Capital

Margin Pressure Mounts In A Higher-For-Longer Marathon

The squeeze on private homebuilders' margins comes from three key sources: High mortgage rates eroding demand, leading to greater price concessions; tighter credit access, leading to higher borrowing costs; and land price inflation due to lot supply constraints.

Capital

Margin Pressure Mounts In A Higher-For-Longer Marathon

The squeeze on private homebuilders' margins comes from three key sources: High mortgage rates eroding demand, leading to greater price concessions; tighter credit access, leading to higher borrowing costs; and land price inflation due to lot supply constraints.

November 14th, 2023
Margin Pressure Mounts In A Higher-For-Longer Marathon
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Getting over the hump of high interest rates, now that the hump could be more like an exhausting and expensive plateau than a quick path of peak-and-descent, might continue to take a heavy toll on homebuilders into 2024, particularly privately-capitalized ones.

While all eyes continue to focus on Fed responses and reactions to signs of progress on its goal to rid the economy of inflationary forces – and bets are evenly mixed on whether and when the Fed will ease off the pressure on borrowing costs and credit access, and perhaps go so far as to reverse it – private home builders now enter a critical window that suggests their own pressures may get worse before they get better.

Two new reports support this reading of what's ahead.

  • One, an October analysis from the National Association of Home Builders indicates trends of tighter access to acquisition, development, and construction credit and increased costs associated with AD&C finance.
  • Two, an October private homebuilders survey from the team at Wolfe Research, led by senior housing equity analyst Truman Patterson that indicates trends of increasing price incentives to buoy order pace even at seasonal levels.

Both releases contain news of tougher sledding, particularly for private home builders' defense of their gross margins. This is especially the case if that hump is a longer, more drawn out period defined by increasing signs of homebuyer fatigue on the one side of the equation and yet another factor – rising land prices – on the other.

The squeeze begins to come clear in this week's note from Paul Emrath, VP for Survey and Housing Policy Research at the NAHB, who draws attention to a steep rate of deterioration in access to credit not seen since "the 2010 trough of the Great Recession."

Further, the ways that tightening of credit took shape were, of course, increased bank borrowing costs. Emrath writes:

Image courtesy of National Association of Home Builders Eye On Housing
What happened to the cost of credit during the third quarter depended on if you were a builder or developer. On loans specifically for single-family construction, the average contract interest rate increased—from 8.37% to 8.66% if the construction was speculative, and from 8.18% to 8.37% if it was pre-sold. In contrast, the average contract rate declined on loans for land acquisition (from 8.62% to 8.31%) and land development (from 8.70% to 7.78%).
Although the average initial points also declined (from 0.81% to 0.58%) on loans for land development, it increased on the other three categories of loans tracked in the NAHB AD&C survey: from 0.52% to 0.86% on loans for land acquisition, from 0.71% to 0.93% on loans for speculative single-family construction, and from 0.44% to 0.86% on loans for pre-sold single-family construction.
... The effective rate paid by single-family builders on construction loans, meanwhile, continued to climb much as it had over the previous five quarters: from 12.85% to 13.74% on loans for speculative construction, and from 12.67% to 14.57% on loans for pre-sold construction.

Tighter credit and higher loan costs blend now in land acquisition backdrop noted by D.R. Horton executives of higher land inflation, probably due both to pre-existing chronic lot supply constraints, and to lumpy and spotty conditions that make some local markets opportunistic while others may languish in economic doldrums.

Further, those inflationary drivers on land prices can be expected to ratchet up even more in the next 12 to 24 months as national publics muscle for greater market share – for homebuyers, land parcels, access to labor resources, and materials supply chains – at the expense of smaller, privately-held operators.

What is more, according to Truman Patterson's recent survey, private builders' gross margins have already begun to take a hit from this past year's turbulence, even despite a less-severe-than-expected impact from the Fed's rate run-up. Sales absorption paces for October and Q4 widely underperformed normal seasonal trends, and – thanks to 30-year-fixed mortgage rate spikes to above 8% in October, also took a big jag downward sequentially, Patterson notes.

What happened to margins in this context comes through in the roll-up data points among the Wolfe Research survey panel of operators:

October Gross Margin performance declined -50 bps sequentially, with mostly negative results among respondents. Only 30% of respondents indicated margins improved versus September. We expect our Public HB Group’s 4Q GMs to decline -60 bps QoQ as companies ramp incentives. October Survey Order pricing declined -20 bps sequentially with a little more than 50% of respondents reporting declining MoM pricing. Incentives on average moved modestly higher in October. Among common respondents, incentives averaged 4% in October versus 3.7% in 3Q. Less than 20% of respondents saw incentives decrease versus 3Q levels."

Some of the builder-operators' verbatim replies to a question on their use of mortgage buydowns to maintain their backlog closing and forward order pace reflects a growing need to leverage gross margin as a "shock absorber" to keep the business's machines running.

During mid-summer we were able to offer ~4.75% rate buydowns. That has since increased to ~5.5% - 5.75% and at a higher cost."
Until now, we have not offered our homebuyers with any mortgage rate buydowns. Beginning next week, we will start to offer a mortgage rate buydown that will average about $10,000 per house and applies only to market homes."
Yes we are buying down mortgages and the cost is significantly higher than mid-summer. The key is to get below 6% but in many cases that is not realistic, the good news is that this year end slowdown is much more focused on payment than price compared to last year." Wolfe comment – we are hearing this comment consistently from builders. Buyers are more focused on getting a payment that meets their budget, rather than being nervous that home prices are rolling over.
$15K - $20K is the current buy down range. This has meaningfully increased since July ($0 - $7K)"

So, margin erosion on three fronts: Cost of sales increases due to rates and prices demand deterioration; costs for finance; and land costs likely to push higher in a lot-constrained near- and mid-term future.

SLC Advisors president Scott Cox points out:

At least as big a threat, and related, is G&A spread over less units when you can't reload. Which means your GM looks ok, and the net, not so much."

How low can it go? We'll soon see how much shock this financial "shock absorber" can absorb.

ABOUT THE AUTHOR

John McManus

John McManus

President and Founder

John McManus, founder and president of The Builder’s Daily, is an award-winning editorial, programming, and digital content strategist. TBD's purpose is a community capable of constant improvement.

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John McManus

President and Founder

John McManus, founder and president of The Builder’s Daily, is an award-winning editorial, programming, and digital content strategist. TBD's purpose is a community capable of constant improvement.

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