Homebuilders: It's A Buyer's Market

May 29, 2019 4:50 AM ETSPY, PHM, DHI, TOL, LEN, KBH, XHB, ITB, NVR, MTH, MDC, TPH, TMHC, PKB, NAIL, HOML, HOMZ2 Comments17 Likes

Summary

  • Homebuilders had their backs against the wall in 2018 as a myriad of headwinds looked certain to derail the grinding post-recession recovery, sending the sector lower by 30% last year.
  • Homebuilders were squeezed from both sides as rising mortgage rates forced homebuilders to cut prices while surging construction costs squeezed their already-razor-thin operating margins.
  • The winds have shifted rather dramatically over the last five months as these headwinds have become favorable tailwinds. Unaffordability issues have been temporarily allayed by the plunge in mortgage rates.
  • Rising wages powered the best year for household formation growth since 1985. Demographics become favorable for single family markets in the 2020s, though entry-level households may favor single family rentals.
  • Homebuyers appear to have a short window of opportunity. Home price appreciation has moderated, but housing data is forecast to gain steam throughout 2019 if rates remain this low.

Homebuilder Rankings Overview

In our Real Estate Rankings series, we analyze each of the commercial and residential real estate sectors. We analyze homebuilders based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We update these reports every quarter with new developments.

homebuilder rankings

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Homebuilding Sector Overview

The US homebuilding sector is a highly cyclical, competitive, and fragmented industry. The top ten largest builders account for roughly a quarter of the total new home sales, but this concentration has intensified since the recession. In our Hoya Capital Homebuilder Index, we track the ten largest homebuilders, which account for roughly $70 billion in market value: D.R. Horton (DHI), Lennar (LEN), PulteGroup (PHM), NVR (NVR), Toll Brothers (TOL), KB Home (KBH), Meritage (MTH), M.D.C. Holdings (MDC), Taylor Morrison (TMHC), and TRI Pointe Group (TPH).

homebuilder overview

Smaller publicly-traded builders include Beazer (BZH), Skyline (SKY), LGI Homes (LGIH), Green Brick (GRBK), Hovnanian (HOV), William Lyon (WLH), and Century Communities (CCS). Homebuilding segments can be roughly split into four categories: entry-level, move-up, luxury, and retirement. As construction and regulatory costs have risen, homebuilders have shifted their focus towards higher-end units which command high enough margins to offset these increased costs. According to the Census Bureau, the median new home price was for a newly-built home was $309,100 in the first quarter of 2019, down 6% from 1Q18. As shown, these ten builders are skewed towards the higher-end segments of the new home markets.

selling price homes homebuilders

There has been renewed investment over the last year on the entry-level segment amid concern over the impact of tax reform on the upper-tier segments. The presence of institutional single-family rental operators has also supported demand for affordable "built-for-rent" homes. Consistent with our view that the "institutionalization" of the single-family housing sector is a trend in the early innings, which we discuss in our report on the single family rental REIT sector, we expect built-to-rent buyers to account for a growing percentage of new home sales over the next decade.

built to rent

Homebuilding is really two distinct businesses, each with different risk/return characteristics: 1) Land Development; and 2) Home Construction. Historically, homebuilders have been overweight in the land development business, holding hundreds of millions of dollars worth of unused land on their balance sheet and going through the multi-year permitting to get the land ready for single-family development. Large builders have increased their use of land options since the financial crisis, which reduces risk and increases return on equity, but comes at the expense of lower margins. For homebuilders, it's all about the 5 Ls: lumber, lending, labor, land, and legislation. In 2018, all five of these factors were considerable headwinds, but at least two - lumber and lending - have become significant tailwinds in 2019.homebuilders 101

By conventional measures, the US housing market is the largest - and arguably the most important - asset class in the world with a market value of roughly $33 trillion dollars. We estimate that annual spending on home building and construction accounts for around 30% of total spending on housing and housing-related services at roughly $1.1 trillion in 2018 and within that category. Because of the high percentage of housing assets owned by individuals and home development that takes place by private builders, indexes weighted based on market capitalization like the S&P 500 (SPY) are significantly underweight the residential housing industry relative to their importance to overall spending at the GDP level.gdp spending housing

Bull and Bear Case for Homebuilders

Understandably, homebuilders remain one of the most "un-loved" sectors of the equity markets, so it makes sense to begin with the bear-case for homebuilders. On the front-lines of the housing crisis, the homebuilder ETFs (XHB and ITB) plunged more than 80% from peak-to-trough and these funds actually remain below the levels they began trading at when they launched in 2006. A cataclysmic event on many levels, the housing crisis resulted in the end-of-operation for more than 30,000 small private builders and the aftermath of the housing crisis is still being felt across the sector.

