In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss the differences between the existing-home market and the new-home market, explaining why homebuilders have an advantage as they sell their homes in today’s environment.

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Listen to the REconomy Podcast™ Episode 66:

“Some builders purchase forward commitments, which provide tranches of money at below-market rates to originate those mortgages for their buyers as an alternative to buying down the rate for the term of the mortgage. But the point, really, here is, essentially, the buyer of that new home can get a 5.5% instead of a 6.5% mortgage and, therefore, can still pay the higher price. But, to them, it's the monthly payment that matters not the actual price of the home.” – Mark Fleming, chief economist at First American

Transcript:

Odeta Kushi - Hello, and welcome to episode 66 of The REconomy Podcast™, where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey, Mark. So, in preparation for today's episode, and simply out of curiosity, I searched the available listings for sale in a nearby neighborhood here in D.C. up to a reasonable price limit.

Mark Fleming - Hi, Odeta. I'm really wondering what that reasonable price limit in D.C. is, but interesting, and what did you find?

Odeta Kushi - Well, I found that there were just five homes for sale in this particular neighborhood. And four of them were new construction, while just one was a listing for an existing home.

Mark Fleming - That's not normal. I think there are two surprising points in your finding. There are very few homes for sale. We've talked about that a lot. And, more interestingly, such a high share of new construction. That's not usually the case.

Odeta Kushi - Right? Historically speaking, new-home construction inventory has made up just 10% of the total inventory of homes for sale. In today's market, it's nearly 30% of all homes for sale. Now, we've talked about this in previous episodes, but I think it's worth dedicating an entire episode to the new-home market, which is currently performing better than the resale market. But why is that?

Mark Fleming - Well, that has everything to do with the differences in market structure between the new and existing markets and, specifically, who the seller is. But, before we get to that, let's talk about what's driving that new construction inventory share higher, because so often we interpret a change in share as reflective of the numerator. In this case, new homes for sale, when the share change can also be due to a change in the denominator.

Odeta Kushi - Exactly. The share is a function of two factors. Existing-home inventory has fallen dramatically and new-home inventory has picked up. On the first point, 92% of existing homeowners have mortgages with rates below 6% and 83% have rates at or below 5%. Why would anyone sell their home and have to get a new higher mortgage rate, when it will cost them more each month to borrow the same amount from the bank?

Mark Fleming - Yes, that financial reality, assuming rational behavior, is keeping many homeowners rate locked into their homes and limiting that existing home inventory.

Odeta Kushi - And, when inventory gets so low, there's the existing homeowner's fear of not being able to find something better to buy.

Mark Fleming - And what a dilemma the existing homeowner faces. The other reason for the new-home share of inventory being so high is that new-home inventory itself is also elevated. While less than the recent peak in October of last year, it is elevated compared to pre pandemic levels. Builders over the pandemic were responding to record demand for homes by building more homes. Haha, and that rhymes.

Odeta Kushi - Yeah, you're a poet and you just don't know it.

Mark Fleming - I'm gonna stick to my day job.

Odeta Kushi - Yeah. It is important to note that a lot of that new-home inventory is made up of homes that are not yet started or under construction. So, to be precise, in the April 2023 report, 61% of new-home inventory was inventory that is under construction, 23% was from inventory not yet started, and 16% was completed home inventory. That completed and ready-to-occupy home inventory may seem low, and it is, compared to pre-pandemic. However, the count has been increasing and is up 106% on a year-over-year basis. But, have builders been successful in offloading this inventory in a much higher interest rate environment than, let's say, a year ago?

Mark Fleming - The surprising answer is generally, yes, new-home sales have trended higher in recent months.

Odeta Kushi - Interesting considering quite the opposite has happened with existing-home sales. In the month of April, new-home sales increased by 4%. While existing-home sales declined by 3.4%.

