Navigating Volatility in the U.S. Residential New ...

Navigating Volatility in the U.S. Residential New Construction Sector

Tailwinds to sweep through near-term turbulence

Abstract

Over the course of 2018, factors impacting supply and demand for housing in the U.S. trended negatively, causing a shift away from prior expectations of a steady and strong growth environment in residential new construction. Wells Fargo Securities and L.E.K. Consulting analyze these factors, among others, against historical housing activity to assess the potential impact of a near-term housing down-cycle. We put into context current residential new construction activity relative to longterm averages and quantify the level of pent-up demand in household formation, most notably from the millennial generation. Our view of the data suggests a positive outlook despite current fears of near-term softness.

Table of Contents

Summary Takeaways Introduction Near-Term Residential New Construction Activity: A Blend of Consumer Psychology and Housing Supply/Demand Fundamentals Long-Term Residential New Construction Outlook: Slow Recovery and Demographic Tailwinds Support Sustained Growth Conclusion: Scenario Planning Appendix A -- Supplemental Exhibits Appendix B -- Interpreting the Housing A ordability Index Authors About Wells Fargo Securities and L.E.K. Consulting

Summary Takeaways

Are we heading into a down-cycle in housing? What are the biggest near-term tailwinds for residential new construction? ? Since 1970, there has been no instance of total housing starts turning negative prior to reaching the long-term average.

Current total housing starts of 1.256 million are 13% below the long-term average of 1.438 million starts. A housing cycle peak at this level would be unprecedented, and we anticipate any down-cycle in housing would produce a relatively modest decline in starts, if one were to occur at all. ? Housing market fundamentals are positive as the consumer remains healthy and the market undersupplied. ? While sharp declines in housing affordability captured headlines in late 2018, subsiding expectations for rate hikes paint a brighter picture for homebuyers in 2019.

If we do go into a near-term down-cycle in housing, what is the expected impact on single-family vs. multifamily? ? Depth and duration of housing down-cycles are heavily influenced by starts levels relative to long-term averages at the

inception of a downturn. We view the 1994 and 1999 housing cycle peaks as helpful guides to our current environment, as these cycles peaked at low starts levels relative to the long-term average. In these down-cycles, the average year one decline was 6%, less than half of the decline in year one for the remaining down-cycles dating back to 1970. ? As a result, we would expect a near-term down-cycle (if one occurred at all) to be mild in both depth and duration but with noticeable differences for single-family and multifamily activity. ? Single-family housing experienced a slower recovery since the last trough, with current housing starts still 22% below

the long-term single-family average. We believe it would be resilient in a downturn scenario and is most likely to resemble the 1999 housing down-cycle, in which single-family starts declined a modest 5% over a single year before returning to robust growth. ? Multifamily construction typically sees a faster recovery than single-family construction after a housing down-cycle, as lenders prefer institutional owners over individuals during periods of tight credit markets. Our current recovery has followed this pattern, with multifamily starts rebounding to 13% over the long-term average. Thus, we would expect a housing down-cycle to have a moderately greater impact on this segment of the market, with a near term down-cycle most likely to resemble a typical correction that declines a cumulative 20% over three years before returning to growth.

What has held new housing demand below the long-term median ( . million starts) in the current recovery? What will support growth in the long term? ? A weak labor market post the Great Recession, unprecedented student loan balances and other behavioral factors have

delayed millennial household formation. We anticipate an unwinding of this delayed demand as the millennial generation ages and closes the gap to prior generations' headship rates. ? The underproduction of homes due to the slow recovery in housing over the past decade, coupled with upcoming millennial demand, has created a healthy supply/demand environment that is supportive of steady growth regardless of noise around the health of the broader economy. ? In 2009, the market had an excess inventory of 740,000 new and existing homes, relative to the long-term average. It

took three years of recovery to work through this excess inventory to reach normalized levels. Currently, inventory of new and existing homes is 529,000 homes; 21.6% below the long-term average.

How can industry participants be positioning themselves in the current environment? ? Now may be an attractive time for both organic and inorganic investment in the industry -- in capabilities and capacity. In

fact, the recent pullback could help create attractive entry points for opportunistic investments. ? Millennials are likely to fuel a significant portion of future growth as they age -- industry participants should evaluate

opportunities to serve the outsized growth by aligning themselves to millennial demand in terms of style and price point. ? Opportunities to serve the single-family market (particularly first-time buyers) are likely to provide greater growth and more

resilient demand.

