The housing market looks very different now than it did last year. Mortgage rates, which fell to historic lows early in the pandemic, have nearly doubled from a year ago, while home prices are still high. The result: Prospective buyers are grappling with higher costs while homeowners are staying put with their locked-in low mortgage rates, creating a relatively short supply of homes for sale.
With the homebuying boom behind us, Barron’s assembled its inaugural housing roundtable for a read on where builder stocks, mortgage rates, and home prices are headed. Participants in the roundtable, which took place virtually in mid-March, are Carl Reichardt Jr., home-building analyst at BTIG; Bill Smead, chief investment officer at Smead Capital Management; Carly Tripp, head of Nuveen Real Estate Investments; and Mark Zandi, chief economist at Moody’s Analytics.
The group sees a slow spring selling season, particularly in the market for existing homes, as long as mortgage rates and home prices remain high. At the same time, there’s plenty to like about the future—from demographic trends that foreshadow housing’s eventual rebound to the balance sheets and valuations of big public builders. An edited version of the conversation follows.
Barron’s: Let’s start with the news driving financial markets: the failure of Silicon Valley Bank and the bank sector upheaval that followed. The turmoil recently sent the 10-year Treasury yield down sharply. Mark, let’s start with you. What does this mean for mortgage rates and the housing market?
Mark Zandi: The angst in the system and the flight to quality pushed down long-term Treasury yields—so mortgage rates have come in a bit. If this all plays out reasonably gracefully, I expect them to kind of bump around 6.5% and 7% through this spring selling season. Obviously, I could be wrong, and there could be another shoe to fall. Then, rates could go a lot lower, given the angst and the turmoil.
As far as mortgage rates go, what can buyers tolerate?
Zandi: They don’t like 6.75%. Affordability is the problem. The surge in housing values was 30% from the start of the pandemic to June. You mix that in with much higher mortgage rates, and of course folks can’t afford that. That’s why we’ve seen home sales crater.
“Markets that got the most juiced during the pandemic will be the most vulnerable to price declines.”
First-time home buyers are really locked out. Existing homeowners with mortgages are effectively locked into their homes. Investors have gone to the sidelines, so they certainly cannot digest the current mortgage rates, given the current high house prices and where incomes are.
Bill Smead: There has always been a close connection between the 10-year Treasury rate and mortgage rates. And that close connection has run maybe 150, 175 basis points. [A basis point is 1/100th of a percentage point.]
Mortgage rates right now are completely out of line with the past 30 or 40 years. They’re way higher relative to the 10-year Treasury rate. When it was at 7% on the mortgage rate and 4.25% [on the 10-year Treasury yield], that’s an outlandish spread.
Carl Reichardt Jr.: The publicly traded home builders have been buying down interest rates. That’s hurting their margins, but they’re able to take an existing rate, buy it down 150, 200 basis points, and get a consumer into a payment. In addition, they’ve been exceedingly aggressive at lowering asking prices or honoring incentives. For the companies that we cover, selling prices are down peak-to-now 10% to 15% in some markets. The builders have been working on finding that affordability point, that market clearing price.
Right now, new homes make up about one of every four or five homes on the market. Normally, that’s one in 10. Due to rate lock, the existing inventory is exceedingly thin. The builders aren’t the only game in town, but they’re more the game in town than they have been in past periods.
Smead: The market share of [D.R.] Horton was 1% in 1994, and it’s going to be well past 10% in the year 2023. Five or six companies are completely dominating this industry. You listen to their calls right now, and at the end of the call they say the No. 1 thing we’re working on through this difficulty is to come out with bigger market share on the other side of this—because they see those [millennials] coming, and they’re salivating.
What do you expect this spring homebuying season to look like?
Reichardt: For the first time in about 10 months, more private builders are seeing their traffic above internal expectations than below. In terms of sales rates, about 27% of those we surveyed said their sales in February were above their expectations, 27% below—so, equivalent. I think that’s a pretty good sign that we’re starting to see an improvement in the field.
[Builders are selectively increasing prices in part] because they want to provide a sense of confidence among home buyers that pricing is stable. That creates, ultimately, more sales down the road. Builders also have a fair amount of inventory ready to move right now.
