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The US housing market continues to confound and confuse. Search social media and plenty are still waiting for an '08 style crash.
Which, considering the supposed drag from higher interest/mortgage rates is a little surprising...
So, there must be a good reason, right?
Let's focus on two of the big guns. Lennar (LEN) and D.R. Horton (DHI). Some quick context from this Harvard paper 👇
Together, D.R. Horton and Lennar grew their market share of new single family homes sold by some 9.0 percentage points from 2002 to 2020, accounting for about two thirds of the gains made by the top 100 builders, as well as all of the share increases of the top 10 and top 5 builders.
TL;DR, they're the big guns. And the only reason DHI didn't post a new 52 week high yesterday is because it traded a smidge higher at the start of February...
So why would anyone want to own housing stocks if the real estate industry is on the verge of crisis?
Is the market just dumb, and can't see WHAT'S COMING...?
"I'm smart and the market's dumb" isn't usually a good strategy...
Homebuilders such as Lennar have sacrificed margins, but kept building regardless...
For Q1 2023, Lennar reported:
- New orders decreased 10% to 14,194 homes; new orders dollar value decreased 18% to $6.4 billion
- Backlog decreased 29% to 19,403 homes; backlog dollar value decreased 33% to $9.0 billion
- Net margin on home sales decreased 560 bps to 13.8%
In the earnings call, Miller explained the reason for the margin compression.
While margins fell 360 basis points over the prior quarter and 570 basis points year over year, they reflected the use of price reductions and incentives, that is, closing cost payments and interest rate buydown, to offset volatile interest rate and market shifts.
We used these tools both to sell homes, as well as to protect our backlog, by adjusting pricing and incentives to ensure closings. Our first quarter cancellation rate improved to 21.5%. While this is higher than the 10.2% last year, it is decidedly lower than the 26% last quarter and has been falling in each consecutive month.
On top of this, he thinks that people are getting used to higher rates, plus input cost reductions will be able to offset any further incentives that will be required to keep sales ticking over...
The sudden sticker shock of rapidly rising interest rates in 2022 has mellowed. And while net prices are lower, incentives are moderating, cancellations have been normalizing lower, and margins have been bottoming as cost reductions are beginning to provide an offset.
This improving, optimistic sentiment ties in with the NAHB Index...
After hitting its lowest level in 10 years (excluding the drop during the COVID outbreak) the NAHB Market Index has steadily risen in early 2023 (top chart), as limited inventory is helping boost demand.
While still far below pre-pandemic levels, the gains in the headline index indicate the housing market may have already faced the worst of the current Fed hiking cycle.
And, as we have repeatedly said, there's no real reason to panic over the housing industry right now. Yes, it's cyclical, but there are ways to bridge the gap from current higher rates to what buyers hope will be lower rates a couple of years down the line. 👇
But that still doesn't answer the original question... Why would anyone be buying homebuilders NOW near ATH's?
Goldman covered the sector recently. LEN's trading at $109, very close to the GS $112 price target. DHI is trading at $102, a little over Goldman's $99 price target...
Maybe you can make the case that they're solid companies with cash flows and operating profits, and/or that they should lead the recovery if/when the Fed pivots, but there's not a lot of margin for error here.
Maybe you buy them for the dividends?
Lennar's dividend yield is currently 1.43%. Hardly groundbreaking, but it's something at least...
DR Horton's dividend yield currently sits just under 1% (subject to change - the company reports earnings tomorrow after the close).
Those dividends might not be too reliable going forward either. Jefferies screened for companies likely to disappoint on dividends (based on their view that slowing global growth, tight liquidity, higher rates and a profit recession will be significant headwinds to dividend strategies this year) and found Lennar as one of the most likely candidatesl...
So are these homebuilder stocks priced for perfection?
The immaculate disinflation, a soft landing, access to credit stays easy and open, lower mortgage rates soon, & low available housing inventories keep homebuilders ticking over, with only a very mild recession if there's even a recession at all...
I mean... Maybe?
But then, people said the same about the used car market too, and we'll see how tightening credit impacts there soon enough...
Credit tightening has definitely started and is expected to continue. Here's what Ally Financial said today:
As we progress throughout 2023, we continue to see opportunities across all our businesses, but are mindful of the current environment and are making necessary adjustments to manage risks.
Our focus remains on risk-adjusted returns, which may lead to slightly lower origination levels as we look to tighten underwriting in certain segments that don’t meet return thresholds
i.e. We will be lending less, and/or charging more to lend (which amount to the same thing).
So, on the back of David's tweet here...👇
There might actually be more compelling shorts in the sector than the homebuilder ETF (once the worm finally turns). Homebuilders generally look vulnerable to bad news.
Signs of a genuine credit crunch, a re-acceleration of inflation, pricing out of 2023 rate cuts and/or long rates moving higher are key risks to a sector pricing something close to perfection.