What to Watch
Is it time to go short (or long) the home builders? No, but as Peter Sellers famously said in “Being There” ………. I like to watch.
First, allow me to lay out some ground work as to what I am watching.
US home values heat map, via Homeinsurance.com
The Business of Home Building
Home building is not about building houses, it is about monetizing land. You buy land today using a bundle of projections of future value, estimates of development costs, assume that building costs will remain stable, then wait many years for the bucks to roll in. If the market appreciates during the holding period, the builders look like geniuses. If the market tanks, they blame the weather, but will keep their executive bonuses while waiting for the market to turn.
The Decoupling of the Real Estate Market and Home Builders
Home builders are not stupid. They build where they can sell. They build what they can sell at the highest margins the market can bear. It is therefore natural that all builders, especially the big publicly listed ones, are crowding the same markets, although some may be more dominant in certain geographical areas than others. Consequently, land prices are driven up in these hot markets making national statistics irrelevant.
As for what they will build, forget about entry level housing. That is terrible for the bottom line. They will only build affordable housing as a requirement, if mandated by some local zoning ordinances and master plans. They will build the highest priced product the market can support. In other words, they are all Toll Brothers now.
Toll Brothers share price monthly, over the past 15 years. Back in bubble-land – click to enlarge.
This transition has been on going for a few years and has now become the new norm. Going forward, I believe it is important to understand these changes so as not to be misled by data points from public builders and apply them to the general real estate market, or vice versa.
The Gift that Keeps on Giving
If the too-big-to-fail banks are the Federal Reserve’ favorite sons, then the builders are the Feds’ favorite bastard sons. The Feds have been showering them with gifts – easy money for them to acquire land, financing for their operations and easy financing for their customers while boosting the price of their products.
The biggest gift of all: mortgage backed securities held by the Federal Reserve System – click to enlarge.
These gifts are taken for granted and baked into the system. Just imagine how many of these builders would have been around after 2008 if not for these gifts. Further imagine what would happen to the builders today if the gifts had to be reduced or even eliminated?
Where are we Today?
Assume there is a baseline for home builders. This baseline is the value using certain expectations of costs and future revenues resulting from the land in their portfolios today. Sales volume higher than this expectation reduce SG&A expenses per unit, resulting in net margin improvement. Higher sales prices add to gross margins. These are almost pure profit.
Most builders have higher than expected sales in volume and price year-on-year. Now that represents the new baseline.
Where do we go from Here?
Expectations have been raised for the sector. Comps are not going to be as easy going forward. How did builders get into trouble in the past? They bought too much land at too high a price, and ended up with impairments instead of profits. Is a repeat around the corner?
Current FY P/Es are floating in the high teens. I believe the builders are rewarded for growth that is not sustainable and P/Es should be lowered to below the mid teens.
Almost every builder experienced robust sales growth over the last few quarters, partially due to easy comps and partially due to increased community counts. Sales/community should be coming down.
Specs are great when market conditions are favorable. They are terrible for margins if they turn into standing inventory, often requiring incentives and price cuts for their disposition. No builder has been overly aggressive in spec building, but such inventory can also result from cancellations.
Average Sales Prices
Most builders are enjoying 4-5% annualized increases in sales prices. Part of this increase is due to changes in product mix, part is due to organic growth. In addition, this increase is not offset by incentives, so it really fattens the bottom line. When price increases stall, margins can come down disproportionately, as incentives are used to keep prices level.Mortgage Rates
Mortgage rates were driven to current levels by three rounds of QE. Will rates stay low, now that QE is supposedly discontinued? Has it already lost its stimulative effects? Watch the change (or no change) in mortgage rates, but more importantly, watch for the market’s reaction.
The builders may have reached the peak of the cycle. This cycle was driven by cheap prices of land purchased after sub-prime bubble, or land that was impaired in their portfolios during that era. The combination of low mortgage rates and favorable price trends contributed to improving margins.
Home builder ETF XHB, weekly – still making new highs. Are the good news fully priced in by now? – click to enlarge.
Land prices have been rising. Builders may not be priced for perfection, but an optimistic outlook is baked in. For margins to improve, future quarters will have to rely more on price increases. Community counts have been increasing, but are likely to decelerate in the future. Higher sales will have to rely more on sales/community instead of just on adding more communities.
In conclusion, it might not be the perfect time to short the builders just yet, but the situation is deserving of attention.
Charts and maps by: StockCharts, Homeinsurance.com, St. Louis Federal Reserve Research