We’re starting to see the return of local customers to markets, as opposed to out of state [or] out of area, especially as prices are falling. The spring has got some momentum early on here. My expectation is that will continue if rates can stay relatively stable.
Zandi: It’s going to be a tough spring selling season. Maybe better than expectations, but still pretty tough. Builders have cut effective prices. There has been very little correction in existing market prices. I think the price declines are only just beginning in terms of restoring affordability. As far as construction, I do think we’re done with most of the correction in home sales.
“The spread between the cost of renting a home versus buying—it is really massive at this point.”
Carly Tripp: I agree with the undersupply on a national level going forward. I agree with the demographic shift and the aging millennials. I understand how that supports the market. But if you look at the cost of housing right now, and you look at the national wage index to the cost of owning a home, it’s well above the prior bubble. It’s not affordable.
The spread between the cost of renting a home versus buying—it is really massive at this point. You also have a stalling household formation and general macro backdrop of uncertainty, and people just don’t want to make a decision in those circumstances.
At the same time, why is anyone going to sell their home with a mortgage of 3% and move into a home where it costs them 7%? I think there are more headwinds in terms of home pricing than there are tailwinds.
Smead: I have five millennial kids. I can tell you that the game is on. It’s more affluent couples having children, with grandparents who are starved for a grandchild [who] will put any amount of money toward a down payment to get close to them.
How would you describe the state of the rental market? And what’s your outlook for this year?
Tripp: It’s still relatively strong from a historical perspective. Rents peaked at 18% year-over-year growth, which is extraordinary. But that’s coming off of very, very low and deflated numbers pre-Covid. We are still well above, on a fundamental basis, pre-Covid levels.
There are some markets that are getting concerning from a supply standpoint, [such as] the Sunbelt. As you can imagine, all of the population migration that occurred across the Sunbelt, the massive amounts of inflows in terms of capital and investment dollars, was the catalyst for a lot of supply. We’re watching fundamentals there, because they probably have a lot of supply to work through, and there are some dynamics that need to equalize.
A third of the consumer price index is related to shelter costs. What we’re seeing right now on an operational basis would indicate that number lags. When the current rental numbers come through, it will ease inflation a lot, which should ease Federal Reserve concerns.
Is the outlook different between multifamily rentals and single-family?
Tripp: We are not as active in single-family, nor is the market of single-family rental investors. Home prices need to decline before we start investing again.
Reichardt: One of the biggest risks, from my perspective, to new single-family purchase activity is what happens to rents. We’re at 50-year highs in terms of multifamily units under construction. Granted, we have very little built between 1986 and 2011. I’m curious whether some pressure on rents might actually hurt demand for single-family units.
The other side of my concern is that the single-family rental business has really been institutionalized for the first time in the past six or seven years. I’m not 100% certain how the institutions are going to think about a softer environment.
“Mortgage rates are completely out of line with the past 30 or 40 years.”
How aggressive will they be on rents? What will they do with [their] portfolios? And what about the $30 billion to $60 billion that has been raised to buy single-family units? I’m somewhat concerned about the supply dynamic in the rental market impacting the for-sale market.
Having said that, the folks who are buying single-family units have to get them from somewhere, and that somewhere is probably going to be the companies that we cover. Does that change return profiles? Does that change margins? Does it change how we value the stocks? There are a lot of really interesting ingredients in the mix that the rental market is bringing.
Zandi: Both homeownership and rent are now unaffordable, and household formation is being hurt by that. The average monthly mortgage payment at the current mortgage rate is $1,900 a month. If you go back 18 months ago, when mortgage rates were at their low, it was $1,300 a month.
Most first-time home buyers cannot afford that house. I expect house prices to decline, even without a recession. I expect national house prices to fall almost 10% peak to trough, with the trough occurring in late 2024 or early 2025.
Reichardt: What is unaffordable in San Francisco may be tremendously affordable somewhere like Denver or Austin, Texas. There is some flexibility here for people to make other choices besides just the neighborhood that they’re in. The vast majority of companies that I cover build entry-level homes. You’re taking people out of rentals. [Builders in] the entry-level market don’t have that rate-lock dynamic to deal with.
Geographically, which markets are poised to be the strongest and weakest this year in terms of sales and home-building?
