The best deal in housing: new construction

In response to the ongoing mortgage rate shock, builders across much of the country have adopted a strategic approach to stimulate home sales by offering so-called mortgage rate buydowns. Look no further than Lennar, a homebuilder ranked No. 119 on the Fortune 500, which presently promotes a "fixed [mortgage] rate of 5.75%" in Colorado.

“It [builder buydowns] is very successful. A huge savings, who wouldn't want that?" John Burns, CEO of John Burns Research and Consulting, said during a recent interview on Barron’s Live.

The Barron’s podcast episode with Burns, who probably understands the ins and outs of today's housing market better than anyone, is a must-listen. Keep in mind that it was recorded a few weeks ago when the average 30-year fixed mortgage rate was still above 8%. (As of today, it’s at 7.45%).

How Burns summarized the new construction sector: “The homebuilders usually get around 12% to 15% of the sales [market share]… Right now they're at 30% to 35% of the homes available to sell because there's so little on the resale market. So if you relocated to Atlanta, you're going to be looking at a new home because they are a higher share than what's historically been available. So they're taking market share. They also, the big ones, tend to own their own mortgage company or have a deal with a large mortgage company. They've done so well the past few years, and there has been so much price appreciation, that they can afford to buydown peoples’ mortgage rates. So if you bought that resale home you may be paying an 8% mortgage rate, but if you bought the new home they'll offer you a 6.5% mortgage rate. That's a pretty compelling reason to buy a new home.”

Why are builders opting to offer mortgage rate buydowns rather than steeper cuts to house prices?

“There's an anomaly going on with the inverted yield curve that is probably too hard to explain right now. But the last time I did the math, if a builder bought down and took 6% of the mortgage amount and paid that upfront in fees, they could buydown the interest rate a point and a half. What that does is lower the payment by 16%. So for a cost of 6% [of the mortgage], I can lower your payment by 16%, why would I drop the price? That would just lower your payment by 6%. So they're using this anomaly in the mortgage market to provide people with a great 30-year fixed mortgage for really cheap,” Burns tells Barron’s.

If builders, like Lennar, can juice up sales through rate buydowns, why aren’t they dramatically ramping up home production?

Burns says: “Building homes and developing land is a very local game, and the cities have made it much more difficult. Also there has been a lot of talk about cost increases on building homes, but cost increases of developing land have been even more. So most of my land developer clients are not growing, there's not a lot of money going into land development. They need to build on land they are entitled to build on that has all the water and sewer. And there's just not a lot of investment there. So homebuilders have had to start developing the land themselves, which is more expensive and more risky and they're trying to grow their business. At the same time—just about all them get our research, so I talk to a lot of them—they're not stupid, they're very smart, there is a 50% odds of a recession, mortgage rates are going up. ‘Am I [a builder] going to go crazy and buying up a lot of land and developing a lot of land right now. No, I'm going to manage my business very wisely.’ So that's why we're not seeing a lot of supply.”

What enables prominent homebuilders like Lennar and D.R. Horton to implement such aggressive buydowns is their sustained strong profit margins. These profit margins persistently surpass pre-pandemic levels, affording them the financial flexibility needed to undertake strategic initiatives aimed at boosting sales and making homeownership more attainable in these turbulent times

“It [the money for the buydowns] is coming straight out of their profit margins. But remember they bought the land 3 or 4 years ago, when they were anticipating selling the home for $500,000, and now it's worth $700,000. So they have a lot of profit built up, and so they're giving some of it back to the homebuyer,” Burns tells Barron’s.

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As always, nothing in this article is investment advice. Please do your own research.