year. So we are very bullish on housing.”
He’s not alone. Back at Meritage, after experiencing 2019’s pivot firsthand, Anderson suddenly sees the market in a whole new light.
“Home price is the ultimate amenity,” says Anderson, who notes that in addition to first-time buyers, Meritage also has been seeing a lot of baby boomer move-down buyers in its sales mix, another section of the market that he feels is ready for the lower-priced homes his company is now focused on.
“We see enough headroom in the markets to fuel additional growth,” Anderson says. “The strategy is still new enough that we’ve got a ways to go, but we think we’ve got many years to enjoy this market before it plays out.”
