Housing: Starts and Permits and the Working Capital Challenge

We look at the latest numbers in the home construction working capital cycle as the builders face clutch time.

“Life as a homebuilder inventory manager…balance counts.”

• We look at March new residential construction data as the homebuilders wade further into the spring selling season and the need to weigh construction rates and spec inventory with new start activity and uncertain mortgage rates.

• An interesting trend this month was the divergence between seasonally adjusted and not seasonally adjusted as even the “models” are a bit confused.

• The absence of bad news and optics of stabilization helps, but the mortgage rate moves and rate of inventory liquidation hold the keys for homebuilder fundamentals and construction planning from here.

The housing cycle YoY trends hold little mystery at this point since they remain down double digits with single family units down -27.7% YoY seasonally adjusted. The focus will remain more on the sequential debate, and so far this has been mixed overall even if it signals stabilization. The transition from very high levels of construction into a crucial spring selling season sees the builders in a key planning stretch at this point. The decision points for new construction plans and permits are hard to read sequentially so far in 1Q23. So, it will be a crucial few months ahead. 

The builders are in the same boat with the debt and equity markets in trying to make a prudent call on the direction of the UST curve, employment trends, tightening credit conditions from lenders, and how that all rolls up into recession risk. The homebuilders are in a recession now. Whether it gets worse or shows slow improvement will drive decisions on working capital management and pricing.

The working capital conundrum…

We looked at some of these decision points for builders in a detailed report on D.R. Horton as the #1 builder (see D.R. Horton: Credit Profile 4-4-23). D.R. Horton has discussed the topic in detail around how it balances its spec building strategy with managing the start of new construction activity. The near 100 bps swing in mortgage rates in recent months makes for a challenge planning on starts levels, and the protracted yield curve inversion is leaving many variables uncertain.

Current levels are clearly running below the long-term median as would be expected with this mortgage rate backdrop. That said, the median from the Jan 2009 housing collapse period through March 2023 at 723K is even more dramatically below the long-term median. It took a pandemic, a spike in relocation flight in the work from home stretch, and record low mortgage rates to get the start levels materially higher.

We have covered those topics in various other commentaries, and there are way too many moving parts big and small that go into the story. The critical driver for now remains mortgage rates and monthly payments and the rent vs. buy decision.

The above chart updates the time series for seasonally adjusted single family home starts. The modest sequential rise of +2.7% in seasonally adjusted annual rates conflicts somewhat with the “not seasonally adjusted” monthly unit tally, which was +23.6% sequentially from Feb 2023 to March 3023. The +73.3K actual tally in 1-unit starts for the month was at a 6-month high. The actual (not seasonally adjusted) monthly total starts (single family and multifamily) of 118.4K was +14.2% sequentially vs. the seasonally adjusted rate decline of -0.8%. The multifamily (5 units or more) was -6.7% seasonally adjusted and flattish not seasonally adjusted.

The above chart frames the actual “not seasonally adjusted” starts and permits for a frame of reference on the pipeline for total construction activity overall and especially in the single family segment that drives homebuilder revenues and earnings. 

As we show in the next chart, new construction of homes has been booming under the heading of “units under construction,” so economic activity is very high in cyclical context. The peak selling seasons ahead will go a long way to settling how quickly completed homes and the homes in process can get closed and moved off the homebuilder books. That generates cash for the homebuilder for the next question around “What do they do with that cash?”

The working capital cycle of permits to starts to “under construction” to “completion” to closed sales/deliveries is not all that mysterious. That said, the process and execution is enormously complex in the context of so many communities across so many regions and so many pricing strategies, subcontractor and supplier chain plans, and the unpredictable state of the mortgage market and where the curve is headed.

Record high payrolls and solid employment trends help the homebuilder story while all-in mortgage rates do not. The interplay with apartment and single family rentals adds to the builder planning factors and the same for the potential homebuyer.

As we covered in a recent commentary (see Footnotes and Flashbacks: Week Ending April 2, 2023), the current UST curve is well below where the curve was in the 2005-2006 housing bubble, but mortgage rates are similar with mortgage related spreads so high in this volatile UST market. There is a path ahead based on history to 5% handle mortgage rates (in theory) even with a stable curve, but that is easier to theorize than realize.

The above chart updates the “under construction” timeline, and the combined single family and multifamily are trending lower from the peak (5-unit hit a high this month). The level of construction activity remains at high absolute run rates in historical context. The peak selling season demand, mortgage rates, incentive game plans, and the rate of spec inventory sell-down and completion will be the key to where builders want to take permits and starts in coming months.

Completions are up YoY in total but essentially flat in single family on a YoY basis seasonally adjusted (-0.2%). Actual completions for 1-units in March 2023 (not seasonally adjusted) were up very slightly vs. March 2022. Completions in multifamily for 5+ units were up substantially YoY in total across the US by 59.7% seasonally adjusted and were also up substantially in monthly actuals (not seasonally adjusted). That drove a total unit completion increase of +12.9% seasonally adjusted. The significance there is that multifamily supply is supposed to keep pressure on rental rates.

The above chart plots Multifamily permits, aka “New Privately-Owned Housing Units Authorized in Permit-Issuing places.” (Note: we agree with those who think the titles and labels get annoying after a while). The booming supply in 5-unit structures under construction and bringing supply into numerous markets is likely to stay weaker until the recession clouds clear, mortgage rates get better visibility on trends, and some markets see some caution exercised around supply-demand balances. 

The above chart tracks Multifamily (5-unit) starts across time. The YoY number remains positive with +6.1% YoY for March 2023. The level was down sequentially by -6.7%. The numbers in multifamily can be lumpy, and Feb 2023 had put up a very strong number (581K) that was the third highest of the past year.