While the building industry is still recovering from the crisis, home prices have more than climbed back since the depths of the recession (at least on a nominal basis), prompting renewed worries about housing affordability. Home prices have outpaced personal income growth by more than 3% per year since home prices bottomed in 2013, aided by historically-low mortgage rates in the post-recession period. Likely rising at above-trend-levels, home price appreciation began to moderate in 2018 amid a steady rise in mortgage rates that significantly slowed the single-family markets. Unaffordability issues have been temporarily allayed by the plunge in mortgage rates.home price appreciation

Rapidly rising construction costs have further pressured the already razor-thin operating margins for homebuilders. The 2017 tax reform also removed key tax code incentives to homeownership by capping the state and local tax deductions and raising the standard deduction. These changes have led to significant softness in the high-tax and high-cost coastal markets in particular and we think may result in a lower long-run equilibrium homeownership rate. Further, whether fundamentally justified or not, homebuilder valuations have become increasingly more interest rate-sensitive in recent years.

bearish homebuilders

The winds have shifted rather dramatically over the last five months as many of the headwinds faced by the homebuilding sector have become favorable tailwinds. A central theme that we continue to discuss is the lingering underinvestment in new home construction during the post-recession period and the ripple-effects it has on all segments of the US housing industry. By nearly every metric, single-family housing markets remain significantly undersupplied. With the exception of the three "bubble" years from 2003-2006, the United States has been under-building homes since the early 1990s, and that trend of underbuilding has intensified dramatically since the housing bubble burst in 2008. A shortage primarily rooted in sub-optimal public policy at the local, regional, and national levels, the US is building homes at a rate that is less than 50% of the post-1960 average after adjusting for population growth.

housing shortage

Household formations outpaced new housing starts by more than 100k in 2018 as the vacancy rate for both owner-occupied and renter-occupied homes reached multi-decade lows in the fourth quarter. More importantly, demographics suggest a significant increase in demand for single-family housing based on historical trends of homeownership preference. The average age of a first-time home buyer is 32 years old, a cohort that will grow by more than 1.5% per year through 2025 as the largest five-year age cohort in America (born 1989-1993) enters prime single-family homebuying age.

household formations

Unaffordability issues have been temporarily allayed by the plunge in mortgage rates. While the lagging housing data metrics continue to reflect the slowing conditions of late 2018, forward-looking metrics have turned very favorable over the last several months and we believe housing data will strengthen throughout 2019 if mortgage rates remain at these levels. Further, a significant factor in this sustained undersupply has been the downright dismal economics of new home construction for all but the most operationally-efficient homebuilders. Homebuilding operating margins average barely 10% for the largest builders and decrease to under 5% for the typical small private builder. For that reason, size and scale have become a critical competitive advantage for large homebuilders and we think that market share gains will continue to accrue to the most operationally-efficient builders.

bullish homebuildersRecent Homebuilder Stock Performance

Homebuilders had their backs against the wall in 2018 as a myriad of headwinds looked certain to derail the grinding post-recession recovery, sending the sector lower by 30% last year. Powered by the sudden reversal in mortgage rates, the continued strength in household formations, and the retreat in lumber prices, homebuilders have led the broader equity market rally this year, surging more than 25%, the best-performing housing sector in the Hoya Capital US Housing Index, an index that tracks the performance of the broader US residential housing industry. Having been bearish since late 2017, we turned positive on the homebuilding sector in our November 2018 report, Homebuilders: Relief in Sight and we remain positive on the sector in 2019 given the trends that we discuss in the housing data section below.

homebuilders YTD

At the company-level, one of the notable trends this year has been the underperformance of the high-end-focused homebuilders. The three homebuilders with the highest-priced homes, Toll Brothers, TRI Pointe, and MDC have been the laggards so far this year as high-end home values are seeing steeper declines across many markets due to the effects of tax reform, notably the removal of the state and local tax deductions. KB Home and Meritage have been the best-performers, each jumping more than 38% so far this year.

