It is a classic tale of dueling data points when it comes to the health of the housing market. In this particular instance, the data points concern sales of new homes. Just last week, the reading of homebuilder confidence soared to its highest level since 2005. That data point pales in comparison to the headline this week that new home sales plunged to their lowest level in last 9 months. Clearly this is fueling the bearish camp as the homebuilder stocks continue to trade well off of the lows notched earlier this year. The question that investors need to ask themselves is what can they divine from these two data points and what should they do from an investment standpoint. My two cents are that homebuilders have not forgotten about the last housing crash. While builders are being aggressive in acquiring land, that is about the only similarity between today and 2005 right before the bottom of the market fell out. Those articles, such as this that warn that the homebuilders will go bankrupt or see their stock trading for under $5 per share are frivolous in nature. If the homebuilders go bankrupt, that means we have entered a recession nastier than anything anyone has ever seen and no investment outside of gold would make sense at that point in time. Thankfully, the argument about another housing crash is not grounded in reason. I believe the sell-off in the homebuilder sector has long run its course and that as the builders continue to report strong financial performance, show increasing confidence, and continue to operate in an opportunistic yet cautious manner there is tremendous upside in this sector. I believe the best way to play this coming rally is via the homebuilder that has the cleanest balance sheet in addition to paying the highest dividend in the sector. That homebuilder is MDC Holdings (MDC), whom I have admittedly been early on my previous call for a strong bounce in this name. However with a dividend yielding over 3%, if investors are looking for some semblance of safety in this sector as a reason to pull the trigger, MDC offers the largest dividend yield and just about the lowest price to book valuation in the sector.
News Flash: The 2013 Housing Market Does Not Equal 2005 Again
It really is silly that so many pundits are proclaiming the end of the housing recovery, or even the next wave of homebuilder bankruptcies. Let's just tick off the differences between the summer of 2013 compared to 2005:
- The housing bubble had not yet burst back in 2005. Sounds elementary but it is a very important fact to remember. No document home loans, investors buying converted apartment to condo units all across the country, and home prices increasing at a clip of over 20% per year. Is any of that happening today? Not a bit. You have investors in the market snapping up foreclosures and you have people buying condo units in Miami and New York. That is a big difference from investors buying condos in Jacksonville, FL such as what was seen during the 2005 time period.
- Interest rates. Sure they have rapidly risen, but they are still far below the levels seen prior to the housing bubble bursting.
- Affordability. Housing today is still wildly more affordable than it was back in 2005, and any attempt for someone to convince you otherwise is just patently false.
There is absolutely zero comparison between the home buying environment today and that seen during the housing bubble. The same can be said for the mortgage lending environment. It would be very hard to have a bubble without an excess of liquidity and non-existent lending standards. Neither of those factors are present in the mortgage market today.
Understanding The Divergence In Data Points
What is not as simple to understand are how the data points with regards to new home sales could be sending such conflicting signals. How could homebuilder executives be so optimistic when the new home sales figures are trending down?
It is really two part simple answer. Interest rates have skyrocketed, and business has not cratered. When the last homebuilder confidence survey took place, covering the month of July, Interest rates had already moved almost 100bps higher off of all time lows. Yet confidence about the current sales environment as well as the future sales environment continued to strengthen. I believe there is a simple explanation for this, and it is confirmed in the conference call transcript from almost every homebuilder conference call from earnings this past quarter. The CEO of Taylor Morrison (TMHC), Sheryl Palmer, made the following comment on the Q2 2013 earnings call:
Further, we are intentionally limiting construction releases in some of our communities which slows pace in order to manage our growing backlog, our production and overall customer expectations, while maximizing profitability in our land assets.
In the most simplistic terms, what this means is that the homebuilders are purposely throttling back home sales in order to maximize the price and profit they achieve from the land and homes they currently own. To do this, they are raising prices and lowering incentives. When you compare this to the same period last year, or even earlier in 2013, prices were significantly lower, and incentives were significantly higher.
It is a simple math equation. Land is a finite asset. Maximize the value that can be achieved from each piece of land you own, as the odds are that the next piece of land you buy will have a higher cost and will carry more risk due to holding that land for an uncertain period of time.
The housing supply on the market today is still below a healthy level. This means that builders continue to be prudent in not building thousands of spec homes (homes started without a buyer) and that the resale market still has a very limited supply of homes available for sale.
Could housing stocks fall further? Absolutely they could, but they have already fallen much more than the broader market in this latest pullback. I would adamantly argue that if Fed tapering fears drive the market lower, the sector that is going to bounce first and furthest when interest rate clarity is divined will be the homebuilders.
You can listen to the naysayers who believe the next housing bust is upon us. If you believe them, then short the banks who own the paper associated with all the mortgages in the country. Don't assume that homebuilders, whose bread is buttered by the land they own, which is essentially a commodity, have any more risk than any number of other companies that would get crushed in a market sell-off. Instead, look at how far these companies have fallen and how profitable they are today assuming no further improvement in their businesses or the level of home sales, and realize just how much upside there is in this sector.