Housing Stocks Rally Despite Negative Equity Trapping More Americans

 |  Includes: DHI, HD, KBH, LEN, MAS, PHM, PIR, TOL, TPX, WHR, XHB
by: The Financial Lexicon

If you thought the soaring stock prices of the well-known homebuilders were an indication that the housing market is healing, think again. As housing-related stocks were soaring in recent months, more Americans were being trapped in their homes.

As if rising food and gas prices and falling real average hourly earnings aren't bad enough, CoreLogic (NYSE:CLGX), a data and analytics company, recently reported that as of December 31, 2011, 22.8% of all residential properties with a mortgage were in negative equity. This was up from 22.1% at the end of September 2011. In terms of gross numbers, an additional 400,000 residential properties with a mortgage fell into negative equity during the fourth quarter 2011, for a total of 11.1 million. Furthermore, when adding in the additional 2.5 million properties with less than 5% equity, 27.8% of all mortgages on residential properties were in negative equity or in a situation in which the real estate agent's commission would push them into the red.

In terms of the states with the highest negative equity rates, the top 10 are Nevada (61.1%), Arizona (48.3%), Florida (44.2%), Michigan (34.7%), Georgia (33.0%), California (29.9%), Idaho (25.0%), Maryland (24.3%), Ohio (23.9%) and Virginia (23.0%). In fact, these 10 states are the only states with negative equity rates above the national average. With 80% of U.S. states at or below the national average for negative equity, it shows that a smaller number of bad seeds are pulling up the headline numbers.

When digging a little deeper into the numbers, we discover that those 10 states alone account for $4.105 trillion in mortgage debt outstanding. This is 36.73% of the $11.177 trillion in mortgage debt on one- to four-family and multi-family residences, as reported by the Federal Reserve in its December 2011 "Mortgage Debt Outstanding" release (Fed's data only through Q3 2011). Therefore, just 20% of the states account for roughly one-third of residential mortgage debt. While the comparison between CoreLogic's data and the Fed's data is not a perfect one, it helps paint a picture of the importance of the top problem states on the nation's housing market as a whole.

When looking at the states with the highest percentage of properties within 5% of negative equity, the top 10 are the following: Colorado (7.7%), Tennessee (7.3%), Nebraska (7.1%), North Carolina (7.1%), Georgia (6.9%), South Carolina (6.7%), Arkansas (6.1%), Ohio (6.1%), Utah (6.1%), and three states tied at 6.0% (Oregon, Virginia, and Washington).

Perhaps you are wondering just how much underwater the 11.1 million borrowers are. According to CoreLogic's report, 6.7 million of the mortgages in question are first liens with an average mortgage balance of $219,000 and negative equity of $51,000. This means the borrower will need the value of the property to appreciate, on average, 30.36% to get back to even and 36.875% when adding in a 5% real estate commission (a higher commission and other closing costs could increase this number). Unless these homeowners win the lottery, inherit a lot of money, default, or are granted principal forgiveness, they are not going anywhere anytime soon.

The other 4.4 million mortgages have first and second liens with an average mortgage balance of $306,000. They are, on average, underwater by $84,000. These borrowers need an average 37.84% rise in the value of the property to get back to even. When factoring in a 5% real estate commission, the needed appreciation increases to 44.73%. Of course, with regard to the underwater mortgages, as the prices of the homes and outstanding values of the mortgages change, the appreciation needed to break even will also change.

According to the latest Case-Shiller Home Price Indices, home prices are still declining, reaching new post-housing-bubble lows in December. On a national level, home prices declined by another 3.8% during the fourth quarter of 2011 and fell by 4.0% year-over-year when compared to Q4 2010. If the plan of the people in power is to keep interest rates low (and get them even lower) long enough to help homeowners work down their loan-to-value ratios, they will likely first need home prices to stop declining before any serious headway can be made. But home prices in Las Vegas and Atlanta reaching new lows in December doesn't bode well for helping the 61% of underwater mortgages in Nevada or the 6.9% of nearly underwater mortgages in Georgia.

Lowering the interest rate on an underwater mortgage might help the homeowner stay in the home for a longer period of time or free up cash for other purposes. However, with rising food and gas prices and negative real earnings, it's going to be difficult for a lot of people to make solid progress changing their negative equity situations. Furthermore, according to the Bureau of Labor Statistic's latest National Occupational Employment and Wage Estimates (next report to be issued on March 27, 2012), the average wage in the United States was $44,410 in 2010. However, in Nevada, the state with the most underwater mortgages, the average was just $41,220. In Arizona, number two in terms of underwater borrowers, the average wage was $42,390. In Florida, the average was $40,270; in Michigan, it was $43,280; and in Georgia, it was $42,270. All five of the states with the most underwater borrowers have average wages below the national average.