Reichardt: For new home builders, the Southeastern markets are particularly good; Florida and North Carolina, South Carolina, as well. Land is relatively inexpensive compared with the rest of the country, and importantly, it’s relatively easy to build.
I think the markets that are likely to struggle this year are the ones that we often see struggle when the housing market is soft; places like Phoenix, which tends to get overbuilt very quickly. The Denver market is tough. Boston has gotten much more difficult.
We’ve got markets like Boise, Idaho, where there was a lot of in-migration and arbitrage for folks leaving places where housing was expensive, [which] raised prices beyond what locals could afford. That’s now receding.
Zandi: Broadly, I think those markets that got the most juiced during the pandemic will be the most vulnerable to price declines, just going back to affordability. They’re also being affected by slowing in-migration. Remote-work dynamics aren’t reversing, but they’re certainly slowing.
“Builders have more ability to adjust pricing and inventory levels to meet demand.”
Prior to the pandemic, out-migration from urban centers to suburbs, exurbs, and rural areas was about 350,000 people per annum. It doubled during the pandemic peak in the fall of 2021 at just over 700,000. And now, we’re back down to about 500,000, and it continues to moderate. So, there’s less net in-migration from those high-price markets on the coasts, the Northeast, and California.
The tech centers are already struggling. The San Francisco Bay Area has already experienced the largest price declines.
Some markets will hold their own—mostly, though, in the areas that didn’t see a significant surge in pricing during the pandemic. But I don’t think anyone’s going to see any significant increase in prices over the next couple of years—and I am assuming no recession. If there is a recession, then the weakness is going to be much broader-based and deeper across the country.
On geography, are people coming back to urban centers?
Zandi: New York is a bit unique in that they’re getting a lot of young people coming back, people who are in their 20s up to early 40s.
Some of the other large urban centers—Boston; Philadelphia; Washington, D.C.; Chicago; Seattle; San Francisco; and Los Angeles—you’re just not seeing the same kind of dynamic. And some places, like Philadelphia, continue to lose as many people net as it did at the peak back in the fall of 2021.
Tripp: To Mark’s point, New York has been incredibly strong. Our investments there are performing really well. It’s location-dependent right now.
Miami is really strong. Miami has had a ton of consumer and corporate migration supporting its economy. It’s a mixed bag: I would expect New York, Miami to do well. I would expect the West Coast markets to perform less well.
Institutional buyers were active in the housing market in recent years. What role do you expect them to play in the coming year or two?
Zandi: I think they’re waiting for prices to come in and for opportunities to develop. And, of course, capital markets aren’t functioning well, so that makes life a bit complicated.
I think they’ll be on the sidelines, but I do think they’ll be an important source of demand once a bottom has been put in. They may be the folks that determine the bottom, when they come back into the market. I expect them to be back in a big way once the market stabilizes.
The only thing I’ll throw into the mix is: Lawmakers hate single-family rental. They’re definitely going to be working on efforts to make sure that investors are good landlords. A lot of communities have flipped over to being largely investor-owned.
Reichardt: I have this theory: As this business becomes more institutionalized, the institutions that have been positioning their product as a substitute product for homeownership will begin to position it as a value alternative.
[Instead of buying an entry-level home], what if the pattern in the future is: rent an apartment, rent your first small house, save, buy your move up, buy your move down? In other words, you see more entry-level homes rented as opposed to sold.
Institutions—now that it’s not just Ma’s and Pa’s who own the product—may market their product that way over time. This is a wild pet theory of mine; it’s just something I’m thinking about as the idea of shelter evolves in the U.S.
Tripp: I think if you increase a consumer’s options long term, they will be better off, period. Prices will come in for the consumer. The dynamic that we’ve seen since 2012 is the fact that a lot of folks started to move out of the coastal cities, started to move along the Sunbelt, and there just wasn’t enough supply to feed the demand in owner-occupied and [single-family rentals]. So, once that all equalizes, then naturally you’re going to see prices come in.
Smead: This industry has changed completely since the 2003-06 debacle. These [companies] have gone from land developers that made money by putting houses on [land] to make their profit on their lots, to now making a profit off of building the home. That has taken a lot of the cyclicality and risk out of these companies. They have pristine balance sheets.
