Homebuilders: Rejuvenation Set To Continue Into 2020
- Left for dead early in the year, homebuilders have sprung back to life this year - surging more than 50% - after falling into a "mini housing recession" in 2018.
- After dipping 30% last year, the combination of sharply lower mortgage rates, strong demographic-driven demand, and lower construction materials prices have rejuvenated single-family builders.
- Don't let this year's performance fool you. Homebuilders remain an unloved sector, still trading at deep discounts to historical and market multiples despite double-digit earnings growth.
- Homebuilders have increasingly shifted into entry-level segments where projected demand growth is strongest. Order growth jumped more than 15% in the latest quarter.
- Millennials - the largest generation in American history - are coming full-steam into the single-family housing markets over the next decade during a period of historically low housing supply.
- This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »
Homebuilder Rankings Overview
In our Real Estate Rankings series, we analyze companies within each of the commercial and residential sectors, focusing on property-level fundamentals and the macroeconomic forces driving overall supply and demand conditions. We then analyze these firms based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives.
(Hoya Capital, Co-Produced with Brad Thomas through iREIT on Alpha)
Homebuilding Sector Overview
In the Hoya Capital Homebuilder Index, we track the 15 largest homebuilders, which account for roughly $80 billion in market value: D.R. Horton (DHI), Lennar (LEN), NVR (NVR), PulteGroup (PHM), Toll Brothers (TOL), KB Home (KBH), Taylor Morrison (TMHC), MDC Holdings (MDC), Meritage Homes (MTH), M/I Homes (MHO), TRI Pointe (TPH), Century Communities (CSS), William Lyon (WLH), Beazer Homes (BZH), and New Home Company (NWHM). Together, these 15 firms will have constructed approximately 200,000 homes in 2019, accounting for roughly a quarter of total single-family deliveries this year. Below we note the regional and price-segment focus of each of these 15 builders.
While single-family homebuilding ETFs including the SPDR S&P Homebuilders ETF (XHB) and the iShares Home Construction ETF (ITB) are sometimes viewed as a proxy for the entire US housing market, single-family builders account for only around 15% of total housing-related spending in the average year, as tracked by the Hoya Capital US Housing Index. While a small number of single-family builders including Lennar have made investments towards multifamily development in recent years, these builders remain almost exclusively focused on single-family development. Similar to the commercial REIT sector, due to the high degree of private ownership of assets and companies within the industry, homebuilders represent just a tiny slice of typical broad-based equity indexes relative to their total economic impact.
The US single-family homebuilding sector is a highly cyclical, competitive, and fragmented industry. The top 10 largest builders account for roughly a quarter of the total new home sales, but this concentration has intensified since the recession in a trend we've described as "Go Big or Go Home" due to the challenging economics of homebuilding, a business where net operating margins are typically in the single digits even in the very best of times. New home construction has been slow to recover since plunging during the recession, and by nearly every metric, the US has been significantly under-building homes - particularly single-family homes - over the last decade. The effects of this housing shortage, as we'll analyze in more detail below, have been a rise in housing costs through higher rents and a growing share of spending allocated towards housing and housing-related services.
Millennials - the largest generation in American history - are coming full-steam into the housing markets over the next decade amid this period of historically low housing supply. Harvard University's Joint Center for Housing Studies (JCHS) projects that annual household growth from 2018 to 2028 will average 1.2 million households per year, which is 20% higher than the prior five-year average. As JCHS points out, over the next 10 years, the population in key demographic groups will swell - particularly in the critical 35-45-year-old associated with incremental single-family housing demand.
While the "Boomer" generation seems to get all of the attention, the age cohort currently between 25 and 34 years old is significantly larger than the 10-year cohort preceding it, currently aged 35-44. Having entered the labor markets during a historically strong period of economic growth, this cohort is also in far better shape financially across most metrics than the preceding 10-year cohort. This combination of historically low housing supply and strong demographic-driven demand has resulted in a compelling macroeconomic backdrop for companies involved across the US Housing Industry over the next decade, especially companies involved in new home construction.
