Housing market activity has strengthened in recent months. This has raised the hope of another leg up in the recovery. Yet, investors are still skeptical about the industry’s future prospects.
2016 started off slow; but since March, new home sales have posted double-digit year-on-year gains that have accelerated since mid-year.
Through November, new home sales were up 12.7%. They are virtually guaranteed to end the year up more than 11%, which would mark the fourth year (out of the past five) of double-digit gains.
According to Census Bureau data, the average new home sales price has slipped 0.2% to $359,900 in 2016, but the median price is up 3.0% to $305,400. Most of the growth in sales has come in the $300,000-$500,000 price range, but sales of entry-level homes, priced $150,000 to $200,000, were also up this year until just recently.
Single-family housing starts got off to a strong start in 2016, but then faded through the summer. In October, though, starts surged nearly 25% over-prior year levels, but the pace of year-over-year gains slowed in November and December. As a result, single-family starts were up 9.3% in 2016, down slightly from 2015’s 10.3% increase.
The recent surge in housing activity is due mostly to the firming of economic activity. Job growth has been solid all year, even though it has slowed recently. Average hourly earnings have risen more than 2.5% per year in 2015 and 2016, compared with only 1.9% from 2009-2014. Median household income was up 5.2% in 2015, the strongest rise on record. Third quarter GDP growth was clocked at 3.5%, up from 1.1% in the first half.
The consensus estimate, as given in the Philly Fed’s Survey of Professional Forecasters (SPF), anticipates GDP growth of 2.2% in the fourth quarter. That would bring GDP growth to 1.6% for all of 2016. The SPF consensus estimate anticipates that GDP growth will improve to 2.2% in 2017, but the survey was published on November 14, about one week after the presidential election and before most of the stock market’s impressive advance. Consequently, I expect to see a lift in 2017 GDP growth expectations to at least 2.5% when the next survey is released in February.
On the other hand, interest rates also rose significantly in the 2016 fourth quarter. The yield on the benchmark 10-year Treasury note rose by 76 basis points from 1.86% immediately before the election to 2.62% in mid-December. Since then, the 10-year yield has slipped back to about 2.41%. With the Fed poised to continue raising short-term interest rates and expectations of a strengthening in economic growth, it seems likely that the yield on the 10-year will rise above 2.50% and possibly even approach 3.00% later in 2017.
Along with the rise in Treasury yields, the rate on the 30-year mortgage, according to Freddie Mac’s survey, rose from about 3.5% before the election to a peak of 4.30% in late December before slipping back to 4.09% in the latest reading on January 19. The recent rise in mortgage rates is probably not enough to slow the housing market’s momentum, but it can effect the ability of marginal buyers, especially first-time homebuyers, to qualify for mortgages. A large part of the negative effect of rising mortgage rates might be offset by a strengthening in the economy, especially with continuing gains in jobs and wages.
Demographics are supportive of an increase in demand for housing. The millennial generation, which has overtaken baby boomers to become the largest cohort, is now well within the prime first-time home buying years (i.e. ages 25-32). Yet, the homeownership rate has fallen to 63.5%, down 5.7 percentage points since the peak of 69.2% in 2004 and the lowest level since the early 1990s. The decline, of course, is due mostly to the housing bust, when many people lost their homes in foreclosure.
Since the financial crisis, mortgage underwriting standards have been tightened, making it more difficult to qualify for a mortgage. On top of this, millennials are burdened with payments on student loans and high rents, which make it difficult to save for a down payment. No wonder, then, that the percentage of home purchases by first-time buyers has remained near record low levels (32% in 2015 and 35% so far in 2016, compared with a long-term average of 40%).
Despite these challenges, the homeownership rate could climb back to 65% or higher over time in an extended economic recovery and with the help of policies and programs designed to encourage sustainable home ownership. That switch of 1.5 percentage points from renters to owners translates into potential sales of nearly 1.8 million homes. Raising the percentage of first-time buyers back to the historical average of 40% could result in 450,000 more home sales annually.
Although many millennials claim to be happy to rent or to stay at home with mom and/or dad, an increasing percentage of them would prefer to own a home, if they could afford to do so.
Low mortgage rates have helped to offset some of these impediments to homeownership by reducing mortgage payments and thus raising borrowing capacity. Unfortunately for potential house buyers, however, a significant portion of the benefit from low mortgage rates has accrued to sellers in the form of higher house prices.
From the post-financial crisis lows in 2011 to the third quarter of 2016, house prices increased 6.1% per year on average, according to the Federal Housing Finance Agency. Since inflation, as measured by the PCE deflator, averaged 1.2% over that period, the 4.9% real rate of house price appreciation is very high by historical standards. Using FHFA data, I estimate that from 1992 to the post-housing bust low in 2011, the average annual rate of increase in house prices was 2.9% and real rate of return on housing was 0.9%.
The recent 4.9% real rate of house price appreciation has offset much of the benefit from low interest rates. In my view, the increase in house prices has been a major cause of the perceived slow recovery in housing.