This brings us to the stock conversation. Carl, how do you expect housing stocks to perform in the next 12 months?
Reichardt: It’s a tale of two halves. The stocks have done very well since October. My expectation is that, over the course of the next two or three months, there will be a consolidation, and the stocks aren’t likely to move a lot. By the time we get to the back half of 2023, the builders are going to be facing some incredibly easy order comparisons, because things really fell off a cliff from an order perspective starting in the second quarter last year and really into the fourth quarter.
The stocks tend over time to move with new orders, as opposed to earnings. I expect that we might see a more aggressive positive movement in those names as we head toward the back half of the year.
I think that in order for the stocks to really continue to work, they need to start accelerating growth. And I think that’s more likely an easier order of comps in the back end.
Tell us about some of the stocks you’re recommending now, and why you like them?
Reichardt:
D.R. Horton
[ticker: DHI],
Lennar
[LEN], and
PulteGroup
[PHM] are three of the biggest four builders in the country. A really important driver to returns on equity in this business has been local operating scale and share. Two-thirds of the cost inputs of home builders—land and labor—are locally provided. It therefore follows that when you have a lot of local market share, your ability to command price and access to resources allows you to lower your costs and, ultimately, to drive your margins and your returns.
I like the fact that in both
D.R. Horton
and Lennar’s case, the focus during this downturn has been to find the market clearing price for the product. Asset turns, to me, are more important than margins as a driver to returns. And as two of the low-cost producers in the business, that has allowed them to actually begin to grow their business, especially at the entry level.
Pulte is a little bit of a special case: a slower grower, a more diversified product portfolio. They’re about a quarter active adult, 35% to 40% move up, and 35% to 40% entry level.
They bought back a lot of stock, they’ve cut costs, and they’re earning returns on equity in the high teens, despite the fact that we’re probably close to an earnings bottom in 2023. The stock doesn’t really trade like its returns suggest it should.
Those are the three right now that we’re most focused on—and D.R. Horton would be our favorite.
Bill, you’re the other stockpicker in this group. Which kinds of builders can best succeed in this macro environment, and which are likely to struggle?
Smead: We own Horton. We own Lennar. And we own
NVR
[NVR]. Price-to-cash flow or price/earnings in October, these were ridiculously low, [at] like five times earnings for a premier company. I viewed the performance of those stocks since October as just a P/E bounce back from ridiculousness. The second thing is: The supply-chain issues of 2021 and the Fed tightening of 2022 stopped these companies from building.
Where do you see valuations going from here?
Smead: Our bullishness is over 10 years. Let’s say their earnings grow from here at 8% compounded for the next 10 years. They don’t have the debt they used to have. They’re buying back their stock. They’re paying dividends. When you start at an eight multiple, and you’re earning high return on equity, you can make an awful lot of money on a stock. We could have a [bad] home sales market in the next 12 months, and that really doesn’t affect where these guys are going to go over 10 years.
Do either of you like the smaller or midsize home builders?
Reichardt: I’m not recommending them at this time, but I’d like to see some of the smaller players that don’t have scale begin to focus on improving their business model, growing their margins, or especially their returns and their asset turns. There are some players that are beginning to do that, that look interesting, although we’re currently Neutral.
One is
Meritage Homes
[MTH], which has transformed the company from a second-time move-up builder to a much more efficient first-time-only builder.
Another is
Taylor Morrison Home
[TMHC], which we downgraded late last year after it outperformed the group. Its margins are relatively low, and its returns are, too. I think the company is making some really positive changes to how they run the business on a day-to-day basis that I think could lead to some expanded returns over time.
A way to think about it is: Meritage is kind of a miniature Horton, and Taylor Morrison is kind of a miniature Pulte.
Smead: We don’t own any of the smaller ones. It’s hard enough with the big ones. They’re very successful companies, but they went through a depression in 2006 to 2016, and they’re still feeling the effects.
[During this cycle,] we had a bit of a boom in prices, but we didn’t have a boom in the number of units. And it’s the number of units that caused problems for these guys. The worst thing you could possibly do is saturate demand for your product, and that’s what they did in 2003 to 2006.
These are pristine borrowers nowadays. Their balance sheets are great. Household debt-service ratios are at close to 40-year lows.
