Sell Homebuilders And Buy Manufactured Housing

Summary

• The combination of a shortage of housing and increasing demand for housing is a powerful tailwind.
• While this tailwind helps both homebuilders and MH, strategic factors suggest MH will get more sustaining benefit.
• UMH and LEGH are my plays on the space.
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Photo by photovs/iStock via Getty Images

The Sell and replace thesis

As a value investor I feel compelled to warn my fellow value investors that the homebuilders might be a value trap. With impressive recent growth and price to earnings multiples under 10X, the homebuilders Lennar (LEN) and PulteGroup (PHM) look quite enticing at first glance. A deeper dive, however, reveals the earnings are near a cyclical peak and a shaky strategic foundation threatens future fundamentals.

In a previous article I discussed how the homebuilder’s margins are being squeezed by sawmills charging astronomical prices for lumber and showed that the sawmills are more strategically positioned within the vertical.

Today, I want to show that direct competitors are also better positioned. Specifically, manufactured housing or MH has barriers to supply which make its long run fundamental outlook superior to that of traditional homebuilding. In this area, I think a basket of UMH Properties (UMH) and Legacy Housing (LEGH) looks opportunistic.

Demand for housing – a tailwind for both homebuilders and MH, but MH benefits by more

Unemployment has dropped to a post-pandemic low.

From a macro-economic perspective improving employment leads to increased demand for housing. While this effect would normally be incremental and somewhat small, it is being amplified this time around by the increased ability of people to work remotely. Without being forced to cluster in big cities, demand for homes in suburbs is ramping up significantly.

This demand is quite clearly beneficial for both homebuilders and manufactured housing providers. That said, the supply dynamic is, in my opinion, going to cause the manufactured housing providers to benefit far more.

Quite simply traditional home development is encouraged by the various layers of the government from local to national while MH is still somewhat restricted.

HUD (the department of Housing and Urban Development) has recently started to somewhat facilitate MH, but at the local level there is still a massive amount of NIMBY (not in my backyard) sentiment and red tape. This red tape makes new permits extremely difficult to obtain and has kept supply to a trickle.

The effects can be seen in the numbers.

Traditional housing construction has been increasing since the end of the financial crisis and post pandemic has spiked to levels not seen since the housing bubble of 2005-2006.

In other words, supply is keeping up with the increased demand when it comes to homebuilders.

Manufactured housing has had constrained supply. New MH deliveries have been around 94,000 per year for the past 3 years.

Supply of MH is not keeping up with demand for MH.

As a result, the value of MH properties has risen significantly.

Over this time period, traditional home prices have also risen significantly but there is key difference:

The rising prices of MH are secular in nature while the rising prices of traditional homes are more cyclical in nature.

Since Manufactured housing supply is so constrained, it rarely catches up with demand while the unconstrained supply of traditional housing has a tendency to overshoot.

Back in 2005-2006 far too much traditional home supply hit the market causing a dramatic oversupply when the recession hit. This is the basic boom bust cycle of homebuilders. Check out the peak to trough of the previous recession in which Pulte and Lennar lost 83% and 94% of their value, respectively.

Source: SNL Financial

In contrast, manufactured housing didn’t get oversupplied so its dip was much more shallow. UMH Properties (UMH), a long tenured owner and operator of MH communities, did not suffer nearly as much during the financial crisis and was able to use that stronger positioning to grow nicely through the long expansion phase that followed the financial crisis.

Source: SNL Financial

I fear that traditional housing is headed for another run-in with oversupply and while I doubt it will be anywhere close to as bad as the financial crisis, it is generally not good to own such violently cyclical stocks at the peak of their cycle.

I can’t tell you if the peak is today, next year, or 3 years off, but the earnings that Pulte and Lennar are getting presently are not sustainable forever.

A look at the earnings per share of Lennar over time shows that times can be really good or they can be really bad.