Homebuilding segments can be roughly split into four categories: entry-level, move-up, luxury, and retirement. As construction and regulatory costs had risen over the past decade, homebuilders had shifted their focus towards higher-end units which command high enough margins to offset these increased costs. Recently, however, we've seen that trend reverse with homebuilders increasingly shifting their focus into entry-level segments where projected demand growth is strongest. That shift is still in the early-innings as these builders are still skewed towards the move-up and luxury segments. According to the Census Bureau, the median new home price was for a newly-built home was $316,700 in October, while the median public builder in our 10-company coverage is $414,000 in 3Q19. On the high-end, Toll Brothers has the highest average selling price while D.R. Horton has the lowest ASP.
Homebuilding can be broken down into 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 and entitlement process to get the land ready for single-family development. Post-crisis, however, the large public builders have increased their use of land options, offloading the land development responsibilities onto residential lot development companies (most of which are privately-owned), allowing these firms to focus on construction. This reduces risk and increases return on equity, but typically comes at the expense of lower margins. On average, about 50% of developed land secured via land options with NVR making the highest-use of this options strategy at around a 90% utilization rate.
For homebuilders, it's all about the "5 Ls": lending, lumber, labor, land, and legislation, and in 2018, all five of these factors were stiff headwinds. Most notably, for lending, higher mortgage rates pushed affordability to cycle-lows while lumber, labor, and land costs were all significantly higher throughout the year. Legislation - through tax reform and the continued challenges on the zoning and permitting front - may have been the most significant headwind of all given the reduction in homeownership incentives associated with doubling the standard deduction and the "SALT" state and local tax deduction cap. Helping to power this year's recovery, at least two of these headwinds - lending and lumber - have become significant tailwinds in 2019 with mortgage rates flirting with historic lows while lumber and other construction materials prices also pulled back significantly after hitting record highs in 2018.
Homebuilder Stock Performance
Left for dead early in the year, homebuilders have sprung back to life this year - surging more than 50% - after falling into a "mini housing recession" in 2018. Homebuilders fell into "correction territory" in late 2018 as a myriad of headwinds looked certain to derail the grinding post-recession recovery, sending the sector lower by more than 30% last year. Propelled by the sharp 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. With gains of 54%, homebuilders are the best-performing industry sector in the Hoya Capital US Housing Index, followed by the related homebuilding products and materials sector.
Among the major themes in the homebuilding sector this year has been the significant outperformance of builders focused on the lower-priced entry-level segment. Interestingly, much of the demand for this entry-level product has come not from individuals, but from institutional rental operators including single-family rental REITs, which we discussed in a recent piece: Millennials Knocking On The Door. For the "Renter Nation" generation, single-family rentals have become the new "starter homes." Despite the higher price tag compared to existing homes, institutional rental operators value the certainty in repair and renovation costs of new construction as we see the lines between homebuilder and rental operator getting blurred in the next decade. American Homes 4 Rent (AMH), for example, plans to add 2,400 deliveries in 2020 from a combination of internal development and partnerships with homebuilders through their National Builders Program. Below we note the near-linear trend of outperformance this year among builders with lower average selling prices.
Homebuilders have more than doubled the performance of the S&P 500 ETF (SPY) this year, led by KB Home and Meritage Homes with gains above 80%. The four homebuilders with the highest average selling price have been the weakest performers this year, highlighted by Toll Brothers which has gained just 21%. The four largest homebuilders - D.R. Horton, Lennar, NVR, and PulteGroup - have all gained over 50% this year. The gains have been steadily paced throughout the year with positive monthly returns in 10 of the 11 months so far this year.
Rejuvenation Confirmed in Earnings Results
For the 10 homebuilders in our coverage, third-quarter earnings were impressive, to say the least. While revenue growth rose just 3% from last year, the most closely-watched forward-looking metric, net order growth, significantly exceeded expectations, rising more than 15% from last year confirming that lower mortgage rates and resilient demographic-driven demand are indeed translating into improved demand, and at a rate stronger than even many of the most bullish analysts predicted. The strength was most pronounced, interestingly, in the smaller homebuilders as these companies reported an average of 34% year-over-year net order growth, by far the highest print of this economic cycle. Commentary on earnings calls was decidedly positive with most builders noting momentum continuing in the weeks since quarter-end.
