CEO Jeffrey Mezger has experience in the housing industry. In his 17 years as the homebuilder’s top executive, he has witnessed just about everything, including the 2008 “housing bubble” and subsequent catastrophe. Even with all that time, he has never seen the property market change dramatically as it has since spring 2020.
Since the pandemic began, “it has been an incredible pendulum swinging back and forth,” Mezger tells Fortune. “If you think back to 2019 and the months leading up to the pandemic in January 2020, our business was very good. Then, it stopped [during the lockdowns], and you navigated that, and then buyers came back with a vengeance that summer. And then, in 2022, the Fed decides they’re going to stop housing and raises [interest] rates, and it [housing] stops again. Those were really significant changes that occurred quickly. In contrast to the delayed shift in trend that typically occurs over months, this one happened quickly.
Mezger claims that this year’s new construction market was once again unpredictable as purchasers went to builders after finding limited options in the inventory-constrained existing house market. After declining 29% on a year-over-year basis in July 2022, the demand rebound resulted in a 31% increase in U.S. new home sales in July 2023.
The Fortune 1000 company KB Home, ranked No. 518, witnessed the demand bounce personally as net orders increased this spring. In fact, the 3,936 homes that KB Home received as net orders during the three months that ended on May 31 were comparable to the 3,914 homes that the business sold during the same time period in 2022.
When 2023 rolled along, the [new house] market immediately recovered. Considering how [mortgage] rates have continued to rise, we have been pleasantly surprised by how robust 2023 has been, Mezger tells Fortune.
Can homebuilders, however, sustain this uptick in sales? After all, the affordability of housing has fallen to levels that have not been seen since the housing bubble. Let’s begin by carefully examining how, in Mezger’s estimation, we arrived here in order to better comprehend what can happen next.
Builder cancellation rates spiked at the outset of the COVID-19 lockdowns before rapidly falling after the housing market began to blossom in the summer of 2020 amid the work-from-home and stimulus-driven frenzy. A good example of this is KB Home, whose cancellation rate increased from 15% in Q2 2019 to 43% in Q2 2020 before falling to 9% in Q2 2021.
However, cancellation rates soared once more in 2022 as mortgage rates rose from 3% to 7%. At its highest point in the housing downturn last year, KB Home’s cancellation rate in Q4 2022 was a startling 68%.
Confusion frequently results from the cancellation rates that builders submit to the US Securities and Exchange Commission. These so-called “can rates”—rather than cancellations as a percentage of backlog—are determined by dividing cancellations by gross orders. Mezger demonstrates that even if cancellations themselves remain level, cancellation rates might rise if gross orders undergo a dramatic fall.
While Mezger claims that the steep decline in gross orders was mostly responsible for KB Home’s 68% cancellation rate in Q4 2022, there was a little increase in customers backing out of commitments.
It is up to each buyer to lock their interest rate; if they chose not to do so and instead chose to “play the market,” as rates climbed from 3.5% to 6.5%, in some cases their payment changed so drastically that they either lost their eligibility or decided not to buy. We did have some of that, according to Mezger. If their payment changes the way it did last summer, it will be difficult for them to stay in their home because they will refuse to pay an additional $600 or $800 a month for it.
It wasn’t always bad for homebuilders when purchasers started to back out of agreements. After all, if purchasers cancel, builders get to keep the money.
Therefore, we had buyers who would leave. The deposits are not refundable once we begin building the house. Because they no longer want the home, some of our purchasers walked away from earnest money deposits of $20,000 or $30,000. This was an emotional cancellation. We had millions of dollars in retained deposits on those cancellations, if you look at the financials, Mezger tells Fortune.
Builders started to cut their profit margins, which had reached record highs during the Pandemic Housing Boom, when the U.S. housing market started to tank last year in an effort to attract buyers back to the market. That means offering aggressive rate buydowns, which in some cases lowered purchasers’ mortgage rates to 5%, or offering money at closing for select builders. Builders completely reduced their prices in several communities.
We reached a high of $540,000 [average home price] over our entire footprint, and right now we’re right around $500,000. [House] pricing is down around $40,000 from the peak across our entire footprint. As a result, Mezger tells Fortune, “We’re off 9% to 10%. “In our [KB Home’s] business, [home] price decreases predominate; we don’t offer many incentives… We are committed to providing the finest value to our customers. If we are going to adjust, we will usually do it in pricing.
“Occasionally, the media will single out a market and portray it negatively when we are operating there and saying, ‘Hey, it’s actually pretty good.’ The demand can move up and down the pricing ladder in any area, so it partly relies on where in the cities you’re developing and the price point [you’re] building at, according to Mezger.
According to Mezger, the Inland Empire market has held up well over the previous 12 months.