Source: SNL Financial

So while Lennar is trading at just 10X 2020 earnings, it is trading at a much higher multiple against its average earnings. Unless one thinks these boom times are going to last forever, we have to be cautious on using the current PE multiple of a highly cyclical stock.

Manufactured housing is still economically sensitive, but the impacts are less drastic because the supply is constrained. Compare Cavco’s earnings below to those of Lennar above. Source: SNL Financial

It was clearly impacted by the recession, but much less violently.

This is more than a mere difference in volatility. It boils down to MH being fundamentally in a superior position.

High demand and high supply is simply a worse outlook than high demand with low supply.

Low supply buffers existing operators in a downturn and amplifies the upside during the good times. Well, because MH remains so undersupplied it would appear we are heading into a long period of the good times.

The market understands this and trades Manufactured housing stocks at very high multiples.

• Cavco (CVCO) trades at 28.8X forward earnings
• Sun Communities (SUI) at 25.5X forward FFO
• Equity Lifestyle (ELS) at 27X forward FFO

These multiples are warranted as I think earnings will grow enough to justify them. For these particular securities, however, the growth is priced in. At fair value, they should do fine but are not opportunistic.

Hidden gems

A persistent phenomenon across the market is that smaller stocks often get overlooked. There are 2 manufactured housing plays that trade at low multiples despite having access to the secular growth of the sector; UMH Properties and Legacy Housing Corporation.

LEGH is a direct peer of Cavco and is the 4^th biggest producer of manufactured housing. Cavco correctly trades at 28X earnings, but LEGH is left in the dust at 10X earnings.

Source : SA

As LEGH grows and gets recognized by the market I think its multiple will start to creep up much closer to its peers. That would represent substantial upside to those who get in at today’s price.

Legacy Housing is somewhat new to the public scene, but is already developing a nice track record of growth.

Source: SNL Financial

UMH Properties is a manufactured housing REIT and a direct peer of Sun Communities and Equity Lifestyle.

Unlike its peers which trade at 25X and 27X, UMH can be bought for just under 20X FFO. I find this opportunistically cheap given its impressive organic growth.

Source: SNL Financial

UMH’s rental rates that it charges tenants are still about 20% below market rates so its NOI can keep ratcheting up until rents are in parity with market.

In brief, owning UMH and LEGH provides exposure to the tremendous growth of the manufactured housing sector but because these stocks are overlooked by the market, you don’t have to pay for the growth.

I specifically like these stocks together because despite being in the same sector they actually somewhat hedge each other.

UMH as paired with LEGH

LEGH, as a builder of MH is a supplier of UMH which owns and operates MH communities. This entire industry vertical benefits from the strong demand for manufactured housing, but certain things could affect each business differently.

UMH is a big beneficiary of the red tape and regulatory environment which is stifling new MH permits. Without competing properties, the value of UMH’s communities is rising swiftly. Thus, one of the greatest risks to UMH would be if the permitting process were to be relaxed.

LEGH, as a builder of MH, would benefit from the permitting being relaxed because it would allow them to increase their volume of business. 15 years down the road the relaxed permitting would not be good because it would risk oversupply similar to what happens in homebuilders, but because there are so few incumbents, LEGH would make so much money before that happened that it would be a net positive.

Wrapping it up

Strong employment and trends of moving to the suburbs are creating strong demand for all kinds of housing.

Homebuilders seem risky to me because I think they are at or near a cyclical peak. The supply constraints on MH makes its growth more secular in nature and it is therefore my preferred way to play the demand for new housing.

While the big MH companies are trading at fair value, some smaller overlooked MH companies are opportunistically cheap. I see favorable reward to risk ratio in owning UMH and LEGH.

