Homebuilding Stocks: Rising With Reason

The latest round of homebuilding data suggests (shocker) continued weakness, with demand refusing to budge despite vastly lower home prices and low mortgage rates. The slumping sales reflect a lack of desire to buy homes that are losing value as well as an inability to secure loans under restrictive lending standards.

The situation is very worrisome indeed, yet it will not play out like this forever, and investors know there is a fortune to be made in housing stocks upon the eventual turnaround. Homebuilders, such as of Ryland (RYL), KB Home (KBH), Hovnanian (HOV), and D.R. Horton (DHI), have already appreciated more than 50% from the low points in January as the outlook has become far more optimistic, with investors lining up to jump aboard when the good news begins to flow.

The question is, will we ever see this good news or has the market become unnecessarily hopeful? The reality is improvements are on the way and to take advantage of its eventual arrival, one must look past the conditions directly in front of them and focus on the capacity for a turnaround. This is easier said than done given that the bottom always occurs when the situation appears most dire and the pundits are most critical.

The National Association of Realtors’ existing home sales index released on April 22 demonstrated continued slowness, with sales slowing 2% month-to-month in March and inventory rising 1% amidst increasing foreclosures; slowing in the South and Midwest offset gains in the West and Northeast. Annually adjusted housing starts dropped 5.8% in March, which could be viewed as a good sign as homebuilders try to alleviate the overhang in inventory.

Meanwhile, pending home sales also dropped 1.9%. None of this data suggest any sort of improvement yet, but homebuilding stocks have remained resilient upon the news as investors wonder if the worst has already been seen in terms of loss of income.

In the back half of the year, we should begin to see some results from the changes in Federal monetary policy as well, as rate cuts slowly take effect to add liquidity to the lending process, and raised portfolio limits on Fannie Mae (FNM) and Freddie Mac (FRE) make more lenient FHA loans more readily available to consumers who otherwise would not qualify.

On the negative side, foreclosures are still mounting, but looking at a schedule of ARM rate resets, one can see that a peak is achieved in the middle of this year, followed by a steep drop off, which marks the point at which lenders and banks realized risky ARMs were not worth the investment. After this point, the ARM market follows a whole new policy in which risk is greatly reduced. The residual effect of the final wave of resets will take several months to hit a peak in foreclosures. It will take time for delinquencies to be filed under the newly raised rates, but realistically the worst could be over at year end, though still ongoing.

Though sales are poor for homebuilders, inventory is being sold off while much of the inventory left on the books has already been proactively written down to mitigate future losses. It is very probable that the homebuilders will begin to be increasingly more profitable, even before there is any actual industry improvement. Lennar Corp. (LEN) illustrated this idea by recording a $0.56 loss in its first quarter while the consensus estimate called for a loss of $1.12; the surprise was due to reduced write downs following formerly proactive inventory impairments. Lennar’s management commented that it expects the worst of its write downs are now over as a result. Meanwhile, the homebuilders are also nimbly seeking out investments in cheap real estate to take advantage of markets that are more likely to improve before the others.

Listed below are a few promising homebuilding stocks:

Hovnanian Enterprises (HOV): One of the more volatile stocks, the Company is still dealing with some debt pressure. However, its recent performance suggests it has redeemed itself and its probability of default now seems very low. In its first quarter, it achieved excellent sales results, while also looking to exploit potential growth markets and take market share from smaller, weaker competitors. This stock should be considered as a more risky play, but we like the stock’s value appreciation potential.

KB Home (KBH): Though the Company’s sales results were slow in its first quarter, the Company held a respectable cash balance that will keep its debt obligations fully in check. Its newly constructed homes are smaller and cheaper, with 95% of its communities priced within FHA loan limits. The Company is actively streamlining its operations to mitigate losses and has also seemingly written down a majority of its impairments.

Ryland Group (RYL): The Company ended its fourth quarter with excellent sales results and a rock solid balance sheet. Management expects it will not have to tap into its credit line in 2008 due to its strong cash flow.

Disclosure: none

Comments

[jdub]

"The" bottom is nowhere in sight. Most homebuilder stocks are still significantly over valued. Too soon to buy I think.

[DonPaulOlshove]

A fine article, but it fails to mention perhaps the most important event to occur since the housing debacle began. Last week the rate of home building finally fell below the rate of household formation. This doesn't even include the fact that houses are continually being removed from the market due to obsolescence. From now on, every day that passes will mean there will be fewer vacant houses available on the market. Very soon all those home buyers who have been holding back waiting for the bottom will realize the bottom has already passed. Of course this is a total national event. One can expect the recovery to be geographically uneven. The places with the largest actual oversupply will be the last to recover. The nice houses near the beach in sunny California have already passed the bottom. Michigan may have a ways to go. If you are thinking of perhaps buying yourself a housing stock or a new home, you better get busy with your homework. As these houses are soaked up, the next housing shortage is in the process of creation. The housing market is inherently unstable.