Mark Fleming - Exactly. Bucking the trends, shall we say. But that's because of who the seller is. Think about the position that the existing homeowner is in right now. First, looking at house prices, which in many markets have come down from last year's peak. I'm going to put my behavioral economist hat on right now. By the way, listeners, no 80s music references, but multiple Econ hats in today's episode. Behavioral hat on. Many homeowners have anchored their price expectations to last year's exceptional market. People are not always rational economic robots.

Odeta Kushi - But our economic theories are so much easier when they are.

Mark Fleming - Oh, that math works out so much more nicely when we assume certain things. But, that's not reality. This is a great example of anchor or recency bias. Let's say my neighbor sold their identical house next door to me in the spring of last year and had multiple offers bidding up the sale price to $300,000. But, in today's market, I can only get $275,000 for it. The economic reality is that mortgage rates today are much higher than one year ago. So, potential buyers' house-buying power has declined, and they're offering less.

Odeta Kushi - That's right. It's all about the monthly mortgage payment. Rates have gone up, which means you can afford less home, all else held equal. But, to your earlier point, homeowners aren't necessarily considering the economic reality. They just think my neighbor with the worse yard got a higher price than I would get. No way. I'm not selling.

Mark Fleming - Anchor bias, a really big anchor in that case, not to mention that existing homeowners today are facing a seller's prisoner's dilemma. We touched on this at the beginning.

Odeta Kushi - Exchanging your behavioral economist hat for your game theorist hat, I see.

Mark Fleming - Number two, that's right. A prisoner's dilemma in game theory is a paradox in which two individuals acting in their own self interests do not produce the optimal outcome. You see where I'm going with this?

Odeta Kushi - I sure do. Now, as a reminder, the housing market is different than most markets. This is an important backdrop here. In most markets, the seller, or supplier, makes their decision about adding supply to the market independent of the buyer, or the source of demand, and their decision to buy. Yet, in the housing market, the seller and the buyer are in many cases the same -- it's the existing homeowner. So, in order to buy a new home, you have to sell the home you already own. And not just any home, a home that you like better. Every home is different, an almost perfectly heterogeneous, immovable good. The fewer homes there are for sale, the harder it becomes to find something better than what you already have.

Mark Fleming - Very well said. So sellers face a prisoner's dilemma, a situation in which individuals don't cooperate with each other, even though it seems in their best interest to do so. If sellers all chose to sell, they would all benefit as buyers because they would all increase the inventory of homes available and alleviate the supply shortage. However, the risk of selling if others don't in a market with a shortage of inventory keeps all those existing homeowners from selling altogether.

Odeta Kushi - So potential sellers are rate-locked in, anchored to last year's prices and facing a seller's prisoner's dilemma. That's what's keeping a lid on existing-home inventory.

Mark Fleming - Right. And the heart of all of this is one thing -- existing homeowners don't have to sell. And, by not selling, they continue to gain the utility of shelter. 

Odeta Kushi - That's very different from a homebuilder. A homebuilder doesn't live in the home, so no utility of shelter. They build a home to sell the home. In other words, they don't get any utility from that home until they can make a gain from the sale.

Mark Fleming - So a fundamental difference between the sellers in one market and the sellers in the other. And that's why new-home sales have fared better than existing-home sales. A builder will do what's necessary to sell their inventory, no anchor bias, no lock-in effect. No prisoner's dilemma.

Odeta Kushi - That's exactly what they're doing. According to a report from the National Association of Homebuilders, from their housing market index survey, it showed that incentives have played a key role in attracting buyers in this economic climate, but that the use of the sales incentives is gradually slowing. So, a couple of data points here, the share of homebuilders reducing home prices dropped to 27% in May. That's down from 30% in April. The average price reduction remains at about 6%. That's been unchanged over the last four months. And 54% of builders are offering some type of incentive to bolster sales. That's down a little bit from April when it was 59%. And down significantly from December when it was 62%.

Mark Fleming - Ah, yes, those incentives instead of price reductions directly. They can come in the form of a mortgage rate buydown, paying points for buyers and, as we've just mentioned, offering price reductions. They can also offer upgrades on appliances and other interior quality features or adding a deck. Lots of different ways to adjust the value of that home.