Analyst’s Disclosure: I am/we are long UMH, LEGH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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Comments

[larryklein]

The management at Legacy is not growth-focused. Financial results are anemic. They cannot increase revenue unless they build more plants. The best possible situation for shareholders would be a buyout by a bigger player. UMH is a good situation but after the runup in the last 12 months, the P/ffo is where it should be. Further growth needs to come from increases in FFO and 10% annually looks doable. By the way--I found the Legacy shares because management at UMH made a comment that they could grow faster if the manufacturers could deliver. It indicates an industry shortage that Legacy can address only with more capacity.

[david foster 1]

If manufactured housing is supply-constrained...usually, what happens in an industry in this situation is that either the existing players add capacity, new entrants joint the industry, or both. Why wouldn't that be happening in this case?

[Dane Bowler]

@david foster 1

Good question. It is because supply is not being constrained by the free market, but rather by the government red tape. Local zoning bodies are hesitant to give permits for MH communities because of the NIMBY aspect. Everyone agrees we need more affordable housing in America yet most people say "not in my backyard".

Thus, it is a long, expensive and difficult process to get zoning for a new MH community.

[Timo90]

Thank you for this interesting article and analysis. I'm invested in the US housing market via TopBuild and Patrick (some MH exposure). Do you think 3d Printing could influence the housing market in the future? Could that lead to some disruption? I read some interesting success stories regarding 3d printed houses in the last weeks. Thanks and best regards from Germany

[Dane Bowler]

@Timo90

3D printed houses? That is a fascinating concept but not something I have any expertise in so I cannot make an educated comment on its viability.

[Long_investing_horizon]

@Dane Bowler
Thank you for a good article focusing on this little covered sector. I agree with your main thesis that MH is in much better position than homebuilding sector due to supply contraints - resulting in the fact that MHs are less "commodity-like" comparing to traditional housing. I would add a clear economic advantages in productions of MHs vs. on-site homebuilding as the first can benefit from continuous progress in manufacturing technologies and processes and has somewhat less dependancy on labour, while on-site homebuilding does not differ in its nature from how the sector worked many decades ago.

I have two comments on the picks:
UMH shares many features with SUI and ELS, but its focus on workers communities represents a difference that warrants certain level of discount in my opinion. It's on one hand defensive being the most affordable housing option, but it's quite dependant on employment structure in respective regions, particularly on traditional energy sector.

LEGH has some risks worth mentioning, esp. ownership structure (concentrated control). Also it has less spare capacity the CVCO so it has less room to benefit from the positive trend on volume side. Having said that its price seems to be very opportunistic and upside looks really good here.

Long: ELS, SUI, CVCO, LEGH

[Dane Bowler]

@Long_investing_horizon

Good point on the production efficiency. Regarding the working class demographic for UMH, I see it as different rather than worse.

UMH is more economically sensitive while ELS/SUI are more sensitive to cultural preferences since its residents don't live there by necessity.

[hawkeyec]

The data seem to show that MH output is essentially flat for the last five years. If there is really an imbalance constraining the industry it would seem that it should have begun to correct itself by now. As a former senior executive of a major supplier to this industry my sense would be that it is the inherent nature of the product and the characteristics of those who are the buyers of the output that determine the constraints to output. (I wrote my doctoral dissertation on this topic.) For a brief time in the middle 1960s into the early 1970s the industry sold four to five times its current output. Soon after that period (marked by the gas crisis of 1973, output fell precipitously and essentially stayed below 100k units a year there has been little to support higher output since. There is unlikely to be any reason to expect significant growth among the major players here.

[Dane Bowler]

@hawkeyec

Thanks for the perspective. The imbalance as I see it is the red tape. Because it is so hard to get permits for new communities, the communities are being constructed at a pace below the natural level of demand.

So rather than the high demand resulting in high supply it results in significantly increased value of the already existing communities.

[mendo]

@Dane Bowler I would sa that (potential) increase in value of MH is constrained by conventional housing. The closer the price ranges, the lower is demand for MH. If pricing is not much different, then most of the (potential) buyers/tenants probably prefer traditional housing. Just not sure what are difference in taxes and other associated maintenance costs.

