In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi explain why new homes are making up a growing share of the overall supply of available homes for sale in the U.S. and what that means for the housing market in 2023.

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Listen to the REconomy Podcast™ Episode 56:

“Builders have a lot of homes under construction in the pipeline on a non-seasonally adjusted basis. There are more homes under construction of all units than in the history of the series, which dates back to 1970. Builders were trying to make up for the lack of existing homes on the market and the high demand for homes over the course of the pandemic. So now builders will focus on finishing those homes and selling them, rather than starting new projects, at least until things stabilize in the economy and mortgage market.” – Odeta Kushi, deputy chief economist at First American

Transcript:

Odeta Kushi - Well, hello and welcome to episode 56 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey, Mark. You know, we talk a lot about the resale housing market on this podcast, you know, what motivates and demotivates potential buyers and sellers. But what we don't readily discuss is the substitute good within the purchase market.

Mark Fleming - Hi, Odeta. Starting strong with the economics of substitute goods. I love it. You might be referring then to new construction homes as the substitute goods to the resale market.

Odeta Kushi - You hit the nail on the head. Get it?

Mark Fleming - Get it? I think I need some more coffee before we get into all these construction puns.

Odeta Kushi - I was pretty proud of my shelf.

Mark Fleming - I thought the witty commentary was my job. Moving...get it...right along. You won't go down that easy. What makes you want to discuss the new construction side of the purchase market?

Odeta Kushi - Well, I was recently updating some charts and I came across one that I hadn't updated in some time. So, of course, I decided to quickly refresh the numbers. And what I found was very interesting.

Mark Fleming - Would you say it was riveting?

Odeta Kushi - Welcome to the punny side. Things are better here. But it was indeed riveting. Let me back up a little. This chart, which you can find on my Twitter at @OdetaKushi, graphs the share of overall inventory made up by existing homes and new homes.

Mark Fleming - Alright, so in other words, if the total national inventory of homes for sale on the market was 100, and 50 of those were new, then this graph would show a 50% share.

Odeta Kushi - Precisely. And I show how those shares have changed over time. Now, from the year 2000 up until the pandemic, new homes on average made up about 11% of total inventory. Want to take a guess at what the share is in the latest available November 2022 data?

Mark Fleming - Well, I know that the conventional wisdom was that the vast majority of the inventory at any point in time was existing homes as your chart shows. But I'm guessing it can't really be that much higher, so let's go with 20%.

Odeta Kushi - 29%.

Mark Fleming - Woah. Now is that because of existing-home inventory having declined? Because we know that that has happened recently. Or is it because new-home inventory has somehow exploded and increased by so much?

Odeta Kushi - It's actually both. So new-home inventory as a share of total home inventory has been picking up rapidly since 2020. And that's been a function of both higher new-home inventory and lower existing-home inventory. So higher new-home inventory increases the numerator of that share, while falling existing-home inventory reduces the denominator. It is important to note, however, that the new-home inventory number includes inventory at all stages of construction.

Mark Fleming - So I guess the question there is whether it's really available, like the existing inventory is, and this is an important caveat, because, according to the latest U.S. Census Bureau new residential sales data for November, only 64,000 of the total new-home inventory is completed and ready to occupy. That's only 14% of the new-home inventory. This count has been increasing in recent months, it's up 88%. That's almost doubled since a year ago. But where is the rest? Homes under construction account for 63% of the total new-home inventory, and the remaining 23% aren't even started in terms of the inventory. So only a very small share of what we call inventory is actually ready to go.

Odeta Kushi - That's right. Builders have faced all sorts of supply chain disruptions, as well as labor and materials shortages, that have delayed the completion of a new home. I was just taking a look at some data that shows the average number of months from a housing start - that's groundbreaking on a new home - to a housing completion between the years 2000 and 2019 for a single unit built-for-sale home. And that average length of time was 5.8 months. Now, in 2021, which is the latest available, that had increased to 6.5 months. In other words, it takes materially longer now to build a home. But I digress. New single-family home inventory remained elevated at an 8.6 months' supply in the latest November data, a measure near a six months' supply is considered balanced. So does that imply that the new-home market is oversupplied?

