U.S. housing: An underappreciated growth market
Martin Jacobs
Equity Portfolio Manager

Many investors, economists and policymakers have doubted the strength of the U.S. housing market, largely due to skyrocketing mortgage rates and plummeting affordability.

The near-term dynamics that drive the housing cycle are sending mixed signals today, with prices higher even as sales have been depressed. But I believe longer term trends point to solid growth in housing over the next decade. People need a place to live, and home ownership remains a centerpiece of the American dream.

As an equity portfolio manager for AMCAP Fund, a growth strategy, I focus much of my time on megatrends like artificial intelligence, cloud computing, productivity and globalization.

But I also spend time looking for the lonely investment idea. And in my view, housing stands out as one of the more underappreciated growth markets in the U.S. economy today. Here are three reasons why:

1. New home construction hasn’t kept pace

Simply put, new construction has not stepped up to meet demand. By my estimate we may have a housing shortfall today of as many as five million homes. The number of households in the U.S. increased by 1.65 million in March. Non-replacement housing starts, a measure of new housing units being built, stood at 889,000, year over year, in March.

Construction has lagged housing demand for more than a decade

The line chart tracks U.S. household formation, a measure of demand for housing, and non-replacement housing starts, a measure of new home construction, from January 2000 through March 2024. The chart shows that new construction has generally lagged household formation — or demand — since the end of the global financial crisis in 2008. Vertical bars represent periods of recession between March and October of 2001, December 2007 and May 2009, and February and March of 2020.

Sources: Capital Group, National Bureau of Economic Research, U.S. Census Bureau. Non-replacement U.S. housing starts reflect actual housing starts less 0.295% of the housing stock (Census Bureau estimate of housing loss). Grey bars represent recessionary periods. As of March 31, 2024.

This gap between supply and demand extends a trend that has lasted more than a decade, except for a volatile period between 2021 and 2022 in the wake of the pandemic. In other words, we have underinvested in new housing.

We will need to see at least 1.5 million to 1.6 million new home starts each year just to keep up with population growth. That doesn't include a potential 300,000 to 400,000 homes that are demolished each year. This suggests the potential for a significant boost in residential construction activity for years.

2. The "lock-in" effect could drive more construction

Higher mortgage rates have created distortions in the supply-demand picture that could provide tailwinds for new home construction in the near term. As the Federal Reserve hiked short-term interest rates 11 times in 2022 and 2023, mortgage rates soared and existing home sales plummeted from an annualized rate of 6.4 million in January 2022 to a rate of 3.8 million in October 2023, a 28-year low.

Rising mortgage rates have weighed on home sales

The chart compares U.S. existing home sales with average 30-year fixed mortgage rates from December 31, 2021, when average 30-year fixed mortgage rates were 3.11%, and existing home sales were 6.2 million units year over year, through March 29, 2024, when average 30-year fixed mortgage rates were 6.79%, and existing home sales were 4.2 million units on an annualized basis. Average mortgage rates rose from 3.11% in December 2021, peaking at 7.79% in October 2023, before declining to 6.79% in March 2024. Existing home sales peaked at 6.4 million units in January 2022 and declined to a low of 3.8 million units in October 2023 before rebounding to 4.2 million units in March 2024.

Sources: Capital Group, Freddie Mac, National Association of Realtors. Existing home sales figures are seasonally adjusted at an annual rate. As of March 29, 2024.

Concerns about affordability may explain some of the decline, but the sharp rise in mortgage rates has also resulted in a lock-in effect for existing homeowners. Typically in any given year, many owners will sell their homes to relocate for a new job or to accommodate a growing family. About 70% of homeowners at the end of 2023 held 30-year fixed-rate mortgages about three percentage points lower than available rates on new mortgages. Many homeowners with such mortgages will conclude that relocating is financially untenable because their existing mortgage itself is an asset that would be difficult or impossible to replace. This lock-in effect has resulted in a substantial decline in homes for sale.

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The smaller supply of existing homes for sale provides an additional tailwind for new home construction in the near term. Homebuilders are scrambling to begin new construction to meet the supply shortfall.

Although much has been written about an affordability crisis, mortgage rates are not extreme by historical standards. It’s worth remembering that in the 1970s and 1980s, when mortgage rates were in the double digits, the housing market remained healthy as millions of baby boomers made initial home purchases. And that was in a period when the U.S. population was around 230 million versus about 340 million today.

Today, I see similarly positive dynamics, with more millennials beginning to buy their first homes, a post-pandemic desire for bigger single-family homes, and the construction lag throughout the 2010s. I also believe homebuyers will ultimately adjust to a new environment of higher rates and prices.

Rate “lock-in” effect contributed to a stark decline in home sales

The chart shows the estimated reduction of potential home sales attributable to the lock-in effect whereby current homeowners are reluctant to sell because they hold mortgages with favorable rates compared with currently available rates. The chart shows the impact of the lock-in effect, as estimated by the Federal Housing Finance Agency, from January 2000 through December 2023. The most recent period (the quarter ending December 2023) reflects an estimated 57% reduction in the number of existing home sales, the largest reduction in the period tracked.

Sources: Capital Group, Federal Housing Finance Agency Staff Working Paper: "The Lock-In Effect of Rising Mortgage Rates" (published March 2024). Lock-in effect refers to the disincentive to exit a fixed-rate mortgage while the prevailing market rates exceed the "locked-in" mortgage rate. Latest data available as of May 2, 2024.

3. Homebuilders adapt to shifting dynamics

The shortfall in new construction is providing opportunity for homebuilders able to adjust to this new environment. Some builders are providing financing incentives. For example, D.R. Horton, the largest homebuilder in the U.S., has slashed prices and offered mortgage rate buydowns to customers to help boost affordability. What’s more, the Federal Housing Administration (FHA) and Veterans Health Administration (VHA) are backing a significant share of home purchases.

Some homebuilders are taking further steps to strengthen their balance sheets in preparation for market volatility should high rates linger. Lennar, for example, has adapted an asset-light approach, signing option agreements for land rather than buying it outright. A decade ago, many homebuilders went into debt to purchase land up front. Lennar has also invested heavily in digital marketing platforms.

Among building materials companies, TopBuild, the nation’s largest insulation installer, continued to grow its business, improve its margins, and add to its organic growth through acquisitions of smaller installers.

Bottom line: Years of growth in housing

The benefits of a sustained housing recovery can reach beyond homebuilders and materials providers, potentially lifting sales for home improvement retailers and appliance makers as well as boosting construction jobs. While there are signs that the housing market is stabilizing after a few challenging years, there are risks — chief among them a weakening labor market — even if it leads to lower interest rates. That said, while there could be volatile periods, I believe the housing market has several years of potential growth ahead. And my job as an equity portfolio manager is to identify those companies best positioned to tap into that growth potential.

Martin Jacobs is an equity portfolio manager with 35 years of investment industry experience (as of 12/31/2023). He holds an MBA from Wharton and a bachelor's degree from the University of Southern California. Martin is a CFA charterholder and a member of the CFA Institute.

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