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Introduction

In the second half of 2018, rising mortgage rates, all-time-high home prices, and broad business cycle concerns negatively affected growth expectations for the residential new construction market. The headwinds resulted in a broad reduction of the consensus outlook for housing starts in 2019. In this paper, we analyze past housing down-cycles and economic recessions in the U.S. to frame the current fundamental demand for housing and to evaluate the near-term consequences of a down-cycle. Finally, we highlight tailwinds that are supportive of longer-term growth in residential new construction.

Since 1945, the average duration of an economic up-cycle is approximately five years, with the following down-cycle (peak to trough) lasting an average of one year (see Exhibit 1 below). As we approach the 10th consecutive year of economic recovery following the Great Recession, market dynamics are shifting. Given that pundits and investors have increasingly acknowledged the likelihood of a recession in the near term, we aim to cover the possible depth and duration of a potential pull-back in residential new construction and understand what underlying demand fundamentals suggest for long-term growth.

Exhibit 1: Prior Recessions -- Depth and Duration

U.S. Real GDP YoY growth (1945 ? 2017) Percent

10

8

6

Mild recession

Mild recession 4

2

0

(2)

(12) 1945 50 55 60 65 70 75 80 85 90 95 00 05 10 15

Post-1945 recessions

# #

Peak month

Trough month

1 Nov. 1948 Oct. 1949 2 Jul. 1953 May 1954 3 Aug. 1957 Apr. 1958 4 Apr. 1960 Feb. 1961 5 Dec. 1969 Nov. 1970 6 Nov. 1973 Mar. 1975 7 Jan. 1980 Jul. 1980 8 Jul. 1981 Nov. 1982 9 Jul. 1990 Mar. 1991 10 Mar. 2001 Nov. 2001 11 Dec. 2007 Jun. 2009 Average duration (1945 ? 2009 11 cycles)

Duration (peak to trough) (in months)

11 10 8 10 11 16 6 16 8 8 18

11.1 (~1 year)

Duration (trough to

peak)* (in months)

37 45 39 24 106 36 58 12 92 120 73

58.4 (~5 years)

1 234

5 6 78

9

Decline in government spending at the end of WWII led to large decrease in GDP

10 11

*Durations shown are from prior recession trough to peak leading into the recession (e.g., 73 months from Nov. 2001 trough to Dec. 2007 peak) Sources: Bureau of Economic Analysis, National Bureau of Economic Research

The U.S. is past due for a recession (last recession ended 2009) based on

historical averages

Recent growth in U.S. residential new construction has decelerated, potentially foreshadowing a slowdown in the broader U.S. economy. However, in our view, any near-term negative impact should be muted relative to longer-term growth in housing. The core evidence of near-term resilience in housing includes (1) the current level of housing starts (specifically in single-family) relative to the long-term average, (2) low levels of housing inventory due to the slow pace of recovery, and (3) a healthy U.S. consumer. Beyond the next 12 ? 24 months, housing activity will be supported by a demographic shift as millennials continue to form households at an accelerated rate. Together, these factors likely outweigh near-term concerns around a potential pause in demand caused by rising mortgage rates pressuring affordability. Likewise, homebuilders are unlikely to oversupply the market due to input cost inflation, scarce labor, and lot availability.

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Near-Term Residential New Construction Activity

A Blend of Consumer Psychology and Housing Supply/Demand Fundamentals

Historical analysis suggests a housing down-cycle at current starts levels would be unlikely, with past benchmarking pointing to muted depth and duration if a down-cycle were to occur in the near term. We pair that historical analysis with a review of current consumer psychology to provide a more complete picture on the near-term outlook for residential new construction activity.

Consumer psychology Increasing concern over business cycle risk, geopolitical noise, and volatility in the stock market likely contributed to the decline in the health of consumer-related economic indicators in 2018. Despite the 11% decline in the Housing Affordability Index and a 24% decline in the NAHB/Wells Fargo Housing Market Index over the course of 2018, overall consumer health appears strong. As shown in Exhibit 2 below, key metrics measuring consumer psychology are above long-term averages despite the decline from recent peaks.