Notable news this past quarter was Taylor Morrison announced agreement to acquire William Lyon, which will create the fifth-largest homebuilder which will significantly increase the company's entry-level product offerings, especially in West Coast markets. The transaction is expected to close late in the first quarter or early in the second quarter of 2020. Reflecting both these homebuilders' increased focus on entry-level segments and the broader cooling of home price appreciation this year, the average selling price decreased 3% from last year. The backlog, meanwhile, swelled to more than 75,000 units - again led by the smaller builders - while the conversion rate stayed steady around 65%. Cancellation rates, meanwhile, dropped an average of 200 basis points from last quarter and are back at the post-recession average after ticking higher in early 2019.
Last year, homebuilders were hit by the double-whammy of weak demand and rising cost pressures that sent operating margins plunging in late 2018. Homebuilding margins, while weaker on a year-over-year basis, were generally in line or slightly ahead of estimates, and we expect to see considerable margin improvement in 2020. With a high degree of operating leverage inherent in the homebuilder business model, order growth should translate into improved margins going forward. Gross margins averaged 20.5% in 3Q18, down about 20 basis points from the prior quarter, and with SG&A margins ticking slightly higher, operating margins fell about 50 basis points to 11.7%, on average.
As discussed above, the "Go Big or Go Home" theme is still very relevant within the homebuilding sector, despite there being some moderation of this trend in 3Q19 results with the smaller builders seeing margin improvement. Within our coverage, which only includes the largest 10 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 as well as anecdotal and survey data, that very small private builders are still having a very difficult time breaking-even on single-family development projects given these tough economics without taking on a high degree of leverage. As a result, we continue to believe that an increasing share of starts will accrue to the publicly traded homebuilders with the scale necessary to achieve an adequate return. Interestingly, while gross margins are actually pretty similar between both large and small builders, it is the overhead expenses that explain the majority of the net operating marginal differential. Selling, general and administrative (SG&A) expenses average around 8.5% of homebuilding revenues for the smaller builders, but that climbs to roughly 11.5% for the smaller public builders. Again, even the "small" builders in our coverage are among the top 1% largest single-family builders in the country. Extrapolating the trendline below to the left, it isn't hard to see how private builders that deliver several dozen or a few hundred homes per year struggle to break even.
New in this report is a historical analysis of homebuilding margins in the post-crisis period. The chart below again illustrates the point regarding SG&A margins explaining most of the "delta" in operating margins. Gross margins have stayed relatively steady since 2013 at around 21%. The improvement in SG&A overhead from around 12% to 10% explains all of the 200 basis point improvement in operating margins over this time. Again, we see this margin profile supporting the "bigger is better" thesis and believe that these larger public builders have a significant competitive advantage through size and scale. We envision further industry consolidation and a growing share of activity accruing towards these public builders over the next decade.
Homebuilder Valuations: Growth At Reasonable Price
Don't let this year's strong stock price performance fool you. Homebuilders remain an unloved sector, still trading at deep discounts to historical and market multiples despite double-digit earnings growth. Consensus estimates call for EPS growth averaging around 10% through 2022, yet the sector trades at an average forward P/E of just 11x, far shy of the 19x forward P/E multiple on the S&P 500. Since the end of the recession, these builders have traded at an average trailing P/E of around 14.5x, well above the current TTM P/E of 12.5x. Homebuilders also appear attractively valued based on price-to-book with a current P/B ratio of 1.7x, below the 2.0x average in the post-crisis period.
Investors looking for "growth at a reasonable price" would be wise to take a closer look at these single-family homebuilders. Homebuilders trade at an average PEG (price-to-earnings-over-growth) ratio of just 1.0x, below the S&P 500 average of roughly 1.6x. Below, we break down the P/E and PEG valuations of each of the 10 homebuilders in our coverage. Investors award premium multiples to builders with "land-lite" options-heavy strategies including NVR and D.R. Horton and tend to discount the builders focused on luxury development such as Toll Brothers. At current valuations, we're most attracted to the larger, entry-level-focused names including KB Home, D.R. Horton, NVR, and Lennar.
