Understanding building permits and their impact on homebuilders

Along with housing starts, building permits are also a leading indicator of the health of the US housing market. Building permits provide an estimate of the number of new housing units that have been authorized by the government during a given month.

Building permit activity provides an insight into housing and overall economic activity in the upcoming months. You can gauge its importance from the fact that it’s included in the index of leading economic indicators. Building permits lead housing starts, but they’re not required in all regions of the country. So the amount of permits therefore tends to be fewer than the amount of housing starts over time.

If more building permits are issued, this indicates that more investment will likely be allocated to the housing market. As the chart above reflects, more building permits were issued up to 2005, when the economy was at its best. A decline in the number of housing starts relative to building permits may indicate that planned construction is being put on hold, possibly because of unfavorable economic conditions. This trend was visible from 2008 to 2011.

According to the Census Bureau, it may take three months to establish an underlying trend for building permit authorizations because month-to-month changes in seasonally adjusted statistics often show movements that may be irregular. So investors need to closely look at the developing pattern over a few months rather than focusing on monthly data in isolation.

Sustained growth in building permits is often viewed as a positive sign for homebuilding companies such as Lennar (LEN), D.R. Horton (DHI), and PulteGroup (PHM) as well as homebuilder ETFs such as the SPDR S&P Homebuilders ETF (XHB) and the iShares Dow Jones US Home Construction Index Fund (ITB).