Reichardt: There are 11 publicly traded home builders that were around in 2005, the last peak in housing, that are public today. The debt to cap in 2005 for that group was 42%. At the end of 2022, it was 26%.
This group of 11 are building almost exactly the same number of houses as they did in 2005, about 260,000 units. Today, those 11 builders have 42% share of the market, and in 2005, they had 20%.
But here’s the number that I love the most: The 11 companies in 2005 generated a grand total of negative $18 million in operating cash flow. In 2022, those 11 companies generated $9.2 billion in operating cash flow. If there is a number that can tell you how much this industry has altered its thought process around managing its risks, I think that operating cash flow number is really the big one.
What valuation metric do you use to value the companies? And what do you think an investor should use?
Reichardt: That’s a debate that has gone on for a long time. I use price-to-book. There’s a high correlation between the return on equity that a builder generates and the price-to-book valuation at which they trade. There’s less correlation between price/earnings. The stocks tend to trade more on orders and interest rates, which are forward looking, as opposed to earnings, which lag.
There’s what we call a portfolio manager’s mantra, which is: Buy home builders at book and sell them at two-times book. The group, not individual names. Over time, that has actually worked pretty well for these stocks. That channel between one- and two-times book is a self-fulfilling prophecy to a certain extent. So that’s the metric I like best, because of the correlation, and it’s in the traditional pattern that we’ve seen in the group.
Where are they now?
Reichardt: The overall group is about 1.3 times book.
So you’re still in the safe zone.
Reichardt: Yeah—but having said that, we’re also recommending some of the more expensive names, in part because in a cycle like this, we do think there are relative competitive advantages for the large players.
Smead: In 2013, we bought NVR because it was the only company that had a balance sheet that fit our eight criteria for stock selection. And we paid about $940 a share to buy into NVR. Half of the compensation of its executives is based on return on [capital]. It went completely to an option land [model]. That doesn’t mean its business isn’t impacted by a slowdown in home sales; it just means that it’s no threat to the existence of the company.
Can you summarize your outlook for the market, along with any final thoughts?
Tripp: Expect the unexpected. We’re going to see low inventory continue to buoy the market, and we’re not going to have really strong pricing discovery until the market gets activated again. What we need for the market to get activated is lower mortgage rates.
This sounds very conflictive and ironic, but until overall the economy starts to soften a little bit, and demand pulls back, and rates come down, and prices come in, I think that we’re going to have a slow, stagnant market.
Zandi: The next couple of years are going to be a struggle for the single-family housing market in terms of sales, construction, and prices. The market has to adjust, and affordability has to improve. And that’s going to take a bit of time.
Looking toward the second half of the decade, prospects are good. There is a significant shortage of homes—1.5 million units—which is about a year’s worth of production. That augurs well, particularly for housing construction. Or else, house prices will be more pedestrian going forward because the population is aging, and there will be less mobility. I think that’s going to weigh on demand, particularly in the existing market and house prices.
Reichardt: There’s a bifurcation between the existing housing market, which is frozen—and I agree, it is going to see a difficult time with price discovery—versus the new housing market, where the builders have more ability to adjust pricing and inventory levels to meet demand.
That should be good for large builders gaining share of the overall transaction market. The risks here: continued input cost increases over time, both materials and land, and labor, too, which continues to be short. As I mentioned before, how will the rental market compete for customers, especially at the low end, with the for-sale market? That’s where my worry lies: the unknown surrounding that rental market.
Smead: [Warren] Buffett and [Charlie] Munger like to talk about owning a company as if the stock market wasn’t going to be open for five years. We have long holding periods; we’ve been involved in this area for quite some time, and we think it has a long runway.
I can’t tell you what’s going to go on six to 12 months from now better than anybody off the street could. But what we know is: There is an economic need, there is a large pool of people who will want a single-family home, and it’s going to be built by a smaller and smaller number of very well-financed and strong builders. We’re very excited about being involved in that at a price that’s very attractive relative to almost any other stock category. The only stocks that trade as cheaply as the home builders are oil and gas stocks, and we’ve got a slug of them, too.
Thank you, Carly, Mark, Bill, and Carl.
Write to Shaina Mishkin at shaina.mishkin@dowjones.com
Read the full article here
Discussion about this post