Housing Data Continues To Impress
New Home Sales smashed through expectations in October, surging more than 31% from October 2019 to a seasonally annualized rate of 733k units. The rate of home sales in September was also revised significantly higher from 701k to 738k units. Together, September and October were the best two months of New Home Sales in more than 12 years. Sales have now exceeded 700k in four of the past five months. Pending Home Sales rose by 4.4% year-over-year in October while Existing Home Sales are higher by 4.6%, for each representing the fastest rate of growth in more than three years.
As discussed, the year of rejuvenation continues for the US residential real estate sector following one of the toughest years for homebuilders since the financial crisis. For the US housing industry, the story of this year continues to center around the resilient demographic-led growth in household formations along with the sharp pullback of the 30-year fixed mortgage rate, which has stimulated renewed activity across nearly all segments of the housing industry. Perhaps best illustrating this rejuvenation, revisions to 3Q19 GDP data this week confirmed residential fixed investment offered a positive contribution to GDP growth in the third quarter of 2019 for the first time since the fourth quarter of 2017.
Building Permits reached new 12-Year Highs in October while Housing Starts are higher by 8.5% compared with a year ago in October on a seasonally-adjusted annualized basis. The Mortgage Bankers Association Builder Application Survey data for October showed mortgage applications for new home purchases increased by 31.5% compared to a year ago. Refinancing activity has boomed so far this year with the MBA Refinancing Index up more than 150% from last year while the MBA Purchase Index, a leading indicator of Existing Sales, is higher by roughly 8% from the same period last year.
Forward-looking economic indicators suggest that the momentum may well continue into 2020. Lower mortgage rates continue to be a significant tailwind for the broader US housing industry in 2019, which continues to be one of the bright spots for the broader US economy as we head into year-end. At 3.98%, the MBA 30-Year Mortgage Rate is almost exactly 100 basis points lower than the level in the same week last year. Over the past half-decade, there has been a very strong correlation between changes in mortgage rates and growth in new home sales, as highlighted in the chart below, suggesting that the reacceleration seen this year may still have plenty of room to run.
So while the demand-side is looking quite strong, the expense-side may look even more favorable at the moment. 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, construction materials costs have moderated significantly since peaking last summer. Lumber prices have pulled back more than 40% since peaking in May 2018. Total construction materials costs are now lower by roughly 2% on a year-over-year basis, pulling down total construction cost inflation to roughly zero from last year. Again, we should begin to see this show up in improved gross margins from these homebuilders in 2020.
Bull and Bear Case for Homebuilders
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 homebuyer 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.
If affordability - or lack thereof - is the primary headwind for homebuilders, there may be good news. The presence of institutional single-family rental operators has 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, we expect built-to-rent buyers to account for a growing percentage of new home sales and single-family housing starts over the next decade, giving these builders a sales avenue even if individual homebuyers continue to have affordability difficulties.
While the lagging housing data metrics continue to reflect the slowing conditions of late 2018, forward-looking metrics continue to look very favorable and we believe housing data will continue to strengthen well into 2020 if mortgage rates remain at these levels. Additionally, as noted above 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. Below we summarize five reasons that investors are bullish on the single-family homebuilding sector.
Investors have reasons to be cautious as well. Rising construction costs last year pressured the already razor-thin operating margins for homebuilders and the effects of these higher costs on gross margins have lingered into 2019. 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. Below, we discuss five reasons that investors are bearish on the homebuilding sector.
Bottom Line: Rejuvenation Likely To Continue Into 2020
Left for dead early in the year, homebuilders have sprung back to life this year - surging more than 50% - after falling into a "mini housing recession" in 2018. After dipping 30% last year, the combination of sharply lower mortgage rates, strong demographic-driven demand, and lower lumber and construction materials prices have rejuvenated single-family builders.
Don't let this year's performance fool you. Homebuilders remain an unloved sector, still trading at deep discounts to historical and market multiples despite double-digit earnings growth. Homebuilders have increasingly shifted into entry-level segments where projected demand growth is strongest. Order growth jumped more than 15% in the latest quarter.
Millennials - the largest generation in American history - are coming full-steam into the single-family housing markets over the next decade during a period of historically low housing supply. Long-term fundamentals continue to support healthy and growing demand for single-family homes in the 2020s. This combination of historically low housing supply and strong demographic-driven demand has resulted in a compelling macroeconomic backdrop for companies involved across the US Housing Industry over the next decade, especially companies involved in new home construction.
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