Are New Home Sales About to Go Up?

by: Kehong Wen
Much discussion on new home sales has been focused on how bad the recent sales have been (for example, see this post). March's number will probably not be better.
The rear-mirror view is consistent with high unemployment, sluggish job recovery, abundant supply of foreclosed homes, consumer retrenchment and low household formation coming out of a severe recession.
Looking forward, however, there are signs that point to an upturn, however slow it may turn out to be.
GDP has been growing for the past three consecutive quarters. Much of that growth is underpinned by manufacturing expansion, surge in exports and strength in technology. The expansion is spreading to other key industries such as retail, construction, travel, financial services etc. That will add much needed jobs.
Job loss appears to have stopped. And we can now look forward to job growth in the coming months. Job creation is probably the single most important factor that will spur a housing rebound.
In a series of recent posts, John Lounsbury has examined analyst forecast for home builder revenues in the next three quarters (see here and here). While his main point is that these estimated revenues appear to be too optimistic, I think he might have identified a turning point for new home sales.
In the table and the graph below, let’s look at the annual revenue picture as a whole for some representative builders, to smooth out seasonality. The data is obtained from Yahoo Finance, or from companies' annual reports.

On average, builder revenue has been dropping 30% - 40% for at least three years since 2006. The size of some builders as measured by sales has shrunk over 75% since the peak. The correction has been severe, and rightly so. They should not be building so many houses.
Looking forward, analysts are estimating only a 1.2% increase for these six builders - DR Horton (NYSE:DHI), Lennar (NYSE:LEN), KB Home (NYSE:KBH), Standard Pacific (SPF), Hovnanian (NYSE:HOV), Toll Bros. (NYSE:TOL) - for 2010 over 2009. And for 2011, the growth is about 18%.

Looking at the graph below, if these estimates are right, 2010 will represent a turning point for new home sales, and 2011 will only see a modest increase.

Going into the recession, analysts tend to over-estimate sales, whereas coming out of the recession, they tend to under-estimate revenues and profits. So I think it is very likely we are at the turning point. The next couple of quarters should see increased home sales year-over-year.
We all know about the problem with foreclosures and the feared “shadow” inventory. Those are the potential supply that may hit the market over the next few years. That may help depress new home sales.
One can argue that there is a countervailing factor, i.e. the “shadow” demand that may materialize as the economy improves. This potential demand is difficult, if not impossible, to estimate. But we know there is a substantial population growth in the U.S. and people have been putting off home purchase due to jobs and credit. One interesting area to look at is household formation.
Household formation in the U.S. historically has been running at about 1.3 million per year. It has slowed dramatically during the recession, to about 400,000 or so in 2009. Young men and women who cannot find jobs tend to go back to live with parents, or share apartments. If the employment situation improves, there is a glaring gap of nearly one million new households to be formed. That could definitely help drive up new home sales due to affordability and low mortgage rates.

Another important and overlapping demand factor is from those who have jobs but have been sitting on the fence. If they gain more confidence in the economy and the job market, they’re a ready source of buyers who will benefit from owning homes at a low price point.

In many sub-markets, new homes are not competing directly with foreclosures. It is likely that we'll see warm markets developing while many foreclosure hot spots are still facing huge pressure in the next few years. It is not realistic to think that the excess inventory must be cleared out first before new homes can be built.

Disclosure: Long SPF, LEN