Mark Fleming - Yes. But first, the adage of six months being balanced sort of assumes, as economists love to do, that much more of that inventory is completed and ready to occupy, not caught up in the now protracted construction process. Here's where it's important to make a distinction between short-run - ready now - and long-run - ready in the future - dynamics, and perhaps also, where we discuss why the new-home market is fundamentally different from the resale or existing-home market?

Odeta Kushi - Well, let's start with the latter. And the main distinction is who the seller is in each scenario. In a resale transaction, the seller would be the homeowner. So you know, your or I, whereas in new construction, it's a builder.

Mark Fleming - Aha. And what happens when, oh, let's say mortgage rates go from 3% to 7%, in less than a year, and the economic environment becomes very uncertain.

Odeta Kushi - Well, for the homeowner, they just choose to stay put for a while, whereas for a builder, they need to sell no matter what.

Mark Fleming - Exactly. That's why the resale market is what we refer to as downside sticky in a rising-rate environment, whereas the new-home market is much more sensitive. Recall that price stickiness refers to that resistance of the price to change. So, while house prices may move up easily, which we've seen, downside sticky means that that price won't move easily down, people will not participate in the market, rather than go to lower prices. But that builder asks the question, what price will sell this home that we've already got on the market or is in the process of being built? I can't hang on to this thing forever, I need to sell it. While the homeowner just says, I'm right locked into this home right now, I love the utility of shelter that I'm getting from it, and I don't want to sell at a lower price than what my neighbor got for his home before, so I'll just stay put.

Odeta Kushi - So, in a higher mortgage rate and more economically uncertain environment, prices will need to continue to adjust to make new homes attractive enough to entice more buyers, and they are moving. The median sales price of new houses sold in November 2022 was $471,200. I can see Mark cringing at my precision but, hey, at least I didn't include a decimal.

Mark Fleming - Well, you know that extra $200 on an almost half million dollar home, I think that's a cringe-worthy level of precision.

Odeta Kushi - Moving right along, still sticking to my moving puns. This is up 9.5% on a year-over-year basis, but 2.8% lower than last month, so prices are adjusting to the reality of higher mortgage rates.

Mark Fleming - And sticker price isn't the only thing that builders can use to bring back potential buyers. According to the National Association of Home Builders, 62% of builders are using incentives to bolster sales, including providing mortgage rate buydowns, paying points for buyers, and possibly offering price reductions, but also doing things like offering upgrades on appliances and other quality features, essentially giving the buyer more home for the same amount of money that they had originally contracted for.

Odeta Kushi - Well, if they can get a hold of some of those quality features, because we know that supply chain issues remain in today's housing market. But we do know that there is some demand elasticity here, at least anecdotally, once a builder lowers the price on a new home or offers some of those other incentives, some buyers are enticed to come back and buy.

Mark Fleming - That's true, but cancellation rates are still north of 25%. Recall, the builders had homes under contract and then mortgage rates spiked. And that rate lock that the customer had doesn't last forever. So that buyer may decide they can no longer afford the home at the new rate that they have to pay and have to cancel instead. And when we look at the U.S. Census new-home sales numbers that's not taking into account cancellations, which means the widely reported new-home sales figures are actually overestimated at the moment.

Odeta Kushi - That's true, the new-home market is certainly in a recession but, at the right price, buyers might come back. Which brings me to our opening statistic that new-home inventory is making up a larger share of total home inventory and that has an implication for national house prices. Because, as we've just mentioned, builders are going to want to sell that inventory and to do so, they'll have to cut prices. That will put overall downward pressure on national house prices. And now I want to come back to an earlier point you made about distinguishing between long-run and short-run dynamics when it comes to housing supply. Because I think a lot of people will be hearing these numbers and thinking that we have an oversupply of new homes.

