Housing has been a consistent bright spot in an otherwise mediocre recovery. Critics complain that the recovery in housing has been lukewarm, because production levels are still well below levels seen in the years before the housing bust. Yet, housing production and new home sales have grown at double-digit rates on average since the 2011 trough.
According to the Census Bureau, 561,000 new homes were sold in 2016, well below the annual average of about 1.0 million recorded in the decade before the 2007 housing bust. While some see this as evidence of a growing housing supply deficit, mortgage underwriting standards are tougher and fewer first-time buyers are able to qualify for mortgages (due to limited incomes, high student loans and low savings). Millenials also seem less driven to own homes. All of this makes a return to the go-go years less likely.
Low mortgage rates have supported the housing recovery, but not as much as one would hope or expect. Much of the benefit of lower rates over the past five years has accrued to sellers through higher home prices. By most estimates (e.g. the Federal Housing Finance Agency and S&P CoreLogic Case-Shiller), house prices have been appreciating at 5%-6% per year, well above the rate of inflation. Although house prices fell more than 20% from peak to trough during the housing bust, they are now more than 5% above prior peak levels.
The National Association of Realtors says that this recent high rate of house price appreciation is due to limited for-sale inventory. Their figures show that the supply of homes available for sale has dropped to 4.3 months (as of May), equivalent to the levels seen during the boom years from 2000-2006. Yet, according to Census Bureau data, housing vacancies remain elevated. A large number of houses are being held off market.
High rates of house price appreciation work against the aim of the Federal Reserve to boost the economy by keeping interest rates low. It is hard to avoid the conclusion that low interest rates have created a bubble in house prices. While the current high level of prices is supported by low interest rates, house prices appear to be at risk of declines if and when mortgage rates begin to rise.
Within the context of the low interest rate environment, housing demand and production have been driven by gains in employment and wages and improving consumer confidence. As long as the economy continues to grow (even if only at 2.0%-2.5%), demand for housing will continue to rise. Thus, most homebuilders have been reporting steady gains in sales and profits, roughly in line with the national averages of high single-digit to low double-digit growth.
In the 2017 second quarter, of the ten publicly-traded builders that I monitor that have reported results so far, the average gain in revenues was 12.3% (with unit closings up 8.7% and average prices up 3%). New orders for the quarter were up 6.7% in units and 11.6% in dollar value.
Consensus estimates for eleven builders (excluding Hovnanian) anticipate that earnings will grow more than 15% in 2017 and 20% in 2018. In their comments included in 2017 second quarter earnings press releases, all CEOs were upbeat about their prospects for achieving full year financial targets, based upon a favorable macroeconomic environment and their individual strategies to grow revenues and earnings.
That projected rapid earnings growth trajectory has helped the builders post year-to-date share price returns of 22.6% (through August 11), according to my homebuilding stock index. That compares with gains of 9.0% on the S&P 500 and 1.3% on the Russell 2000. This year’s gains represents a catch up for the group, which had essentially traded sideways from the middle of 2012 until early 2017.
Homebuilding stocks have been in rally mode since the last major stock market bottom in February 2016. Since that time, the group has rallied nearly 64%, more than twice the gain in the S&P 500 and 50% above the gain in the Russell 2000. At this point, the group is due for a 10% correction, possibly more. (But of course the same can be said for the overall market.)
Despite the stock price rally, the group is still trading at below market multiples. Excluding Hovnanian, the remaining 11 builders currently have an average forward multiple of 11 times projected 2017 earnings and 10 times projected 2018 earnings. While seemingly cheap to the market, those valuation multiples are consistent with historical averages for the group. The market is apparently unwilling to bid up the multiples on the homebuilders, given their cyclical risk. However, the homebuilders can still deliver superior returns when earnings are growing at double-digit rates, even with no multiple expansion.
Longer-term, the homebuilders should be able to continue to grow revenues and earnings going forward as long as the economic backdrop (including low interest rates) does not change for the worse. The sharp rise in house prices since the 2011 housing market bottom does suggest, however, that the group would face greater-than-average downside risk in a rising interest rate environment. That said, the industry should be able to cope with a paced normalization of interest rates, as long as that is accompanied by commensurate gains in jobs and wages (i.e. personal income) and continued high consumer confidence.
August 15, 2017
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
© Lark Research, Inc. All rights reserved. Reproduction without permission is prohibited.