“You have a lot of buyers chasing very few houses,” says John Kendig, a long-time associate broker in the Richmond, Va., area. He says his clients recently missed out on an 1,800-square-foot brick colonial near the city even though the couple offered about $25,000 over the list price of $425,000.
“Housing is in the third or fourth inning of a nine-inning game,” says Bill Smead, lead portfolio manager of the $1.3 billion Smead Value fund, which holds shares of two home builders, Lennar (ticker: LEN) and NVR (NVR), in a 28-stock portfolio. “This is a normally cyclical business in a secular growth trend.”
Housing stocks generally have sold off this year amid concerns that rising interest rates will crimp home-buying. The SPDR S&P Homebuilders exchange-traded fund (XHB), which tracks home builders, home-improvement retailers, and industry suppliers, is down 9.3% on the year, versus a 0.15% gain for the Standard & Poor’s 500 index. Shares of the four leading publicly traded home builders—Lennar, D.R. Horton (DHI), PulteGroup (PHM), and Toll Brothers (TOL)—are down about 12%, on average, after rallying nearly 70% in 2017.
The home builders recently traded for 10 times 2018 profit estimates, compared with the broad market’s price/earnings ratio of 17, even though the companies are expected to notch double-digit earnings growth this year and next. Bullish analysts and investors think that housing stocks could gain 10% to 15% in the next year. Shares of Lennar, NVR, and Meritage Homes (MTH) look particularly attractive, as does home-improvement retailer Lowe’s (LOW), whose stock lost 12% last week after badly missing its fourth-quarter earnings estimates.
BY EVERY MAJOR MEASURE, the housing market is on the mend, although sales remain well below the 2006 peak. Take single-family housing starts, recorded when construction on a new building begins. Monthly single-family starts hit a record 1.8 million in January 2006, plummeted to about 350,000 in March 2009, and came in at 877,000 in January of this year, up 3.7% month to month and 8% year to year.
New-home sales climbed 10% last year, to an annualized 615,000, and Matthew Pointon, property economist at Capital Economics, is eyeing another 10% gain in 2018. He notes that new construction has been hampered by labor and materials shortages, which are driving up builders’ costs. Pointon sees plenty of support for lasting housing demand, as rising wages and the new tax law boost household income. But the tax law takes as well as gives. Changes that limit the deduction on state and local taxes to $10,000 could make owning homes in high-tax states and municipalities more expensive, and less desirable.
To be sure, some recent housing data have disappointed. The National Association of Realtors reported last month that sales of existing homes slipped 3.2% in January from the prior month, and 4.8% from a year ago. And the U.S. Census Bureau said new-home sales fell 7.8% in January, following a 7.6% drop in December. Citing regional disparities, some economists have blamed the negative news on the weather. Lawrence Yun, chief economist at the NAR, cites “the utter lack of sufficient housing supply and its influence on higher home prices, [which] muted overall sales activity in much of the U.S.” in January.
HOME PRICES HAVE appreciated at a mid-single digit rate for the past six years, including 6% last year, although price gains have been much greater in hot markets such as San Francisco, Seattle, Denver, and Las Vegas. Realtor.com (owned by Barron’s parent News Corp) sees price growth cooling to 3.2% this year, partly due to excess inventory at the higher end of the market. Affordability, in short, isn’t a widespread issue, which bodes well for the market’s health.
Yet, low supply is producing bidding wars in some surprising places, including Richmond. Kendig, the associate broker, says the home his clients wanted had 27 viewings in its first day on the market. The sellers received 12 offers and considered three, including that of his clients, who lost to a higher bidder. “It is an attractive house in good condition, and there is extremely low inventory,” Kendig says.
In the aftermath of the housing bubble, he notes, many contractors who built homes went out of business, leaving a dearth of firms to deliver when demand rebounded. Meanwhile, Kendig’s clients, who have been house-hunting for six months, are still pounding the pavement. “We won’t give up because we can’t give up,” says Russell Lawson, the husband. “We need to move to a smaller house.”