Odeta Kushi - Just curious here, how does a rate buydown work and how much might it cost a builder?

Mark Fleming - That's a great question. According to an analysis from John Byrne's real estate consulting, to buy down the rate for the term of the loan, builders pay upfront points. Each quarter-point reduction in the rate typically costs 1% of the loan amount. Some builders purchase forward commitments, which provide tranches of money at below-market rates to originate those mortgages for their buyers as an alternative to buying down the rate for the term of the mortgage. But the point really here is, essentially, the buyer of that new home can get a 5.5% instead of a 6.5% mortgage and, therefore, can still pay the higher price. But, to them, it's the monthly payment that matters not the actual price of the home.

Odeta Kushi - That's a great point. And, I mean, from the perspective of a builder, is a rate buydown preferred to lowering the price of a new home?

Mark Fleming - Absolutely, because, put yourself in the shoes of a builder and a potential buyer. If you're a buyer who locked into a contract on a new home with a price of $300,000, maybe six or nine months ago, and all of a sudden the builder is offering a nearly identical home in that same community as the one you're purchasing in for $10,000 less, you're gonna ask yourself the question, maybe I should just break this contract and get a new one for the price of $290,000.

Odeta Kushi - That's a great point. So maybe a builder is more likely to cut the price on a new home if it's the last one to sell in that newly built community.

Mark Fleming - Definitely. The later you go in the development of a community, the more beneficial it obviously is. There's also the competition with the community across the street from the other homebuilder. So there are lots of options there. But, generally, a builder would prefer to offer quality upgrades on the home, rather than cut the price.

Odeta Kushi - That may explain why new-home prices have remained pretty resilient, though not as resilient as existing-home prices.

Mark Fleming - It sure does. Existing homeowners won't sell at a lower price than their anchored to -- we talked about that -- unless they have to, but builders are able to cut prices -- and I'm air-quoting here on prices because price isn't really the sticker price anymore, it's this combination of incentives and sticker price on that home -- when they need to.

Odeta Kushi - So, according to the U.S. Census Bureau's new residential sales April report, the median sales price of a new home is down just over 8% on a year-over-year basis. Whereas according to the National Association of REALTORS April existing-home sales report, the median sales price of an existing home is down just 1.7% from a year ago. Now we have to be careful when using median sale prices because it doesn't account for the mix of properties being sold. In other words, house prices could be falling because more lower priced homes are selling. But, nevertheless, the point remains a builder is more likely to cut prices than an existing homeowner. Unfortunately, even with the incentives, buying a new home isn't any easier for potential first-time home buyers. Higher builder costs remain a headwind to building more entry-level homes in April 2023. From that same report I just mentioned, only 15% of new-home sales were priced below $300,000. This is significantly lower compared to the pre-pandemic April 2019 share of 37%.

Mark Fleming - That's a tough stat. I mean, this still gets to the point -- you can't buy it, if you can't afford it. But, I will say, traditionally, a first-time home buyer wouldn't buy a new home in the first place because they're, on average, pricier than existing homes. In the past, a first-time home buyer might buy an existing home through the process of filtering. A new home starts out expensive, but then, as it filters down -- in other words, gets older -- it becomes less valuable and the price gets lowered, and it becomes less desirable.

Odeta Kushi - I think this is your Economics professor hat. So that's number three at this point.

Mark Fleming - Hat number three. 

Odeta Kushi - But, perhaps, we tackle starter homes and the process of filtering in a future episode.

Mark Fleming - Fine, fine, filtering next one. 

Odeta Kushi - Well, that's it for today. The takeaway from today's episode is that builders are gaining market share in today's housing market because existing homeowners are incentivized to stay put, while builders are incentivized to use incentives to sell. How many times can I say incentive in one sentence? A lot, it seems. 

Mark Fleming - One more time, one more time. 

Odeta Kushi - What's the incentive for me to say it one more time? All right. Thank you 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.

Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2023 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.