The real estate industry says that the high rate of house price appreciation has been driven by very low levels of for-sale inventories. Yet, housing vacancies have been at historically high levels until recently. Over the past few years, a large portion of those excess vacancies have been worked off. Housing vacancies as a percentage of total housing supply were 12.6% as of the 2016 third quarter, which is still modestly above the 1993-2004 average of 11.8%. Given the fast pace of house price appreciation, it is surprising that more owners have not opted to put their vacant properties up for sale.
As long as the economic recovery continues to chug along (with solid gains in job and wages), I expect to see steady improvement in new home sales. In my opinion, a slower pace of house price appreciation would support gains in housing activity and growth in the broader economy, since it would lead to higher house sales volume and leave more income in the pockets of those that do buy: income that could be spent on housing upgrades and other consumer purchases.
Judging from the performance of homebuilder share prices, investors remain skeptical about the prospects for further recovery in housing. Homebuilder stock prices have essentially traded sideways for the past 3.5 years, underperforming the market. They broke sharply to the downside at the start of 2016, along with most other stocks, but have since recovered to maintain the longer-term trend of flat performance.
In 2016, homebuilding stocks were up 6.1%, according to the Lark Research Homebuilder Stock Price Index. Even so, that performance lags both the 9.5% gain in the S&P 500 and the 19.5% gain in the Russell 2000.
Investor skepticism is also reflected in homebuilder equity valuations. On average, the group is trading at 11.0 times anticipated 2016 earnings (excluding Hovnanian) and 10.0 times projected 2017 earnings. That echoes the valuation given to the group in the run-up to the 2007 housing peak.
Before the housing bust in 2006, homebuilders traded consistently at about a 10 times forward multiple, but average annual earnings growth of 30%-40% still produced investment returns of 30%-40%.
Over the past three years, however, the sales and earnings performance of the homebuilders has been erratic, in part because new home sales stalled in 2014. That helps to explain why homebuilder share prices have been range bound.
Over the past year or so, there has been a wide and somewhat surprising disparity in share price performance within the sector. By and large, the smallest capitalization builders, which are generally considered to be riskier, have outperformed. This includes Hovnanian (up 51% in 2016), KB Home (up 28%), Beazer Homes (up 16%) and M/I Homes (up 15%). The laggards were the largest capitalization builders, including D.R. Horton (down 15%), Lennar (down 12%), and Toll Brothers (down 7%). Shares of CalAtlantic Group (CAA), a mid-cap builder formed at the end of 2015r by the merger of Ryland Group and Standard Pacific, were down 10% in 2016, but that performance reflects slow orders and perhaps continued turnover in its shareholder base.
The difference in relative performance between larger cap and smaller cap builders is also evident in difference in performance between the Lark Research Homebuilder Stock Price Index and homebuilding ETFs. The Lark Research Index, as already noted, was up 6.1% in 2016, while the iShares U.S. Home Construction ETF was up only 1.5%. The twelve homebuilders in the Lark Research Index are equally weighted and the Index is rebalanced at the start of each year. The ITB portfolio, on the other hand, has 60% of its assets in homebuilding shares (the rest is housing-related stocks, including retailers like Home Depot and Lowe’s, and building materials companies, like Sherwin-Williams, Masco and USG). ITB’s holdings of homebuilding stocks are also heavily weighted towards larger cap homebuilders.
One possible explanation for the divergence in performance between larger cap and smaller cap builders may be due to differences in new order trends. For the most part, the outperforming builders have had double-digit gains in net new orders, while the laggards have had only single-digit gains. But there are exceptions: Hovnanian’s net orders declined 1.2% in the fiscal 2016; while Toll Brothers’ orders rose 10.4%.
Interestingly, in 2014 and 2015, D.R. Horton and Lennar outperformed their peers, posting solid gains while the group on average suffered declines. Since this year’s recent gains have come during the post-election euphoria, I am reluctant to draw clear conclusions about the divergence in performance. However, the wide gap in performance suggests perhaps some rotation of ownership within the sector. The larger capitalization builders are often used as proxies by investors looking for exposure to the housing sector.
These investors may have decided to take profits amid the uncertainty surrounding the election. Whatever the case, it does appear that the performance divergence does not support the view of widespread pessimism about the outlook for the publicly-traded builders and the housing industry. Consequently, it is still possible to make the case for better stock price performance for the homebuilders, as long as economic conditions remain favorable.
Before this year’s performance divergence, there was a clear valuation gap between the larger capitalization and smaller capitalization builders. (The large cap builders previously had richer valuations.) After this year’s performance divergence, valuation is now pretty much a mixed bag.
Although stock price performance for individual homebuilders will undoubtedly mirror financial and operating performance, the average below-market valuation for the group suggests that it is poised to outperform the broader market in 2017, especially if the economic recovery gathers some steam. At the threshold of the upcoming spring selling season, homebuilder sentiment, as tracked by the NAHB/Wells Fargo index, had rebounded nearly to 2005-2006 peak levels. Given the double-digit gains in national new home sales in the second half of 2016, the first half of 2017 is shaping up to be strong for both the homebuilders and the housing industry.
January 24, 2017
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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