Moreover, according to Table 728 of the U.S. Census Bureau's The 2012 Statistical Abstract, the cost of living in Las Vegas, Phoenix and Miami was above the national average. In particular, groceries in all three cities cost 6% or more than the national average. In terms of cost of living, Detroit was slightly under the national average, although it is ranked 15th out of 315 urban areas surveyed for the cost of utilities, coming in nearly 30% above the national average. I recognize that "all real estate is local" and that cost of living will vary depending on the spending patterns of households. With that said, I hope the data presented help illustrate some of the difficulties many borrowers will face when trying to reverse their negative equity situations anytime soon.

From an investing perspective, stocks typically bottom before the fundamentals reveal themselves as having bottomed. The SPDR S&P Homebuilders ETF (NYSEARCA:XHB) bottomed with the broader stock market in March 2009 and hasn't looked back. It is now trading just shy of $20 per share, versus its bottom at $8. In fact, since October 4, 2011, XHB has rallied more than 60%. It should be noted that despite its name, XHB is not an ETF that holds just the homebuilders. It also includes companies like Tempur-Pedic (NYSE:TPX), Whirlpool (NYSE:WHR), Masco (NYSE:MAS), Pier 1 Imports (NYSE:PIR) and Home Depot (NYSE:HD).

In terms of the homebuilders themselves, Toll Brothers (NYSE:TOL), PulteGroup (NYSE:PHM) and KB Home (NYSE:KBH) reached their post-bubble lows in 2011, not in 2009 like XHB. However, since those lows, they too have soared. Pulte and KB Home's stocks have more than doubled, and Toll Brothers' stock is up more than 70%. Lennar (NYSE:LEN) is the exception in the group with its stock price reaching the nadir in 2008. Since that time it is up more than 500%. It is true that these stocks are still trading well off their 2005 highs. However, if you have enjoyed the fabulous rally these stocks have had off their bottoms, still want housing exposure, and are open to adjustments in your portfolio, here are a few ideas:

Given the XHB's exposure to a broad range of housing-related companies and the strong correlation it has shown to the S&P 500 in terms of direction (not magnitude of direction), XHB seems like a decent option if you are looking to maintain equity exposure to housing. It has exposure to homebuilders such as Toll Brothers, Pulte and Lennar. While it doesn't have exposure to KB Home, it does own D. R. Horton (NYSE:DHI). If you currently own XHB, given that it is bumping up against decent resistance around $20 per share (the 2010 high and only slightly above the 2011 high), consider selling covered calls using a ladder approach.

If I owned this ETF, I would sell the equivalent of roughly one-third of my position using the September 22, 2012, $21 calls around the current bid of $1.10. For the remaining two-thirds of the position, I would look to sell the January 19, 2013 $25 calls at the current bid, which is floating around near 40 cents. The $25 strike price is just above the XHB's 2008 high.

Should you be willing to have direct exposure to one of the homebuilders going forward (rather than through an ETF), one option is to consider selling some or all of the equity and looking further up the capital structure. The yields on the debt of Lennar, Pulte, Toll Brothers, and KB Home just might be enticing enough for some investors to sell the stock and buy the bond. This is especially true given the fact that should things once again go awry, the recovery rate on your investment will likely be higher with the bonds than it would be with the equity.

For example, Lennar's 5/31/2015 maturing, B2/B+ rated, 5.6% coupon note (CUSIP: 526057AS3) is currently yielding 4.406%, or 440.147 basis points more than a comparable Treasury. It is also yielding 370.9 basis points more than Lennar's current dividend yield. Owning this note for a few years and revisiting the equity in the future might be an option worth considering.

PulteGroup also offers shorter-term notes for investors to consider. However, if you were considering a buy-and-hold, long-term approach with its stock, the same type of approach might be desirable with its 6/15/2032 maturing, B1/BB- rated, 7.875% coupon note (CUSIP: 745867AM3). This note is currently yielding 8.609%.

Toll Brothers notes can currently be found by retail investors searching the secondary market through its subsidiary Toll Brothers Finance Corp. The 2/15/2022 maturing, Ba1/BB+ rated, 5.875% coupon note (CUSIP: 88947EAK6) currently has a yield-to-call of 5.328%. A comparable Treasury currently yields 1.977%.

Last, KB Home's B2/B+ rated debt offers several choices maturing between 2/1/2014 and 3/15/2020. Yields on this debt range from 3.552% to 7.716%. Here are the CUSIPs for six different KB Home notes currently with offers in the secondary market: 48666KAP4, 48666KAQ2, 48666KAN9, 48666KAM1, 48666KAL3, 48666KAH2.

Even if you aren't interested in swapping the equity for the debt, when you buy the stocks of companies with junk rated bonds, keeping an eye on the performance of the bonds can be a useful exercise. Considering what those investors most concerned about credit risk think of a company's prospects can certainly help to put into perspective the potential risk in a stock, especially among companies with debt in the non-investment grade realm.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long Masco's CUSIP 574599AT3.