Andrew and Annie Bolton encountered similar competition for houses in Maplewood, N.J., a New York suburb. In early February the couple, currently living with their young daughter in an apartment in Jersey City, N.J., bid $605,000 for a house listed at $550,000, and were told they were on the low end among multiple offers. The couple agreed to pay $650,000 for a four-bedroom colonial whose price had been slashed to that level from $700,000. Their offer was accepted within 24 hours, but a few days later, as the deal was under attorney review, another buyer emerged.
Andrew Bolton, who works for a technology start-up, had his bank write a letter in support of his application. He also wrote to the seller, raising his offer to $660,000 and granting the seller various concessions. Those moves worked. “It’s a very competitive market,” says Bolton. “It’s all about differentiating yourself through various contingencies and the terms you put in your offer.”
UNDERPINNING TODAY’S STRONG housing demand is the U.S. consumer. “The consumer’s health is about as good as it gets,” Mark Zandi, chief economist at Moody’s Analytics, told Barron’s in a recent interview.
“Unemployment is low and falling, there are lots of jobs, and wage growth is picking up,” said Zandi, a longtime student of the housing market. “Interest rates are still low, household debt service is near record lows, and confidence is near record highs. The recent correction in the stock market notwithstanding, wealth has increased greatly. There are lots of tailwinds behind the American consumer and the American household.”
Yet, even well-heeled consumers could struggle to find desired shelter. Zandi estimates that the supply of U.S. housing totals 1.3 million units, compared with 1.6 million needed. “That’s a gap of 300,000 units annually, on top of a market that, broadly speaking, is undersupplied,” he says. “The vacancy rates across the housing stock are about as low as they get.”
A national unemployment rate of 4.1% has helped spur housing demand, leading to wage inflation of 4.4% for people in the lowest three quintiles of median income, from about $13,000 to $59,000, notes Susan Maklari, a housing analyst at Credit Suisse. That’s a plus for starter homes, a market segment that has rebounded more slowly than others since the housing bust.
So, too, is an expected surge in home-buying by millennials, the generation born roughly from 1980 to 2000, which has been famously slow to “launch.” Household formation has trended a bit higher lately, to a four-quarter average of about 925,000, helped by millennials moving into the market. Vishwanath Tirupattur, a fixed-income strategist at Morgan Stanley, and his colleagues are forecasting annual household formation of 1.35 million over the next five years, based on current demographics.
Jamie Barnett, a single 30-year-old high school teacher, took the plunge about a year ago, purchasing a three-bedroom Cape-style house in Richmond. “I recognized that renting is just throwing my money way,” she says.
Barnett says she hasn’t seen a big wave of people her age buying homes, but there are some. Among her friends, she says, those who want to stay in Richmond are apt to buy because prices are “still pretty reasonable.” The median listing in Richmond was $289,975 in January, according to realtor.com
Barnett says she didn’t have any trouble securing a mortgage, and many of her peers might not, either. “Employment of 25- to 34-year-olds is at record highs, with employment growth for that group exceeding the national rate for the past five years,” Pointon of Capital Economics wrote recently.
THE DEMAND FOR entry-level homes could give a nice boost to Meritage Homes, a Scottsdale, Ariz.–based builder with a market capitalization of $1.7 billion that has targeted this market segment. The stock has fallen 16% year to date, to a recent $43. Maklari, the Credit Suisse analyst, rates Meritage Outperform, with a price target of $60.
On a conference call with analysts last month, the company’s CEO, Steven J. Hilton, cited the entry-level market as “a significant long-term opportunity…as millions of millennials will be purchasing their first homes over the next decade.”
Meritage aims to make entry-level homes the focus of 35% to 40% of its housing communities. The company operates in Arizona, Texas, Florida, Georgia, and the Carolinas, all of which have seen favorable housing demand. Hilton noted that job growth has been strong in Arizona, “particularly at the lower end of the wage spectrum, and those people are buying houses now.” Phoenix represents 20% of Meritage’s sales.
Meritage expects to grow its earnings at a double-digit pace in the next few years. Its shares are trading at an inexpensive 8.5 times the $5.02 a share analysts expect the company to earn in the current fiscal year. That’s up from $3.41 a share last year, on estimated sales growth of 11%, to $3.6 billion. The stock’s five-year average price/earnings multiple is 12.3, according to FactSet. Meritage also has a solid balance sheet, with a net debt-to-capital ratio of 41%.
