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Will Rate Hikes Aggravate Housing Woes in 2017?

The year 2016 has been considerably advantageous for housing. Yet, the market hasn’t been immune to problems and we wait for the eventual fallout this year. At the start, while analysts have been pinning their hopes on higher building activity, builders were not able to deliver enough homes. Meanwhile, home prices scaled beyond expectations and mortgage rates oscillated between record lows and appreciable highs, before crossing the 4% mark for the first time in two years.

Though healthy supply demand balance will probably draw demand, there are other factors that can deal a fresh blow to the housing industry.

Rising interest and mortgage rates, as well as land and labor shortages, raise concerns -- as do tedious underwriting standards. Intensifying competition also poses a threat.

It would be prudent for investors to take a closer look at these dampeners before investing in this space. Below, we discuss the impact that these can have on the sector in the coming months and years.

Volatile Mortgage Rates

A thought that has been plaguing investors of late is whether a rise in interest rates will affect the housing market. The year 2016 witnessed two significant political events setting the mortgage rates in the opposite direction. Last June, the British vote to exit the European Union put rates near a record low while Donald Trump’s win in November drove rates to over 4% for the first time in two years.

We see limited impact on housing demand from the recent upsurge in mortgage rates owing to the labor market strength. However, its influence on the industry in 2017 is undeniable and uncertain.

The Federal Reserve has raised the benchmark interest rate by a quarter percentage point to the range of 0.50% to 0.75% from 0.25% to 0.50%, citing improvement in the labor market and a strengthening U.S. economy. This marks the first interest rate hike of 2016 and the second since the 2008-2009 financial crisis following a raise at the end of 2015.

However, with the Federal Reserve announcing a hike in the benchmark Federal Funds target rate, mortgage rates will probably rise in 2017 or after that. High mortgage rates dilute the demand for new homes as mortgage loans become expensive. This lowers purchasing power of buyers and hurts volumes, revenues and profits of homebuilders.

Even, the recent movement toward higher interest rates has raised apprehensions about the outlook for home prices going into 2017.

Additionally, the rise in mortgage rates may impact affordability at a time when millennials are taking baby steps into the housing market. Higher interest rates will only heighten issues and may further delay home purchases by millennials.

Labor/Land Shortage

At present, the problem of skilled labor shortage is taking a worse shape in the homebuilding industry as demand continues to scale higher. Meanwhile, rising land and labor costs are threatening margins as they limit homebuilders’ pricing power. Labor shortages are resulting in higher wages while land prices are inflating due to limited availability. There could be more inflation, going ahead. This is eating into homebuilders’ margins considering that home price increases are moderating.

The impact labor/land shortage is twofold. On the one hand, residential construction is failing to meet demand in the absence of sufficient workers. On the other hand, to make up for the rising labor costs, homebuilders are compelled to raise home prices to maintain margins that would deter entry-level home buyers. This will act as a major deterrent for potential buyers.

Meanwhile, a recent report by the National Association of Realtors showed that the supply of previously owned homes for sale dropped to a 17-year low in Dec 2016. Land supply could remain a challenge for housing with homebuilders continuing to complain about a shortage of skilled workers and land.

Rising land and labor costs -- mainly the latter -- have hurt gross margins of the likes of Lennar Corporation (LEN), KB Home (KBH) and D.R. Horton, Inc. (DHI) in the past few quarters.

At present, we will advise investors to stay away from TRI Pointe Group, Inc. (TPH), Taylor Morrison Home Corp. (TMHC), Beazer Homes USA, Inc. (BZH), Hovnanian Enterprises, Inc. (HOV), M/I Homes, Inc. (MHO) and Meritage Homes Corp. (MTH). While TRI Pointe Group and Taylor Morrison hold a Zacks Rank #4 (Sell), the other carry a Zacks Rank #5 (Strong Sell).

You can see the complete list of today’s Zacks #1 Rank stocks here.

Bottom Line

In Housing to Recover on Supply-Demand Balance we focused on the conditions that are expected to drive the industry going forward.

As you can see, there is some catching up to do for these homebuilders even though the economy paints a picture of recovery. But what about investing in the space right now – will the opportunities outweigh the risks to lure in short-term investors?

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TRI Pointe Group, Inc. (TPH): Free Stock Analysis Report
Taylor Morrison Home Corporation (TMHC): Free Stock Analysis Report
Meritage Corporation (MTH): Free Stock Analysis Report
M/I Homes, Inc. (MHO): Free Stock Analysis Report
Lennar Corporation (LEN): Free Stock Analysis Report
KB Home (KBH): Free Stock Analysis Report
Hovnanian Enterprises Inc (HOV): Free Stock Analysis Report
D.R. Horton, Inc. (DHI): Free Stock Analysis Report
Beazer Homes USA, Inc. (BZH): Free Stock Analysis Report
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