homebuilder performance

Recent Housing Market Data

As we've been discussing for the past several months, the forward-looking metrics in the housing market suggest a solid recovery in home sales data throughout 2019 if post-recession correlations hold. Mortgage rates are now lower by more than 50 basis points on a year-over-year basis, a sharp reversal from the 100 basis point headwind that slowed the housing market in 2018. The MBA Purchase Index, a useful leading indicator of new and existing home sales, earlier this year jumped to the highest level since 2010 while the MBA Refinance Index rose to the highest level since last spring.

mortgage rates

Mortgage rates have shown a rather remarkable correlation with new home sales during the post-recession period. We continue to believe that 2018/2019 looks quite a bit like 2014/2015 when home sales ground to a halt following the taper-tantrum-led interest rate surge only to surge more than 15% the following year as mortgage rates reversed. While we do think that the lingering effects of tax reform will negate some of the positive flow-through from lower mortgage rates and lead to a lower equilibrium homeownership rate, we would be surprised if new home sales did not accelerate back to the mid-single-digit growth rates by late 2019 if mortgage rates remain around these levels.

mortgage rates

Another forward-looking metric showing upside, homebuilder sentiment has improved, climbing to seven-month highs in May. Homebuilder sentiment dipped late last year to the lowest level since 2015, but lower mortgage rates continued strength in the labor markets and moderating construction costs have brightened the outlook for single-family construction this year. All three index subcomponents improved from last month with buyer traffic matching the highest level since last July at 49. On the regional level, the Northeast led the gains, jumping 10 points to 65. The South and West, however, remain the strongest regions. Rising homebuilder sentiment data suggest that single-family housing starts should recover in 2019 based on past correlations between the data sets.

homebuilder sentiment

The slower-reacting data, however, continues to reflect the slowing conditions of late 2018. New and Existing Home Sales data for April was released last week and reports both came in shy of estimates. Existing sales data generally reflects selling conditions two months prior while new home sales are a bit more timely. New home sales jumped 7% over the same time last year on a SAAR-basis while existing sales dipped 4.4%. Based on the forward-looking data, we expect these metrics to begin to inflect higher by the June or July data.

existing home sales

Home price appreciation also slowed meaningfully in late 2018 and soft conditions will continue to be reflected in this slower-reacting data for several more months at least. The Case-Shiller Index, released on Tuesday, showed that national home prices rose at the slowest rate in nearly seven years at 3.7%. We think that homebuyers appear to have a short window of opportunity where seller's pricing expectations have trended lower as headlines reflect this "stale" home price data, as we expect pricing to stabilize and perhaps reaccelerate by late 2019 given recent mortgage market conditions.

home prices

We find that investors tend to overweight local market conditions and anecdotal evidence of particularly weak or strong real estate conditions, while often overlooking the wealth of available national data. As always, it's important to remind investors that the US housing market is enormously large and heterogeneous and each of the 120 million housing units in the United States is independently affected by a different set of local economic conditions, illustrated by the nearly 15% spread between the best and worst-performing regional markets.

home prices by markets

In the market-level home price data and the new home sales regional data below, we note the divergence between the weak-performing coastal markets and the better-performing sunbelt markets. Feeling the effects of tax reform and the cap on SALT deductions, home sales in the relatively high-tax Northeast and West Census regions continue to lag the national averages. Seemingly taxed into oblivion over the last several decades, the Northeast region now accounts for less than 5% of total new home sales while the South Census region accounts for more than 50% of new home sales. Over this time, the Northeast has generally been the most challenging region for developers to build due to restrictive zoning and a more hostile regulatory regime. Demographics are especially weak in the northeast markets where boomers outnumber millennials by nearly 20%, adding extra headwinds on home values and home sales over the next decade.

new home sales

Recent Company-Level Performance

Homebuilders delivered results that were all across the map in their recent quarter as the plethora of headwinds - lending, labor, land, lumber, and legislation - all came to a head in late 2018. Deliveries grew just 2% on a year-over-year basis, the weakest rate of growth since the recovery began in 2012. Net orders, the more closely watched forward-looking results, dropped 1%, but this was a material acceleration over last quarter when orders dipped more than 7%. Selling prices of delivered units dropped 2.2% on a year-over-year basis with high-end builder Toll Brothers seeing the sharpest decline. Rising values on existing homes, along with cheap financing from low mortgage rates, have been critical in allowing these builders to remain competitive and offset rising construction costs.

