Housing affordability has never been worse. Never.
In the last three years, home prices have grown twice as fast as incomes, and then 30-year mortgage rates more than doubled, climbing above 7%—the highest mortgage rates in 21 years! Mortgage payments have grown +89% in just three years!
Despite these seemingly insurmountable obstacles, new home sales remain resilient, even exceeding seasonal norms for August and September. Private equity firms, hedge funds, and building product manufacturers ask us daily: how are builders still selling homes with mortgage rates above 7.5%?
It’s all about the rate buydown.
Home buyers desire lower monthly payments, and home builders are delivering. According to our recent survey of 100+ production builders, 60% are using rate buydowns to secure sales, including 30% that offer only full-term 30-year buydowns.
One important note: Builders tell us temporary rate buydowns (for the first 1–3 years of the mortgage) do not solve the affordability problem, and most are committing to a 30-year rate buydown, particularly for first-time buyers.
Buydowns are not new, but builders’ execution has changed.
Pre-Great Financial Crisis:
- Home buyers used to be able to qualify for monthly payments calculated with a teaser rate, an initial low interest rate that popped up to the higher market rate after a few years.
- When the mortgage reset to the market rate, many buyers experienced payment shock. Some defaulted, producing a tremendous wave of housing-related distress.
Post-Great Financial Crisis:
- The Consumer Financial Protection Bureau (CFPB) established new rules to measure home buyers’ ability to pay their mortgage payments.
- For the 30-year fixed-rate mortgages that most buyers and builders rely on, buyers must qualify for monthly payments calculated with the highest rate that occurs in the mortgage term, not the lower teaser rate.
What has not changed:
- A builder prepays part of the home buyer’s interest to buy down the mortgage rate. This technique generates home sales but often eats up most (or all) of the maximum seller contribution allowed unless a forward commitment is used.
- Full-term buydown: Builder cost can be up to 6% of the home sales price.
- 3-2-1 buydown: Builder cost is ~4% of the home sales price.
- 2-1 buydown: Builder cost is ~2% of the home sales price.
- For a more detailed breakdown of costs, see our previous article.
Seller Contribution CAPS
When buyers contribute 10% or lower down payments for a conventional mortgage, the seller’s contribution is capped at 3% of the home’s price, which does not cover the full cost of a 30-year buydown.
However, Federal Housing Administration (FHA) loans allow 6% seller contributions with any down payment percentage.
Forward commitments are the ‘secret sauce’ in new home sales today.
A forward commitment is a block of money that builders use to originate mortgages at below-market rates, with some advantages over the better-known rate buydown. Some builders are spending 6.5% to 12%+ of the new home sales price to help buyers purchase a home using a forward commitment combined with other incentives. This is how a forward commitment works for home builders and buyers:
- Lower-rate money: The builder’s mortgage company pays points upfront to secure a block of money for originating mortgages for select homes at a below-market rate.
- Originate, not buy down: For a buyer ready to close on a home, the mortgage company draws from this reduced-rate money to originate the mortgage and close on the home.
- Higher seller contributions. The builder paid the cost of the below-market-rate mortgage origination before any buyers signed purchase agreements, and that cost does not count towards the seller contribution cap. Builders can help buyers by covering their closing costs or contributing options and upgrades in tandem with originating a mortgage with predictable and affordable monthly payments.
- Short window: The forward commitments have a short window, typically 60–90 days, so builders must have nearly completed homes that can close before the deadline.
- Happy campers: Buyers enjoy lower monthly payments, and many pay limited, if any, closing costs. Some might be able to contribute a higher down payment by avoiding closing costs.
Builders’ strong profit margins and lower construction costs help cover the costs of buydowns and forward commitments.
Builders enjoyed substantial profit margins during the pandemic-driven housing boom, which are offsetting the cost of rate incentives. Materials and labor cost increases have also decelerated significantly from record appreciation in 2020–2021, giving builders the latitude to spend on rate incentives. The graph below shows elevated 2Q23 gross margins for the eight largest public home builders compared to recent history.
Given so many benefits, we aren’t surprised that new home sales represent 13% of total home sales today, matching the recent peak in April 2021 despite rates exceeding 7.5% in the first half of October! Reach out to us for more insights on the new home sector as we head toward 2024.