Believe It or Not, Homebuilders May Have Overbuilt

• The overwhelming narrative in real estate is that not enough homes have been built to satisfy extraordinary demand.
• However, the opposite might be true since metrics such as household growth have plunged to curious lows.
• It’s important to realize that housing experts were singing a similar tune to today’s tracks during the runup to the housing collapse.

Aside from the soaring rate of inflation, if you peruse the internet to find a fundamental explanation for the blistering acceleration of real estate prices, you’ll invariably come across the shortage argument. As a relatively recent article posted on NPR.org stated, “the U.S. is more than 3 million homes short of the demand from would-be homebuyers.”

If that’s the case, why aren’t homebuilders jumping onto this raging opportunity right now? Well, the story goes, they’re doing just that. Unfortunately for the industry, homebuilders can’t build more than their material capacity would allow them to do, which brings up the other component of the housing crisis: global supply chain disruptions.

Eventually, though, supply chains will normalize, facilitating greater material inventory for manufacturers of residential units. At that point, the sector can start vigorously addressing housing demand, which is part of the reason why real estate experts don’t believe that the market will crash. Instead, we may see a mere deceleration of housing prices as the homebuying frenzy fades into simply robust growth.

But what if the above narrative wasn’t accurate? Could homebuilders have instead built too many homes and that demand largely stems from unrestrained emotions à la the fear of missing out (FOMO)? In this case, the contrarian idea isn’t so crazy as it appears.

It’s the Substance, Not the Numbers That Matter

When Dennis McGill of Zelman & Associates stated that there “is a downward trajectory of population growth, household formation as well, that’s really going to undermine the need for what’s built,” most people probably assumed that he suffered a momentary lapse of sound judgment. Indeed, when he made this bold declaration in October of last year, he was running against a wall of logic.

When prices rise, the underlying object of desire in most cases decline in availability. Whether we’re talking N95 respirators amid a pandemic or an affordable single-family residence in a reputable part of town, scarcity is a prime motivator for acquisitiveness. Consumers might not even need the product in question but the idea of denied access may be enough to inspire procurement.

With so many bidding wars erupting across the nation for homes, it would appear that McGill is ignoring basic economic principles.

Yet his statements about household formations are valid. In 2020, the Pew Research Center noted that the metric declined against levels seen in 2010. Further, the institute stated that “U.S. household growth over last decade was the lowest ever recorded.”

Put another way, most real estate experts are focusing on raw numbers. What the better approach entails is to segment the data to people who can legitimately afford home purchases. Taken from this context, McGill argues, homebuilders may have already overbuilt residential units.

A Bit of Deja Vu

Another retort among housing industry professionals is that the underlying market is much stronger than it was in the years leading up to the Great Recession. Plus, everyone, from the brokers to the buyers have learned their lesson. Even the big banks are leery about overextending themselves.

However, if you look at archived business reports during the pre-recession period, you’ll notice that the rhetoric is awfully similar to what we’re hearing and reading about today. For instance, the below blurb from an August 2006 article published by The New York Times is telling:

Moreover, few borrowers are falling behind on their mortgage payments, and the economy looks fairly healthy outside of housing. So if prices start falling, new buyers may jump into the market and prevent any extended slump. “The fundamentals of real estate are solid, still,” said James Gillespie, chief executive of Coldwell Banker, the real estate company.

Demand is strong, the economy is healthy, mortgage borrowers are making their payments, housing prices won’t collapse, the fundamentals are solid -- we’ve heard these stories before because we’re hearing them now. Yet the experts weren’t right back then and they’re not providing much confidence today.

What’s With the Homebuilding Stocks?

Finally, perhaps the most worrisome aspect is the health of the homebuilding stocks themselves. We’re talking about companies like KB Home (KBH), D.R. Horton (DRI) and Toll Brothers (TOL). On a year-to-date basis through the close of the May 6 session, these stocks have shed on average 29.5% of market value.

That’s a hefty loss but that’s only the beginning. If we assume the stock market is a forward-looking indicator, why are the homebuilders suffering so badly when it’s reasonable to assume that global supply chains will eventually normalize? Could it be that the affected companies themselves see other risks -- particularly those tied to longer-term economic viability -- that justify pensiveness?

This discrepancy between supposed bullishness and harshly negative trading is worrying on many levels. Therefore, investors may want to wait for additional news before buying the “discount” on these homebuilders.