The slumped housing market reaches a critical juncture

In September, Fed Chair Jerome Powell acknowledged that last year’s mortgage rate shock would cause the U.S. housing market to pass through a “difficult [housing] correction.” Homebuilders’ earnings showed he was correct: In the fourth quarter of 2022, KB Home’s buyer cancellation rate spiked to 68%. That figure dwarfed the publicly traded homebuilder’s 13% cancellation rate from the previous year’s period. It also surpassed the industry’s peak cancellation rate of 47% during the darkest days of the 2008-era crash.

But the worst of the storm might be behind us. At least for builders.

On Wednesday, KB Home reported that its cancellation rate was 36% in the first quarter of 2023. On one hand, that’s still an elevated share of sales under contract being cancelled. On the other hand, it’s a deceleration from the 68% rate last quarter, and a sign that aggressive builder incentives, like mortgage rate buydowns, alongside home price reductions are slowly bringing back buyers.

“As we entered the spring selling season during the quarter, we began to see an increase in [housing] demand. This reflected in part the targeted sales strategies we deployed, together with a stabilizing mortgage interest rate environment. As a result, we achieved a sequential improvement in our net orders in both January and February, and net orders have remained strong in the early weeks of March. Although there are still considerable interest rates and economic uncertainties, we are encouraged by this progression,” Jeffrey Mezger, CEO of KB Home, told investors on Wednesday.

Among publicly traded homebuilders, KB Home got hit the hardest by the so-called housing correction. The reason being that KB Home has a high concentration of its new home communities in overheated Western markets where the housing correction has been particularly sharp.

Why did KB Home’s cancellation rate drop so quickly?

Here’s the long winded answer: During the Pandemic Housing Boom—a time with seemingly unlimited housing demand—builders like KB Home achieved frothy profit margins as they quickly raised new house prices. That came in handy: As the housing market slumped last year, builders like KB Home had the breathing room to reduce margins (i.e. cutting prices and/or aggressive rate buydowns) in pursuit of finding the market, or the price point at which buyer demand would return.

The drop in KB Home’s cancellation rate suggests the builder is, well, “finding the market.” And the firm isn’t alone: Homebuilders across the country are seeing their cancellation rates improve.

Builders surveyed by John Burns Real Estate Consulting in February had an aggregate cancellation rate of 10.8%. That’s far below the peak of 24.6% hit in October, and just slightly above the 7.3% hit at the height of the Pandemic Housing Boom in February 2022.

Simply put: Homebuilder cancellation rates are normalizing—quickly.

“Our gross margin declined… as we adjusted the price of both our new home sales and homes in [the] backlog to market to promote deliveries and reduce cancellation rates,” Stuart Miller, executive chairman of Lennar, told investors earlier this month.

By offering those incentives and price cuts, Lennar’s first quarter gross profit margin on home sales declined from 26.9% to 21.2%.

“Builders have taken their medicine for the most part right now on pricing. And we think nationally, home prices—on the new-home side, net of incentives—are down about 10% from peak,” Rick Palacios Jr., head of research at John Burns Real Estate Consulting, said in a video posted in February. “There’s probably not a ton of runway there left.”

Unlike homebuilders, who need to cut prices in order to move unsold inventory, existing homeowners are usually more resistant to such cuts. That resistance is why existing-home prices usually bottom out last in a housing market downturn.

“We still think that there’s more [home] price correction to come on the resale side, though. And the resale market is always stickier to the downside when it comes to [home] prices,” says Palacios.