New Home Starts Up, But is There Demand?

By Bob Blandeburgo
Associate Editor
Money Morning

The U.S. housing market continued its tepid trek toward recovery as housing starts in May exceeded expectations, the U.S. Commerce Department said yesterday (Tuesday).

Housing starts soared 17.2% from April to May, nearly double the 7% increase economists were projecting, Actual housing starts reached a seasonally adjusted annual rate of 532,000, also well ahead of the 490,000 economists surveyed by the Dow Jones Newswires had projected, The Wall Street Journal reported.

Despite the unexpected month-to-month uptick, U.S. housing starts are still more than 45% below the pace of a year ago when the housing-start rate was 971,000.

And just because there's been an increase in home construction doesn't mean there's been an accompanying increase in housing demand, Andrew Waite, a former institutional investor who is now the publisher of Personal Real Estate Investor magazine, told Money Morning in a telephone interview.

In fact, says Steve Hagenbuckle, managing principal of real estate private equity fund TerraCap Management, homebuilders may be continuing to construct new homes in the hope that a sale at breakeven - or even at a slight loss - will allow them to continue operation.

"We feel that builders need to keep building a minimal amount of product in order to keep the machine running, meaning their companies running," Hagenbuckle told The Journal. "Even if they're selling these new homes at break-even or even a slight loss, they need to do it to have the revenue in order to keep their doors open and pay their staff. That's part of what's really happening."

The upshot: The continued construction in the absence of growing demand could translate into lower profits for homebuilders.

Builders could battle back by building cheaper houses, says Waite, the magazine publisher. Homebuilders operate on the so-called "33% rule," which dictates that the land a house is built on must cost less than 33% of the retail price of the finished home's sale price. Adding another 33% for construction and a margin of 33% or more attains that retail price.

In this economy where burned consumers are wising up, the cost of ownership of a home beyond its price may come back to haunt builders who had been constructing homes on cheaper lots in more distant locales - a living situation known in industry parlance as the "far-burbs." 

This allows the builder to build a cheaper house and meet the apparent pricing sweet spot," Waite said.

As housing prices soared during the uphill side of the U.S. housing bubble, prospective homeowners often opted for cheaper houses in those more-distant communities - accepting the longer and costlier commute in return for a still-affordable large house, or a lower mortgage payment. But when housing prices swooned - and then plunged - these homes became less attractive to new buyers.

And as the economic slump turned into an actual recession, and job cuts turned many two-income households into single-income families, those commutes became too expensive to afford.

Often, the mortgages became too expensive, too.

The rise in May housing starts for single-family homes, which grew 7.5% to a rate of 401,000, could result in additional unsold homes for builders, according to JPMorgan Chase & Co. (NYSE: JPM) analyst Daniel Oppenheim, who called the gain a "modest negative from a supply standpoint."

Even far-burb houses built on the distant locale "cheap-dirt" lots may go unsold, as the housing market in many areas continues to stagnate. Factors such as rising energy costs-particularly natural gas, which jumped 13.9% in May-could keep homebuyers on the sidelines as they balance their recession-riddled budgets.

One potential wild card is the real estate investor, who buys homes in order to rent them out. For consumers whose poor credit, strained budgets or ebbing cash flow keeps them from qualifying for a mortgage, even renting a far-burbs house is a sound second-tier option to an apartment. And for builders, selling to a real-estate investor is almost as good as selling to the actual tenant.

"The new house market is separate from the resale house market," said Waite. "The question is, are they rentable to the folks that have just lost their homes because of fragile budgets partially brought about by energy and lifestyle costs of an extended commute?"

There are rays of hope in the housing market, due in part to the aforementioned fact that starts are significantly down year-on-year. Inventories in major cities in the western United States are shrinking, Money Morning reported earlier this month.

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