Why Homebuilders Face a Precarious Future

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Signs of change in the U.S. housing market are already beginning to show. And homebuilders and development stocks like Brookfield Residential Properties Inc. (NYSE/BRP) and D.R. Horton, Inc. (NYSE/DHI) are becoming vulnerable. They have already shown some signs of weakness since the beginning of May, and more could follow.

There’s no doubt the housing market has seen a significant run. Home prices in the U.S. economy are increasing at a pace not seen since the housing market was booming. It’s hot; some institutional investors are even betting large sums of money on it and appear to think it will continue to grow at this pace.

But looking ahead, I can’t help but point out that there are some issues that can become troublesome for the already damaged housing market. You need to keep in mind that home prices are still down a great amount since their peak in 2006–2007.

Investors need to know about the most troublesome phenomenon occurring in the housing sector: rising mortgage rates.

If you look at Freddie Mac’s monthly average commitment rate on 30-year fixed-rate mortgages, it climbed to 4.07% in June, an almost 10.6% increase from a year earlier. The same mortgage rates in October 2012 stood at 3.35%—their lowest since 1971. (Source: “30-Year Fixed-Rate Mortgages Since 1971,” Freddie Mac web site, last accessed June 12, 2013.)

As the mortgage rates continue to go higher, many of those who are looking to buy homes now might get discouraged, and a decline in buyers creates a liquidity problem in the housing market. Remember, the housing market isn’t liquid like the stock market or foreign exchange markets, in which you can just place an order and are able to buy or sell with a click of a button. It takes time to sell a house, and you need a buyer.

If the number of home buyers who are actively searching the housing market declines, those who are willing to sell might have to resort to lower prices. Eventually, increased activity like this brings overall prices in the housing market lower.

Such a situation puts companies who are very close to the housing market—homebuilders, developers, and construction firms—at risk. The reasoning behind this is very simple: if the prices in the housing market go down, the activity decreases and hurts their bottom line. For example, if the home prices are going down, making buyers scarce, developers will have difficulties selling their projects.

Investors always need to keep in mind that things in the world of finance can turn very quickly. One decision from the Federal Reserve or the U.S. government can change the fate of the housing market. Investors should always practice caution and not overexpose themselves to just one sector—especially the housing sector.

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