[Dane Bowler]

@mendo

While I agree with you that MH will never sell for the same or higher price than traditional housing, there is a huge gap to work with.

Rents of $700/month for a property of equal square footage to a traditional apartment that would rent for maybe $1300-$2500 depending on location.

[Greg_Maryland]

Nice note, have a small position in UMH-D.

[David Harper, CFA]

Appreciate the well-written argument, but I disagree that house supply is anywhere near imbalance. See fred.stlouisfed.org/... and notice that the US is significantly undersupplied (as measured by months supply anyway). I agree with Michael Madden: little evidence we are near a cyclical peak *especially* on the supply side. I'm long LEN, DHI, TMHC, and NWHM and read all of their transcripts and their situation is undersupply for the forseeable future.

[Michael Madden, CFA]

Nice article - I like the idea and will probably pick up a few shares of one or more listed here. But I dispute the point of homebuilders being at a cyclical peak (and welcome thoughts to the contrary), while manufactured housing for some reason has a much longer runway.

The factors that drove the housing market crash were specific to that time and are not present in this cycle. Loose underwriting standards and speculation drove artificial demand. Manufactured home builders would intuitively be insulated from this, as that's not really the market where speculation occurs. I don't think you'll see as much divergence in returns between these businesses this cycle.

Right now the housing market is supported by a formidable trifecta - monetary policy (cheapest financing in history), fiscal policy (if you're a family making $90k with 3 kids and NO INCOME LOSS, you've gotten or are getting $20k+ in stimulus - also hasn't happened before), and the behemoth: demographics (largest age cohort in US is now reaching prime home-buying age).

This cycle's demand isn't driven by 0% down buyers with 3 mortgages and unverified income (that's a bubble that will pop), it's driven by buyers with healthy balance sheets who are entering prime earnings years and need a place to raise a family. I have no idea how this will turn out for homebuilders, but I'm not ready to call it a cyclical peak.

[Dane Bowler]

@Michael Madden, CFA

I would agree that the quality of loans is much higher this go around so the peak is unlikely to be caused by financial distress. To me it is more the reaching of a point where the supply of homes is sufficient to meet the demand.

[Michael Madden, CFA]

@Dane Bowler housing inventory is at a record low:
www.calculatedriskblog.com/...

Also, here's a post regarding demographics:
www.calculatedriskblog.com/...

Supportive of both traditional and manufactured housing

[Dane Bowler]

@Michael Madden, CFA

Good data, thanks

[aeye]

Thanks for letting me know about LEGH! I'll check them out. Long UMH for the long term.
In your previous article, you mentioned that mills were making all the profit and homebuilders weren't. I checked out CCS recently and while they noted increased lumber prices, their profits were even higher than normal. They were able to offset with higher home prices and increased spreads on mortgages. Very strong earnings, lower inventory. They've increased earnings from about $2/share to $6 over the past 5 years. DHI looks good too. It looks like LEGH is increasing their EPS too, but not as fast as traditional homebuilders. Why?

Many markets have experienced decreasing inventory [active listings] for the past few years, leading to very low supply right now, driving up prices for new homes.
Home ownership rate has been lower in the 2010s than the 2000s, in part due to the "renter by choice mentality" and demographics. Now millennials are:
- entering prime home buying age
- having kids
- at the age where they're starting to earn more
- less leary of home ownership than right after the GFC
Also, interest rates dropped, which enables a large portion of buyers that were on the sidelines previously.
That's why I'm bullish on home builders, lumber, timber, land, etc.
However, in an article a while back, you mentioned a shortage of labor in the construction industry, despite low labor participation

Have you seen evidence of oversupply of homes?
Thanks again!