Exhibit 2: Metrics Influencing Consumer Psychology

Statistic Housing Affordability Index NAHB/Wells Fargo Housing Market Index Wage Growth 30-Year Fixed Rate Mortgage Unemployment Rate Consumer Confidence Index GDP Growth YoY

Most Recent Nov. 2018 -- 144.0 Dec. 2018 -- 56.0 Nov. 2018 -- 3.10% Feb. 2019 -- 4.41% Nov. 2018 -- 3.80% Nov. 2018 -- 120.2 Nov. 2018 -- 3.40%

RECENT PEAK

Reading

Most Recent vs. Trend

Jan. 2018 -- 164.3

Dec. 2017 -- 74.0

Oct. 2018 -- 3.20%

Nov. 2018 -- 4.87%

Nov. 2017 -- 4.10%

Oct. 2018 -- 137.9

Jun. 2018 -- 4.20%

LONG-TERM AVERAGE*

Reading 130.4

Most Recent vs. Trend

54.3

2.40%

10.30%

6.40%

97.2

3.30%

*Long-term average represents 1980 ? 2000 median, or closest available data

Sources: National Association of Realtors, National Association of Home Builders, U.S. Bureau of Labor Statistics, Federal Housing Finance Board, The Conference Board, U.S. Bureau of Economic Analysis

Overall, the recent decline in consumer psychology has already begun to reverse course. The number of 2019 expected rate hikes has decreased from four as of mid-2018 to two as of early 2019, easing affordability pressures from rising mortgage rates. The sharp increase in mortgage rates (off a low base) was a key negative headwind for housing demand in 2018. 30year mortgage rates did, however, peak in November 2018 at 4.87%, with the most recent rates down to 4.41%. As a result, the Housing Affordability Index bottomed at 138 in June 2018 and is currently at 144 (see Exhibit 3 below). As moderately higher rates season and the economy continues to show strong employment and wage growth, a recovery in consumer psychology provides greater support for near-term housing demand.

Exhibit 3: Housing Affordability Index vs. Mortgage Rates

180

164

16% decrease

161

161

160

152

147

140

142

138

140

4% increase 147 147

142

4.87% 144

120

5.50%

4.41%

5.00% 4.50%

4.00%

130

3.50%

3.00%

2.50%

100 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sept-18 Oct-18 Nov-18 Dec-18 Jan-19 Feb-19

Housing A ordability Index

30-year Mortgage Rate

Long-term Average1 A ordability (130.4)

1Long-Term Average reflects 1988 ? 2000 data Note: A Housing Affordability Index value of 100 means that a family with the median income has exactly enough income to qualify for a mortgage on a median-priced home Sources: National Association of Realtors, Federal Housing Finance Agency, Freddie Mac

2.00% 5

Current housing supply/demand fundamentals While we believe the U.S. consumer is relatively healthy and supportive of demand in the near term, we also analyzed key supply metrics in relation to long-term averages to gauge the health of supply in the market. Exhibit 4 below details the current status of housing starts and inventory levels relative to long-term averages. We note that both of these key metrics are significantly below the long-term average with a gap of 12.7% and 21.6% for total housing starts and total housing inventory, respectively. This low level of starts and inventory is supportive of the potential increase in near-term supply.

Exhibit 4: Housing Activity and Inventory Relative to Long-Term Averages

Total Housing Starts (SAAR -- in thousands)

1,438 382

1,303 355

1,210 363

1,334 1,290

448

390

1,327 1,276

445

378

1,329 391

Single-Family Multifamily Total

Year Ago (13.1%) 21.7% (3.6%)

Long-Term Average (21.9%) 12.9% (12.7%)

1,177 326

1,184 323

1,280 390

1,237 358

1,217 353

1,256 432

1,056

948

847

886

900

882

898

938

851

861

890

879

864

824

Long-Term Nov '17 Dec '17 Average

Jan '18

Feb '18

Mar '18 Apr '18 May '18 Jun '18 Jul '18

Multifamily

Single-Family

Aug '18 Sep '18

Oct '18

Nov '18

Total Housing Inventory (in thousands)

2,448

1,815 1,805 1,808 1,839

1,802

1,807 1,841

Total 1,905 1,901

Year Ago 5.8%

Long-Term Average (21.6%)

1,912 1,907 1,905 1,919

Long-Term Nov '17 Dec '17 Jan '18 Feb '18 Mar '18 Apr '18 May '18 Jun '18 Jul '18 Aug '18 Sep '18 Oct '18 Nov '18 Average

Note: Long-term average of Housing Starts reflects 1980 ? 2000 data; long-term average of Total Inventory reflects 1982 ? 2000 data Sources: U.S. Census Bureau, National Association of Realtors

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