“Despite the extensive media coverage of California’s difficulties, our Inland Empire division—which includes the commuter corridor east of Orange County and LA County, which includes the counties of San Bernardino and Riverside—didn’t really slow down. Our market demand held up remarkably well throughout the difficult period and is still performing well today. It’s a fantastic illustration of a vast population, significant demographic demand, and strong desire to purchase a home. Additionally, there isn’t a listing of both new and secondhand properties, Mezger says Fortune. You should visit Florida because the entire state is doing well right now. There isn’t a single area of Florida where we would say, “That’s a tough market.
For us, Denver is the market where the premium for resale went too high, the market has been correcting, and it has been challenging for the sector. Where prices just jumped extremely quickly and got out of reach, and we’re still adjusting there, demand is still a bit slower than usual and definitely slower than we see in the Inland Empire, according to Mezger.
Since it is so localised, “we will often have a 10% to 15% premium over resale [prices] in that ZIP code. In normal circumstances, our home will be [priced] at $340,000 to $350,000 if yours is a 2,000 square foot Phoenix property with a $300,000 resale. When the market was booming before Fed rates increased and mortgage rates increased, our premium over resales in some places reached as high as 30%. Consequently, you are out of step with your main rival, resale. As long as it continues to work, you can continue doing it, but once the market returns to normal, you must stop. It usually reverts to the means over time.
According to the price point, Austin, we’re either doing well or averagely. However, in Austin, we’re paying less. In Austin, we often sell homes for between $350,000 and $380,000. “At the higher price points above us, they’ve slowed down considerably, and prices have dropped fairly significantly on the higher priced homes [in Austin] because it moved up so quickly and moved away from resale [prices] and it’s out of whack,” adds Mezger. It’s a terrific illustration of how each market is localised and has its own characteristics.
Builders’ concerns over their significant backlogs were one factor in their haste to lower prices and offer buydowns. Builders’ backlogs increased during the Pandemic Housing Boom because of supply chain problems that caused them to sell more homes than they could assemble.
Builders have, however, gradually reduced those backlogs over the past year (see chart above).
Look no further than KB Home, which had a backlog of 12,331 homes during the height of the Pandemic Housing Boom in Q2 2022, up from 5,927 homes in Q2 2019. The backlog at KB Home was 7,286 houses as of Q2 2023.
“At any given time, the system is backlogged with a sizable number of residences. We therefore have a huge backlog and are sensitive when sales decline. When rates started to rise and sales started to slow down at this time last summer, we had a backlog of more than 11,000 properties. They had extremely good [profit] margins, but if we did things [lower prices] and chase sales/go find the market, you put 11,000 homes in the backlog at risk of having their prices adjusted as well, Mezger says Fortune.
Simply put, if backlog buyers witness new buyers receiving significant discounts, they will likewise approach and request those deals. According to Mezger, KB Home delayed starting to lower prices and boost gross orders until closer to January, when its backlog had decreased again.
“We turned the corner into January and had bled the backlog down. We were then in a position where we would pull the lever, whether it was financing, modifying price, offering different products, or anything, selectively on a community-by-community basis, to get sales flowing again. And that’s what you witnessed with us, as sequentially, each month in [the first half of] 2023, our orders got stronger,” Mezger tells Fortune.
We’ve been boosting [home] prices across the footprint ever since we quote ‘discovered the market’ and resumed our sales pace, and in the second quarter, we disclosed that we raised prices in 70% to 75% of our communities. I said this on our last earnings call. The bottom, in my opinion, is in. If you think about it at a macro level, it is being caused by the fact that there is no [existing] inventory in any of the cities where we do business. There are typically 6 months of supply and around 5.2 million resales in a typical or average year.
As a result, the county would have 2.6 million listings if there were 5.2 million resales. The number of dwellings available now is 500,000 instead of 2.6 million because it is reported in months of 1 month or 1.2 months. And of the 500,000 named, some of them aren’t even livable; they are houses that would need to be bought, demolished, and rebuilt. As a result, our main rival, resale stock, has no inventory. There are markets where it [months of supply] is priced in days rather than months at our pricing point: 11 or 12 days’ worth of stock for sales. Due to supply chain concerns and other challenges, on the build side, our largest competitor historically [speaking] doesn’t have any inventory.
As a result, there is a shortage of both new and resale homes, which is contributing to a lack of inventory. At the same time, there is a high demand from the millennial generation and Generation Z, who are now in the home-buying age range. Thus, even though rates have increased, there is still enough demand when there is little inventory and strong [demographic] demand for consumers to acclimatise to the higher [mortgage] rates, according to Mezger, who speaks to Fortune.
KB Home decreased home prices by 9% to 10% from peak to bottom. According to Mezger, KB Home is just 4% to 5% off its 2022 price peak as of July, and if the housing market continues on its current course, he thinks they may hit that top once more in 2024.
What if, though, he is mistaken and builders do in fact need to lower costs further? Inventory, according to Mezger, would be the measure to watch.