AMONG THE LARGE-CAP home builders, Lennar offers an attractive valuation and upside potential. Shares are trading at 10.7 times this fiscal year’s profit estimate of $5.30 a share, versus a five-year average P/E of nearly 15 times.
Sandy Sanders, senior portfolio manager of the John Hancock Fundamental Large Cap Core fund, expects total housing starts to rise to about 1.5 million a year, compared with 1.1 million to 1.2 million recently. Lennar, he says, is “very well positioned to capture that growth, but the stock is not capturing that.”
Lennar is based in Miami but operates across the country. It added significant scale when it closed last month on the $9 billion acquisition of CalAtlantic, a smaller home builder. Lennar has targeted $365 million of synergies, with $100 million coming in the current fiscal year, which ends in November.
The combined company will rank among the top three home builders in 24 of the 30 biggest U.S. housing markets, up from 16 previously, according to Michael Rehaut of JPMorgan. It will have the No. 1 position in 15 markets, including Phoenix, San Francisco, and Orlando, Fla. Sanders has a price target of $80 on the stock, based on a discounted cash-flow analysis. Lennar was changing hands on Friday at $57.
Unlike many other home builders, NVR, based in Reston, Va., doesn’t develop much land, which ties up a lot of capital. As a result, its return on equity averaged about 35% in the past two years. “NVR is the superior operator in the industry, by far,” says Smead, of Smead Value.
NVR shares trade for about 15 times this year’s profit estimate of nearly $190 a share, compared with a five-year average multiple of 17.8 times. Analysts expect earnings to compound at a rate of more than 20% this year and next. The company operates in 14 states, mainly in the East, with a concentration in the Washington, D.C., and Baltimore areas.
HOME-IMPROVEMENT RETAILERS offer another play on a housing-market rebound. Michael Liss, a co-manager at American Century Value fund, thinks Lowe’s has a good chance to improve its performance, spurred by an activist investor who has been prodding the company.
Lowe’s tumbled 12%, to $85, last week, after fiscal fourth-quarter earnings missed analysts’ expectations. The company earned 74 cents a share in the quarter, about 15% below consensus estimates, as profit margins shrank by more than half a percentage point. Lowe’s, based in Mooresville, N.C., projected this year’s earnings at a range of $5.40 to $5.50 a share. Wall Street had been expecting earnings of $5.58 in the year that ends next on Jan. 31.
Lowe’s now trades for 15.7 times earnings, using the midpoint of its indicated range, below rival Home Depot’s (HD) P/E of 19. The company’s profit margins have lagged Home Depot’s, as have returns on invested capital. The latter totaled 17.1% for Lowe’s in its latest fiscal year, compared with Home Depot’s 33%. Home Depot is regarded as having a stronger store base, with better locations and a bigger presence in higher-end markets.
D.E. Shaw, an activist hedge fund that recently won three board seats at Lowe’s, has been pressuring the company to improve its own home. Among the areas Lowe’s could address are its level of advertising spending, product selection and availability, store staffing models, and e-commerce operations.
THE BIGGEST RISK to the housing market’s health today is interest rates, which have been creeping higher. Peter Boockvar, editor of the Boock Report, maintains that the uptick in the average 30-year mortgage rate to 4.33% in January from 4.20% a month earlier had an immediate impact on contract signings.
The difference between a 4.2% and 4.3% rate on a fixed 30-year $300,000 mortgage would raise the monthly payment by only about $17, however, hardly a deal breaker for most borrowers. And a mortgage rate of 4.3% is well below the average 30-year fixed mortgage rate of just under 6% from 1997 through 2017, according to Maklari.
The prospect of higher rates also could motivate would-be buyers. That’s just what Saritte Harel, a Short Hills, N.J., real estate agent, has found. “In our New Jersey market right outside Manhattan, the towns along the direct train line…are still seeing a brisk market,” she says. “With interest rates on the rise, many buyers are realizing it’s a good time to buy their first home.”