Homebuilders: A V-Shaped Vendetta
An antihero of the prior financial crisis, Homebuilders have seemingly been on a vendetta over the last six months, asserting themselves as the unexpected leader of the early post-pandemic recovery.
Homebuilders were slammed at the outset of the pandemic on fears that a coronavirus-induced recession could inflame a repeat of the Great Financial Crisis for the critical U.S. housing.
Instead, the U.S. housing industry has roared back to life in recent months. New Home Sales, Existing Home Sales, and Home Prices have all seen a substantial reacceleration this year.
The sharp rebound in housing market activity has been aided by longer-term macroeconomic trends of favorable millennial-led demographics, historically low housing supply, and near-record low mortgage rates.
Housing remains an “unloved” sector despite the compelling long-term tailwinds at its back. Homebuilders trade at deeply discounted valuations to the S&P 500 despite their stellar growth rates.
Homebuilders: A V-Shaped Vendetta
An antihero of the prior financial crisis, publicly-traded homebuilders have seemingly been on a vendetta over the last six months, asserting themselves as the unexpected leader of the early post-pandemic recovery. After being slammed at the outset of the pandemic on fears that a coronavirus-induced recession could inflame a repeat of the Great Financial Crisis for the critical U.S. housing sector, homebuilders have roared back to life in recent months, leading the early stages of the post-pandemic recovery. In the Hoya Capital Homebuilder Index, we track the 15 largest homebuilders, which account for roughly $100 billion in market value. Together, these 15 firms constructed approximately a quarter of total single-family homes built last year.
As we discussed since the dark days of mid-March, while the "Housing Crash 2.0" narrative was certainly a clickable headline, macroeconomic fundamentals indicated that the U.S. housing industry was likely to be an unexpected leader of the post-pandemic recovery, a far cry from their role as a primary provocateur during the prior financial crisis. The U.S. housing sector foretold an emerging consumer-led rebound, which continues to catch analysts and economists by surprise, underscored by record-high readings on the Citi Economic Surprise Index. Perhaps the sharpest "V" of all economic data points has been seen in Homebuilder Sentiment itself, which jumped to the strongest levels on record in September, driven by a record surge in Home Buyer Traffic.
Even before we began to see the rebound in Homebuilder Sentiment, the early signs of the unexpected rebound in housing market activity were seen prominently in the Mortgage Bankers Association's weekly mortgage data as well as in Redfin's (RDFN) homebuying demand index, which formed the contours of a sharp V-shaped bounce amid the depths of the lockdowns in April. Bottoming on the week ending April 15th with year-over-year declines of 35%, the rebound over the last five months has been swift and unrelenting, and has yet to show any significant signs of cooling. The MBA reported this week that mortgage applications to purchase a single-family home are now higher by 25% from last year, the 18th straight week in positive territory. Mortgage refinance activity, meanwhile, is higher by 86% from last year.
While mortgage demand data and sentiment indicators were initially dismissed as "outliers," or as simply reflecting several months of deferred demand, a preponderance of other housing market data points has confirmed the broad-based rebound that has sustained - and even built steam - into the back-half of the year. This week, the Census Bureau reported that New Home Sales surged 43% in August from last year to the highest annual rate since 2006 at more than 1 million units. Not to be outdone, the National Association of Realtors reported that sales of Existing Homes rose by 10.5% from last year to the strongest sales pace in 14 years since December 2006. Meanwhile, Pending Home Sales in July were higher by 15.5% from last year.
A confluence of near-term factors and long-term tailwinds converged over the last five months that have generated a highly favorable environment for the U.S. housing industry, particularly single-family homebuilders. WWII-levels of fiscal stimulus more-than-offset the pandemic-related income losses, leading to a record-high surge in personal incomes over the last quarter. Meanwhile, unprecedented levels of monetary support from the Federal Reserve and other central banks helped to drive-down mortgage rates to record-low levels. Meanwhile, suburban markets in the periphery of the coastal shutdown cities have been seeing a sudden surge in demand amid an ongoing urban exodus. The "cherry on top" has been the dawn of the "work-from-home" era, which fundamentally changes the economics of suburban living.
As we've discussed with readers for many years, even without these short-term factors, the 2020s were already poised to be a very strong decade for the U.S. housing industry. New home construction has seen a slow, grinding recovery since plunging during the prior recession - a period in which roughly half of privately-held homebuilding firms in the United States went out of business. By nearly every metric, the US has been significantly under-building homes - particularly single-family homes - over the last decade, and the record-low inventory levels of both new and existing homes are clear effects of this underbuilding and resulting housing shortage. Residential fixed investment as a share of US GDP remains near historically low levels, a function of underinvestment in both new home construction and existing homes.