[aeye]

At first glance LEGH looks pretty good.
A/R is $115M vs $100M 2 years ago
Loans Receivable is $151M vs $60M 2 years ago
About $40M of earning per year for comparison
Lending is a big part of what they do. They seem to get a good interest rate, but if their customers could get loans at 3-7%, maybe they could sell their homes for a bigger profit margin. Perhaps they could realize more value [higher stock price] by separating the loan book from the MH manf business.
Their designs are dated, but perhaps their target market doesn't care.
Do you see LEGH benefiting from the "silver tsunami"?
Thanks again for sharing!

[aeye]

On UMH's March presentation, page 7, it shows that MH shipments [green bars] seem to match up with the roughly 90K per year figure in your article. But back in the 2000s and 1990s, it was 200K-400K per year. As you do, I believe the conditions are favorable for MH, but this data seems to be contradictory. Why has production decreased substantially over the decades? If the primary factor is regulation, will it continue? Is it appropriate to be bullish on MH builders? Just sharing my thoughts. I prefer to explore impediments to high conviction.

[Dane Bowler]

@aeye

I suspect the red tape will continue and you are correct that it affects the builders rather than to the community owners like UMH. The red tape is neutral for the builders in the long run because it has kept entrants out of the space which allows LEGH to keep its niche. So if the red tape persists UMH is likely to outperform because its product will have minimal competing communities and if the red tape dissipates, LEGH should have increased profitability for a while until new entrants come in to rebalance the equilibrium.

Thus, I see LEGH and UMH as somewhat hedging each other.

[Hungry for Knowledge]

@Dane Bowler There was a time when UMH owned tens of millions of $$ shares of dogs like $CBL and other REITs. Brad Thomas picked up on that and warned me away from UMH.
Has UMH divested of those balance sheet distractions?
Obviously, CBL is bankrupt, so that's one distraction gone (at a large loss). WHat are your thoughts?

[stompers54]

@Hungry for Knowledge This is probably the main reason it garners a low multiple relative to peers. 10% of the assets are invested in other reits! Last 10K at cost $142.5 million with market value of $103.2 million, including CBL, PEI and WPG all dog mall operators trying to stay above water and at mercy of creditors. Criminally poor stewards of capital.

[Dane Bowler]

@Hungry for Knowledge

I'm not a huge fan of the stock portfolio but people over-react to it. Its almost as if some people are valuing it at negative dollars.

Over the long run it is up overall. The stock portfolio that UMH owns is up somewhere between 20% and 40% in 2021. They have had both winners and losers and while I disagree with quite a few of their stock picks, the expected return of investment in the stock market in general is positive.

Therefore, it is worth about the cash vale of the stocks and if you add that roughly just over $120mm to the value of the manufactured housing properties, UMH is trading deeply below fair value.

[Jim Getten]

Good article. Here in Idaho, we have a company that builds them using almost complete robotics and ships almost everything they make to California!

www.idahostatesman.com/...

[algo41]

residential numbers should perhaps be corrected for population which has grown around 50% since 1985.
I do not doubt that getting sites to place MH can be hard. On the other hand, I have always read that the manufacturing has low barriers to entry.

[Dane Bowler]

@algo41

While I agree with you that the manufacturing of MH has low barriers to entry, it hasn't played out that way. There are only 4 major players in the space and they are able to handle all the demand so perhaps there just isn't room for new entrants.

[mkarpoff]

I am skeptical whenever a stock advocate such as yourself says something like, "When the market wakes up..." I am referring to your comment re: LEGH. You may be correct that it is undervalued, but there are some stocks that languish for years while its investors wait for the market to wake up. Unfortunately, I have owned a couple of those in the past. Perhaps that's why value stocks, although popular at the moment, have drastically underperformed growth stocks over the years.
That said, thanks for your efforts.

[Dane Bowler]

@mkarpoff

Depends on your time frame. If you look at the entirety of stock market history value has outperformed growth by a significant margin. Fama and French did extensive research on this matter.

It may not feel like it because 2017 through 2020 were extremely growth favoring years, but with a long history in perspective I would say that was the unusual period.