[Tim Plaehn]

Homebuilders have cleaned up their balance sheets, written down or sold inventory so they will stay in business. Next step is reduction of existing homes on market to something like a 6 month inventory and prices stabilizing. Homebuilders can sit where they are, but until they can start building and selling homes there will be no profits to speak of. I think there is a 6-12 month window here if someone is interested in homebuilders and stocks could be picked up on pull backs.

[DonPaulOlshove]

Since the market seems to run 6 to 12 months ahead of events, then waiting for profits to return will mean you missed the bus.

[Big onCredibility]

Any published article that ends with "Disclosure: none" is without merit.

It should be assumed to be a biased article. As mentioned by "jdub", " 'The' bottom is nowhere in sight. Most homebuilder stocks are still significantly over valued. Too soon to buy I think."

New home sales missed the estimate in a big way this morning. Also today, Pulte homes reported a wider loss than expected by analysts.

What everyone needs to remember is that this time, the housing bubble was so big that it will take much longer than "usual" to work off the problem. As for the statement made by "DonPaul Olshove" that "The nice houses near the beach in sunny California have already passed the bottom.", I have to let any reader know that is simply not accurate. California had massive growth in home values and has only had some of the air come out of its bubble. Home values are still well above the previous low (even at the beach). So high above the previous low that it's quite clear California has longer to go to work off its housing bubble problem than any other region in the U.S.

Take a "reality pill" everyone. The second half of '08 turnaround that some are suggesting is simply not a realistic expectation.

[DonPaulOlshove]

Big On Credibility - Well, yes, the bottom will be round and will not be completely obvious until it has passed. And a "turnaround" for builders which implies increasing profits is different than a bottom which implies no more losses. Perhaps you haven't noticed the general inflation that surrounds us. The gov assisted by the Fed is not about to allow a depression style landing with 30% of all houses owned by banks which is what is required if prices are to continue to fall. They will do whatever is required. If they are unsuccessful, we will have much bigger problems than poor house prices. That's ok, we disagree, time will tell.

[HJ/lasvegas]

I'm not so sure that the forclosure mess is over as the article states. Yeah subprime loans are getting sorted out and the last of them should become REO's sometime towards the end of the year but after that there is a whole new wave of option ARM and ALT-A loans that will start resetting. That will lasy unfortunately until the end of 2011. Take a look, I think there's a chart at bubbleinfo.com

[gwinner]

The Fed will "try" to hold down interest rates as long as possible, but the November elections and continued inflation will ultimately win the day. The ascent of interest rates is guaranteed. As interest rates rise, so do monthly mortgage payments on new "fixed" loans. With continued inflation, less household budget is also left each month for mortgage payments unless wages rise faster than inflation.

We must eat, drive to work/school, insure ourselves to a degree, heat/power our homes, buy some clothes made in China, etc. but we don't need to take on a new mortgage payment. We can stay where we are or rent if we must move to another location.

To add fuel to the Santa Anna fires in Southern California, there are few new home developments without very stiff mello roos tax assessments. As "monthly" home affordability decreases, the additional mello roos tax weighs heavy on the decision to purchase a new home vs. a pre-owned home in a non-mello roos zone. As developers drop the price of new homes in mello roos zones to compensate, downward pressure is placed on pre-owned homes.

No discussion of this topic can be complete without some consideration of the risk of potential shocks to the system. Is another 9/11 scale attack in the works to test a new president? What about severe disruption of our oil supply or refining capacity (anyone remember Katrina)? What impact could the large California earthquake that our geologists are calling inevitable in the next 20 years have on the market? I no events of this magnitude will happen, but history is the best guide and events of this nature could drastically alter market conditions locally or across the nation.

No matter how you look at shrinking/growing inventories of new and pre-owed homes or the improved balance sheet of some home builders, you have to consider the monthly affordability of homes. When the price of a home is not increasing $100k/year, that places an entirely different perspective on the monthly affordability and speculation equations. When there are no longer windfalls from a tech bubble, cashing in stock options for a large down payment is not an option. One bubble can no longer beget another. Speculators flee to the next perceived opportunity and the housing market are rationalized by historic medians, which focuses us on monthly affordability.

It is clear that the bubbles have burst. Anyone who claims to know with confidence where the bottom will be found in the housing market is speculating.

[Magyc]

If the crisis were in fact over (it is not) there are much better places to place your money. HB are not going to return to their bubble peak, it will be like investing in a utility...some are close to fair value right now given historical earning patterns.