Meanwhile, this underbuilding comes ahead a decade in which the largest generation in American history - the millennials - will enter the housing markets in full-force, peaking around 2028. 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. The largest of this cohort - those born between 1989 and 1993 - are just now on the cusp of entering this prime first-time homebuying age.
Confirming these trends, the U.S. Census Bureau reported last month that the homeownership rate jumped to the highest level since 2008 at 67.9%, driven by a continued rise in the household formation rate, which sent vacancy rates of both owned and rented housing units to multi-decade lows. Consistent with the demographic trends we've discussed, we forecast a steady uptick in the homeownership rate over the next decade as millennials and recent gains in the homeownership rate over the last three years have indeed been due primarily to a recovery in the younger age cohorts tracked by the Census Bureau. The 35- to 45-year-old cohort saw homeownership rates climb more than one percentage point to 64.3%, the highest in more than ten years.
Gains in the homeownership rate - and declines in the vacancy rates of both rented and owned households - came as a result of gains in total household formations. The homeowner vacancy rate ticked lower to 0.9% which was the lowest level on record. The rental vacancy fell sharply lower to 5.7% which was the lowest vacancy rate since 1981. Total household formations have increased by 1.9% over the last twelve months, which is the strongest twelve months of growth in household formations since 1985. There are roughly 20 million more U.S. households now than there were at the start of 2000 and we believe that the household formation rate will see continued gradual increases over the next five years as this "mini-generation" enters prime first-time homebuying age which we expect to provide a very positive fundamental backdrop for housing-related industries.
Homebuilder Performance and Sector Overview
Left for dead in late-March with the single-family homebuilder ETFs lower by more than 50% from their recent highs, homebuilders have sprung back over the last five months, as has the broader U.S. housing industry. The homebuilder segment of the Hoya Capital Housing Index has more than doubled from its late-March lows and is now higher by more than 20% this year, significantly outpacing the flat performance on S&P 500 ETF (SPY) and the 21.9% decline on the Equity REIT ETF (VNQ).
We should note, however, that homebuilding stocks tend to be extremely volatile and pay a relatively low dividend yield, so we believe that owning a diversified basket of housing-related companies on both the ownership and rental side of the market may be a prudent option for most investors seeking to gain exposure to housing.
A major theme in the homebuilding sector last year was the significant outperformance from builders focused on the lower-priced entry-level segment with strong demand coming from older millennials and from institutional rental operators including single-family rental REITs, which we discussed in a recent piece: Single Family Rentals: The Burbs Are Back. We've seen that trend continue this year with four of the five best-performing homebuilders targeting the entry-level segment including Meritage Homes (MTH), LGI Homes (LGIH) Century Communities (CCS), and D.R. Horton (DHI). Builders targeting the highest price points, as well as builders with higher exposure to the Northeast and West Coast markets, have generally underperformed this year including Taylor Morrison (TMHC), NVR Inc. (NVR), and New Home Communities (NWHM).
Deeper Dive: Homebuilding Economics
Taking a step back, the US single-family homebuilding sector is a cyclical, competitive, and fragmented industry, while also being one of the slowest sectors to recover from the Great Financial Crisis. 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, but 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 and reduce balance sheet risk.
As construction and regulatory costs had risen over the past decade, homebuilders had been shifting their focus towards higher-end units which commanded 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 this 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 for a newly-built home was $330,600 in July, while the median public builder in our 15-company coverage is $398,000. On the high-end, Toll Brothers and New Home Company have the highest average selling price while D.R. Horton has the lowest ASP.
Record-low inventory levels combined with robust levels of homebuying activity have put substantial upward pressure on home values since the start of the pandemic. All of the major home price indexes are now showing a reacceleration in price appreciation over the last five months, underscored by the 11.4% jump in Existing Home prices recorded by the NAR in August. Meanwhile, the FHFA Index showed home prices rising 6.5% on a year-over-year basis in July while the Case Shiller National Home Price Index recorded a 4.3% year-over-year rise in national home prices in its most recent report in June. Absent a significant "second wave" of economic lockdowns, we expect continued upward pressure on home values for at least the next two years.
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 including American Homes 4 Rent (AMH), Invitation Homes (INVH), and Front Yard Residential (RESI) 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.
For homebuilders, it's all about the "5 Ls": lending, lumber, labor, land, and legislation. The slowdown in the housing industry in 2018 - a year of strong economic growth - caught many investors by surprise and underscored the theme that housing can often diverge from the broader economy over the short and medium term. In 2018, all five of these factors were stiff headwinds, but started to ease in the back half of 2019 and into early 2020 as interest rates and construction cost inflation both cooled. Looking ahead, while the lending environment remains favorable, construction materials cost inflation (and the ability to source materials) has suddenly become a headwind to gross margins amid this single-family construction boom and supply chain issues.
