The housing market has been no friend to residential HVAC contractors over the past few months, and, in order to bring buyers back into the market, mortgage rates need to be lowered. The primary issue we are seeing with new construction is a lack of affordability, and we glean clues from the existing homes market, which we think bleeds into new home demand levels. All in, we aren’t expecting a 2008 moment, but a pause in growth makes sense while supply and demand levels adjust. That said, new home construction is a small portion of HVAC work compared to repair/replace – we estimate about a 25/75 split. Longer term, we think that relief could come in the form of municipal regulatory reform, but we would not hold our breath for this to change.
It is often said that “the cure for high prices is high prices,” meaning that high prices reduce demand and increase supply as consumers become tapped out and builders want to take advantage of rising prices. Higher supply and lower demand leads to lower prices, and the cycle continues. Right now, we are at the “reduced demand and increased supply” phase of this housing cycle. Until new supply sits on the market for a while, the cost of money (i.e., interest rates) comes down, or wages pick up, consumers, we think, will continue to approach home buying with caution.
The rule of thumb used to be that one should spend about one-third of one’s income on housing. Using the median household income and this rule, the maximum “affordable” housing payment is just below $2,400 per month. Unfortunately for many, the median payment, including insurance, tax, etc., is just below $2,900 per month. Clearly, demand is healthy enough to sustain high prices relative to incomes. As such, we think that lower interest rates, will have a limited direct impact on housing demand, but could improve the supply side of the equation for existing homes, which could lower prices for new construction.
From Wall Street’s perspective, residential new construction investments require a view on interest rates, particularly the US 10-year treasury yield. This yield is the baseline for almost all real estate loans. The thinking from the investor class is as follows: when rates go down, all else equal, the monthly payment for a buyer declines, which pushes demand up, and therefore housing prices up. In theory, the monthly payment is eventually the same as before, but the slice of the pie going to builders and contractors is larger, and smaller to the lender. While we don’t have a view on 10-year yields, Fed rate cuts will only result in lower mortgage rates if the number of rate cuts exceeds the bond market’s current expectations.
Right now, the bond market is pricing in two-or-three quarter-point rate cuts for the remainder of 2025. Recall that the bond market expected four rate cuts at the beginning of 2025, so we don’t take current market predictions as Gospel. The Federal Reserve has two jobs: (1) maximum employment and (2) stable prices. It achieves these goals in part by raising or lowering the Federal Funds Rate. When times are tough, the Fed cuts rates, and when times are good, the Fed raises rates to dampen economic volatility. At least, in theory.
Indeed, on some metrics, single-family new construction is as weak as it was during the Great Financial Crisis, and employment growth is slowing. Meanwhile, the median home price per square foot just reached an all-time high. How could this be? A weak housing market, but prices at all-time highs? We think that the issue is supply, not demand. In part, this can be explained by what is referred to as the “Lock-in-Effect,” where homeowners are reluctant to sell due to the large difference between new mortgage rates and their existing mortgage rate. In short, who wants to trade a 2.5% mortgage for a 6.75% mortgage? All that said, supply is beginning to catch up to and exceed demand, and we think that this will begin to drive down prices and bring buyers into the market.
As of the end of 1Q25, according to the Federal Housing Finance Agency (FHFA), over 70% of active single-family mortgages yield a rate below 5%. There are only three solutions to solve this phenomenon: lower rates, recession, or time. The current rate of mortgage attrition is below 1%, so we may be waiting a long time if mortgage rates don’t come down. Geographically speaking, this is most pronounced in Western states, and least in Southeastern states. We think that a recession could spur a tragic form of supply growth – distressed sellers who lost their jobs. Lower rates seem to be the most likely antidote at this point, and we think that shrinking the spread between a new mortgage rate and the average existing mortgage rate should free some homeowners of their golden handcuffs.
Another issue with supply is the patchwork of regulations throughout the U.S. that limit new construction and increase construction costs. Recently, Pulte purchased a defunct golf course near my home in Northeast Ohio. Had I been consulted, I would have voted against this new development. Thankfully for my new neighbors, I was not consulted, but across the country, strict development regulations nearly prohibit new builds. This “not in my backyard” attitude suppresses new housing construction and contributes to unaffordability. The wheels of government turn at a glacial pace, and we don’t think that this will change soon. Recall that in the last Presidential election, the solution of opening federally owned lands for residential development was proposed. While a nice idea in theory, if we look at a map of where Uncle Sam owns land, it isn’t anywhere you’d want to live – unless you like living in the desert.
All together, we would expect home prices to come in a bit, or at least stop going up as fast, depending on your geography. Lower mortgage rates should help, but don’t bank on them. As it relates to HVAC tradespeople, new construction doesn’t move the needle as much as repair/replace work, but it does matter. If the Lock-in Effect abates, which we think it will, housing supply should continue to grow and drive down prices for both new and existing homes, leading to more demand. Longer term, the US has a shortage of houses, and our view is that until this resolves, construction should remain buoyant.