U.S New Home Sales Plunge – Will the Rest of the Sector Follow?

New home sales plunged in February and show persistent deceleration but that drop exceeds the weakness in other housing measures (see table on the left).

Many economists are looking at the lag difference between existing and new home sales. AND maybe that is the right way to look at it. That does not, however, explain the revisions to lower PAST new home sales. I would explain it all differently partly since starts have the same timing asymmetry as new home sales relative to existing home sales and Starts actually rebounded in February. It think the lag is a red herring of sorts, although the existence of a timing asymmetry is a real phenomenon.

It is true that the recording of existing home sales is markedly different from the recording of housing starts and new home sales. Each of the later (New home sales and starts) book at the time of the contract or actual start. But existing home sales are recorded at the end of the transaction when the property legally changes hands – a process that can take one to two months (the gap from sales to closing). Therefore the book on those series in is that new home sales reflect current conditions and existing sales reflected ‘past’ conditions.

But this is not the only difference in these series. Selling a new house is very different from selling an existing house. And let’s see why.

Only builders can sell new houses. Once that house passes to the public it is owned and if it is re-sold or if it is ‘flipped’ – even without being lived-in -- it becomes an existing home sale. So any ‘spec’ seller that owns a home is in competition with builders; some might be selling an identical product (but from a smaller inventory). The inventory size is also a key to understanding the builder. The more homes he has built, and ready to sell, the more reluctant he is to cut price. Since each price cut is like a reduction on ALL the houses he has, that can have a huge negative wealth impact on the builder. But it’s not just on these special cases where builders compete with individuals. New homes sales compete with all existing home sales as well, not just specialized cases where individuals may own a few homes in a builder’s tract.

Next consider existing home sales. These existing home sales do compete with new homes sales. AND for the most part the individuals that are selling houses own only one and are selling it and buying another home (new or used) or renting. They may be motivated sellers or not, for a variety of reasons. But if they are selling with intent to repurchase they are somewhat insulated from weak prices. For example, If you are selling a $400K home to buy a $400K home and if each has a price reduction of 5% how does that hurt you? The answer is that even though there is some balance it does hurt you. For sellers who do not have ‘excess equity in their house a price cut will cost them built up equity and may preclude them from buying the same ‘value of house’ even at a similar lower price.

Consider this: you buy a house for $400,000 and put 20% down ($80,000). So you have a mortgage of $320,000. Now your house price falls by 5% to $380,000. Your equity is reduced to $60,000 as a result ($380,000, the new value less $320,000, the mortgage). So if you wanted to move and buy a similar house to the one you now own, that house would also cost $380,000 but a conventional mortgage would require 20% down or $76,000. Even ignoring all the closing costs and such you now have only $60,000 in equity. Only homeowners with excess equity in their homes will be able to move in this environment or they will have to step down in terms of the quality of house they buy or take a more risky mortgage. Still surveys show that about 60% of the population of homeowners hold more that 50% equity in their house. Despite the drop in equity implied by the calculation above many could still afford to move and the drop in the house they purchase is a wealth buffer of sorts for them, the whole transaction costs them out of pocket cash or put another way forces them to realize their decline in equity.

Even so this is a situation where you get hit on the selling side than helped on the buying side. It is unique to existing homes. Builders are only sellers, so weak prices unambiguously hurt them. This would explain why they would be more reluctant to cut price and why their sales would be hurt more than for existing homes in a downturn. It has nothing to do with the closing Vs the selling lag.