As discussed in Timber REITs: Literally On Fire, the emerging constraint on further upside for the flourishing housing sector is surging lumber prices, the single most important commodity in single-family home construction and remodeling. Lumber prices have soared to record-highs from the combination of insatiable demand and reduced supply resulting from pandemic-related production shutdowns and forest fires raging in the Pacific Northwest.
Timber REITs were caught off-guard by the velocity of the rebound in lumber demand from single-family homebuilding and remodeling activity and have struggled to meet customer demand. Prices of random-length lumber futures (LB1:COM) briefly topped $1,000 in late August before pulling back to around $600, which is still roughly double the average price from 2000-2019.
Naturally, housing-related retail categories have seen a similar resurgence in recent months as the homebuilders themselves as the Building Materials category is second only to e-commerce as the top-performing retail category with a 15.4% higher sales rate than last year. The building materials category, which includes Home Depot (HD) and Lowe's (LOW), as well as the home furnishings category which includes companies like Restoration Hardware (NYSE:RH) and Whirlpool (WHR) have been positive standouts throughout the pandemic, reflecting the continued resilience of the housing sector and the fact that households have exhibited a propensity to prioritize investments in home improvement amid the "work-from-home" era.
Finally, you can't discuss the housing sector without mentioning the enormous impact of real estate technology in fueling the future growth of the sector over the next decade. The "prop-tech" industry includes data and technology companies including Zillow (Z), Redfin (RDFN), CoreLogic (CLGX), and RealPage (RP), as well as the tech-focused brokerage firms like Realogy (RLGY) and RE/MAX (RMAX), all of which have helped to streamline the buying, selling, and renting process of housing properties. The availability of technologies like virtual house tours and the increased adoption of entirely digital relationships between renters/homebuyers and landlords/brokers have proven to be especially critical amid the CV-19 disruptions.
Homebuilder Earnings Showed Robust Strength
Homebuilder earnings have been impressive nearly across-the-board since the start of the pandemic as most of the largest builders entered this period of uncertainty with a full head of steam. Commentary on earnings calls has been decidedly positive as recently-reporting builders - KB Home and Lennar - remarked that momentum has continued and even accelerated in late August and into early September, bucking the normal seasonal demand trends. Despite a weak start to Q2 in April and into May, homebuilders still reported a stellar 20% jump in net order growth, the most closely watched earnings metric, and a leading indicator of future revenue and home deliveries.
Homebuilding is a capital-intensive business with tight margins and a high degree of operating leverage, so gross homebuilding margins are generally the other most closely-watched performance metric. After reporting a pullback in Q1, homebuilders generally reported a solid rebound in gross and operating margins in the most recent quarter. Within our coverage, which only includes the largest 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. 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.
Homebuilder Valuations Appear Highly Attractive
Despite leading the early stages of the post-pandemic economic rebound, homebuilders remain a relatively unloved sector, still trading at deep discounts to historical and market multiples. Homebuilders currently trade at an average trailing twelve-month Price to Earnings ratio of 12.1x, far below the roughly 28x trailing P/E multiple on the S&P 500. That valuation gap extends further when looking at forward P/E multiples, which reflect the particularly strong rebound in EPS expected over the next year for homebuilders.
Homebuilders have delivered EPS growth of nearly 30% per year since 2017, more than double the 13% annual EPS growth by S&P 500 components during that time. Within the sector, we note that investors generally award premium multiples to the large-cap builders like D.R. Horton and Lennar, as well as to builders with more "land-lite" options-heavy strategies including NVR. Investors looking for yield aren't likely to find much of it in the homebuilding sector, however. Only six of the fifteen homebuilders pay a dividend, led by MDC Holdings with a 3.0% yield while PulteGroup, D.R. Horton, KB Home, Toll Brothers, and Lennar pay yields of around 1%.
Key Takeaways: Homebuilders on a Vendetta
A confluence of near-term factors and long-term tailwinds converged over the last five months that have generated a highly favorable environment for the U.S. housing industry, particularly single-family homebuilders. Americans have been spending more time than ever in their homes and it's become abundantly clear that housing is perhaps the "ultimate essential service." The sharp rebound in housing market activity has been aided by longer-term macroeconomic trends of favorable millennial-led demographics and historically low housing supply, factors that should remain tailwinds well into the 2020s as the housing industry continues to play catch-up after a "lost decade" of accumulated underinvestment in residential fixed investment.
Housing remains an “unloved” sector despite the compelling long-term tailwinds at its back. Homebuilders trade at deeply discounted valuations to the S&P 500 despite their stellar growth rates. Homebuilding stocks remain extremely volatile and pay a relatively low dividend yield, however, so we believe that owning a diversified basket of housing-related companies on both the ownership and rental side of the market may be a prudent option for most investors seeking to gain exposure to the U.S. housing sector.
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