homebuilder orders

Smaller builders, in particular, were hit by the double-whammy of weak demand and rising cost pressures that sent operating margins plunging in late 2018. Operating margins for the five largest builders actually improved slightly on a year-over-year basis at 10.5%, but the smaller five builders saw a 260 basis point dip in operating margins down to 5.0%, dragged down by especially weak results from TRI Pointe.

homebuilding marginsWe continue to note the bifurcation between the larger and smaller homebuilders. Even within our coverage, which only includes the largest ten builders in the country out of a pool of more than 20,000 total single-family builders, the critical importance of scale becomes clear through the wide gap in operating margins, which declines linearly with size. It's reasonable to assume, given the linear trend in the data, that small private builders are having a very difficult time breaking even given these tough economics. As a result, we believe that an increasing share of starts will accrue to the publicly traded homebuilders with the scale necessary to achieve an adequate return.homebuilder operating margins

The combination of a reacceleration in economic growth, trade disputes, and immigration policy pushed construction costs higher by more than 6% in 2018. While land prices and labor costs continue to rise above the rate of inflation, two of the five Ls - lending and lumber - have eased considerably over the last two quarters. Lumber prices plunged more than 40% since peaking in May 2018 while mortgage rates have receded as discussed above. Labor costs, however, continue to tick higher as tighter immigration policies may put further pressure on the lingering worker shortage.

construction costs

As we've noted, home price gains in the pre-bubble period occurred despite modest rises in construction and replacement costs. In one of our favorite charts below, we chart home price appreciation against the US Census Bureau's construction cost index for single-family homes. We see that from 1999 through 2006, home price appreciation more than doubled the rate of construction cost inflation, producing an unstable environment whereby homes were priced far above replacement costs. Since 2007, construction cost inflation has more than doubled the rate of home price appreciation. While a negative for homebuilders, who have less wiggle room to pass on rising costs to buyers, it does indicate that overall home prices are on more solid footing than they were in the "bubble" period.

home prices costs

With construction costs rising and largely out of the control of builders, analysts have put increased scrutiny on overhead margins. For years, these homebuilders have touted that overhead is a primarily fixed cost that should improve considerably with increased home sales. While SG&A margins have improved modestly in recent quarters, they remain stubbornly high for many builders.homebuilder overhead

Valuation & Dividend Yield of Homebuilders

A notoriously cyclical industry, homebuilders have historically traded at discounted valuations to the broader US equity sectors. From 1991 to 2016, homebuilders have traded for an average trailing P/E ratio of 11-13x. Even after the recent surge this year, homebuilders still trade at an average 11x trailing P/E, towards at the lower end of their post-recession range.homebuilder valuations

Homebuilders generally pay little or no dividends and instead plow back all of the available cash flow into development. Homebuilders pay a dividend yield below 1%, shy of the 2% yield on the S&P 500 and the nearly 4% yield paid by the average REIT.

homebuilder dividends

Bottom Line: It's A Buyer's Market

Homebuilders had their backs against the wall in 2018 as a myriad of headwinds looked certain to derail the grinding post-recession recovery, sending the sector lower by 30% last year. Homebuilders were squeezed from both sides as rising mortgage rates forced homebuilders to cut prices while surging construction costs squeezed their already-razor-thin operating margins.

The winds have shifted rather dramatically over the last five months as these headwinds have become favorable tailwinds. Unaffordability issues have been temporarily allayed by the plunge in mortgage rates. Homebuyers appear to have a short window of opportunity. Home price appreciation has moderated since early 2018, but housing data is forecast to gain steam if rates remain this low.

Homebuyers appear to have a short window of opportunity. Home price appreciation has moderated since early 2018, but housing data is likely to gain steam if rates remain low. Having been bearish since late 2017, we turned positive on the homebuilding sector back in November 2018 and we remain positive on the sector in 2019 given the significant pull-back in mortgage rates, which has driven a notable acceleration in the forward-looking housing metrics.

If you enjoyed this report, be sure to "Follow" our page to stay up-to-date on the latest developments in the housing and commercial real estate sectors. For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Student Housing, Single Family Rentals, Manufactured Housing, Cell Towers, Healthcare, Industrial, Data Center, Malls, Net Lease, Apartments, Shopping Centers, Hotels, Office, and Storage.

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Disclosure: I am/we are long LEN, DHI, NVR, PHM, TOL, KBH, TMHC, MDC, MTH, TPH. 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.

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