Steve Hilton, the CEO of Meritage (NYSE:MTH) which is one of the nation's 10 largest homebuilders, gave a fascinating interview yesterday on CNBC. In the interview he touched on a few topics and his comments are illustrative of the broader market outlook on housing in general. The optimism around anything housing related has reached a fever pitch at an interesting point in the economic recovery. Top line data suggest that the housing market is continuing to recover. Peeling back the onion, however, reveals in the short term a shaky foundation for the recovery driven by investors and record low interest rates. Over the long term; employment trends, demographics, and a struggle to define the definition of a "normal" housing market suggest the recovery may be nothing more than a mirage. From an investor's point of few it is prudent to examine what is needed for the recovery to continue, while at the same time weighing those positive indicators that would drive the recovery further against the significant barriers that exist today or are looming on the horizon. Ultimately the valuations of housing stocks and optimism of those in the industry has reached a level not supported by the underlying fundamentals. If you believe that is the case, now is the time to take profits or consider shorting the most overvalued companies in the industry.
Admittedly, as my past article history shows, I believe homebuilder valuations continue to bump up against price levels where these companies should be shorted. In the near term there continues to be potential for the homebuilder stocks to move higher. Some of the data points that will continue to come out in the first half of 2013 will, candidly, likely reflect positively on the housing market and homebuilders in general. Home prices should continue to climb, in addition to home starts, and interest rates should continue to stay low especially if Europe turns into a debacle again this year as it did last. All of these positive headlines and more are currently reflected in the stock prices of builders. The S&P Homebuilder ETF (NYSEARCA:XHB) currently sits just below its 52-week high reflecting the optimism noted above.
Some recent focus is on the just released homebuilder confidence numbers declining in March. This decline comes after seeing a pretty much steady climb higher in the confidence index over the last year. I do not think the decline in the index is a negative for the industry. Reading deeper into the analysis, the index still showed that future expectations for orders and traffic were strong. This is a more valuable gauge than current sales expectations as it is forward looking. Also in tracking the prices listed on various homebuilder websites there is a clear trend of price increases at top selling communities. This is a positive trend for the industry, and more so in the context of future order expectations because the builders believe they can continue to sell houses at higher prices. I think these price increases are offset by material, labor, and land price increases, but I have already devoted other articles to making that argument. So price increases are only good for the bottom line and valuation of the builders if they can outpace cost increases.
Optimism From More Than Just Homebuilders
The interview given by Mr. Hilton is but a drop in the bucket in regards to the level of optimism that still surrounds housing. Blackstone Group (NYSE:BX) is now the largest owner of single family homes in the United States. They have invested over $2.5 Billion in cash to buy around 16,000 homes now being managed as rentals. The financial model probably make sense for investors in search of yield as the cash flow generated by the rental income for the properties is relatively stable, today. Blackstone is buying these properties in the markets it believes had the biggest run up and subsequently biggest fall in prices. Smart in the sense that these properties might offer the best rental income yield today. Dumb in the sense that these same markets all fell the most for a reason and if history repeats itself, Blackstone will be left holding the bag. The famed Warren Buffett has also been unabashedly bullish on housing. He has also put his money where his mouth is with his own venture into the residential rental business.
Optimism Built on Shaky Foundation
The reasons are numerous, but here are a few that are more powerful than others as to why the optimism is unfounded.
Do not let the headline job growth and unemployment numbers fool you. The critical headline you should focus on is if we are truly in an economic recovery, why is the labor force participation rate not recovering. Said another way, why are more people still not working today as a percent of the total population in the United States than prior to the start of the recession. This chart, originally published at Calculated Risk says it all:
Why this is a negative for housing in the long run should be clear. Less people employed or in the labor force equals less potential home buyers, or even home renters for that matter.
The next critical data point that those bullish on the U.S. housing market tend to overlook is the changing demographics of the population. What happens as the baby boomer generation passes away and those homes they own come to market over the next 10 to 20 years? While housing supply is limited today because of investors and low interest rates, it will not necessarily be so in the future. When taken into account with the lowest population growth rate since the great depression in the 1930s, the inventory that will come to market from the baby boomer generation will dwarf the population of families or individuals that are employed and capable of purchasing a home.
The Definition Of "Normal" From A Homebuilder CEO
The headline of the interview on CNBC by Mr. Hilton was essentially that the housing market is rebounding but nowhere near being normal. I agree with that sentiment but for the exact opposite reasons of the person leading one of the 10 largest homebuilders in the U.S. Is a normal housing market one where you can finance a home at an interest rate below 4%? Is a normal housing market one where you can still put a down payment of 3.5% of the purchase price as allowed by the FHA, which makes up a large portion of home financing today? It would be fascinating to know what Mr. Hilton believes a normal market to be. Thirty years ago home buyers were paying double digit interest rates and putting 20% down to buy their home. That is how housing in the United State operated for an extraordinarily long time. You can easily argue that high interest rates and a 20% down payment represent a "normal" housing market. It is also not one marked by institutions gobbling up single family homes to generate rental income, as the Fed is forcing them to invest their cash somewhere to earn a return on it.
Mr. Hilton states he will not be concerned about interest rates until they rise to 7 or 8%. This is misguided on a number of different levels with the most noteworthy one being affordability. Take the example of a $200,000 mortgage. Today the principal and interest payment on that mortgage at an interest rate of 3.5% is about $1,000 a month. If rates were to rise to 7%, that same mortgage would have a payment of $1,300 a month. An increase of $300 may not sound like much until you realize how many home buyers today are able to qualify on a debt to income ratio by the skin of their teeth. Rising rates will force more potential home buyers out of the market unless wages begin to rise significantly and there are no signs that is occurring.
What Does This Mean For You As An Investor?
Stop listening to the pundits telling you that housing is back and will make a great investment. History shows this is a cyclical business with ups and downs. Those same pundits did not call a housing peak in 2005. Meritage and all of the homebuilders did not stop buying land in 2005 knowing that the market would fall out from underneath them. Today, they are no more in tune with the market than they were 8 years ago.
There is certainly a chance for additional profits to be made in investments tied to housing. However, if you do not own these companies today you have missed the easy money. The risk of a significant correction in housing related stocks far outweighs the opportunity to catch the last few points of remaining upside.
The market will soon reflect one of two dynamics. The first would be interest rates that spike higher which will hurt housing. Although Mr. Hilton believes there are still people sitting on the fence who will buy when they see rates rise, this is not likely to be a material population. Most with the financial capability to buy a house today are smart enough to realize that interest rates cannot go much lower. Thus, those buyers have already stepped off the fence.
The second dynamic is that interest rates stay low for a long time. If this were to occur, the only sign this will confirm is that the economy is not recovering. When it finally occurs to investors that housing has more headwinds working against it than the headlines would suggest, you may see a rush for exits. My advice is to let Blackstone be the one left holding the bag, or the houses in this case, not you.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.