Mark Fleming - Great point. In the long run, the housing market remains structurally under-supplied. We talked about this at length in episode 40. And it's worth mentioning that there are a wide range of estimates. But the conclusion is that the housing market is structurally under-supplied, meaning there's just not enough housing units given all of the households who would like shelter.

Odeta Kushi - Right. The U.S. housing shortage estimates vary dramatically, depending on who you ask, but most indicate a positive and significant shortage. Bank of America actually recently put out an estimate that the U.S. housing shortage is about 4 million homes. And again, that number will change depending on the methodology. We've done our own analysis to try and pin down a number and I won't get into it in this episode. But what's worth mentioning is that the housing market has been under built for over a decade. So we've built up a deficit of housing, even if we're at a point in the housing cycle where demand has pulled back swiftly and inventory is rising as homes sit on the market for longer. This is a shorter run dynamic. So then is the new-home market oversupplied?

Mark Fleming - Well, you got to put that say 4 million into context. That is basically four years of homebuilding in good years of homebuilding. So this is a significant number, however you cut it. Right now, maybe, given current prices, yes, we're oversupplied, but prices will adjust down and hopefully rates will stabilize. The other question mark is consumer confidence because you need that to make what is arguably the biggest financial decision of your life, buying a home.

Odeta Kushi - Very true. So going back to builders, they're offering incentives to bring buyers back. But are they starting new projects?

Mark Fleming - Aha, increasingly, no. Home builder confidence has been trending lower. While a builder will likely not stop production on a home that's already started - once you get going, you can't stop - they will likely pull back on permits, which are a leading indicator of future starts. Why start now with all the uncertainty about what the price will be in the future when you may be able to sell it, whether it's six months or eight months later. And you have so much already stuck in the construction pipe. And that's exactly what we see in the data.

Odeta Kushi - Exactly. Builders have a lot of homes under construction in the pipeline on a non-seasonally adjusted basis. There are more homes under construction of all units than in the history of the series, which dates back to 1970. Builders were trying to make up for the lack of existing homes on the market and the high demand for homes over the course of the pandemic. So now builders will focus on finishing those homes and selling them, rather than starting new projects, at least until things stabilize in the economy and mortgage market.

Mark Fleming - And may I add that the builder pessimism I mentioned is not only due to the strong pullback in demand due to higher mortgage rates, but also the higher costs for materials and labor. The price of labor and materials remains elevated. It costs more to build these homes today. And these higher costs usually get passed on to the consumer in the form of a higher new-home price. But we just talked about how that's going the other way right now during a time when affordability is down. This makes a great challenge. Builders are trying to attract potential home buyers by cutting prices and offering incentives. But there are limits to that based upon the higher material and labor costs used to build the homes in the first place.

Odeta Kushi - That's a good point. I mean, we did mention earlier that, while prices are decelerating and will likely continue to come down in order to attract buyers, they're still quite high. And that's particularly true for lower price tier new homes. So this is a stat I find pretty amazing. One year ago 12% of new-home sales were priced below $300,000. In the latest November 2022 data only 7% of new-home sales were priced below $300,000. And pre-pandemic November 2019, it was 40% of new homes. So it's pretty tough for a potential first-time home buyer to buy a new home these days.

Mark Fleming - That's a tough step. But it's also the point that we don't build new homes for first-time home buyers necessarily. We build them for the existing homeowner who's going to move up. And, oh, they're rate-locked in and staying put. But you know, the market will adjust. Prices will come down. And the hope is that rates in 2023 will stabilize, alongside stabilizing inflation. But can I just ask, did you hear the joke about the roof, Odeta? No? Oh, nevermind. It's over your head.

Odeta Kushi - Oh, my goodness. Okay, I think now's a good time to end the episode. Thank you, everyone for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And, as always, if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

This transcript has been edited for clarity.