Homebuilding stocks have had a rough 2022. Year-to-date (through 4/12), my equal-weighted index of 11 publicly-traded U.S. homebuilders has fallen 34.8%. That compares with declines of 7.7% in the S&P 500 and 11.5% in the Russell 2000.
Following a three-fold surge in the index from the March 2020 lows to the May 2021 highs, homebuilding stocks were due for a correction anyway. This year’s 34% fall, though eye-catching, still qualifies as a normal correction from a technical point of view, according to Fibonacci retracement analysis.
The homebuilders are now extremely cheap on forward earnings. I estimate that the group is valued at around 4.0 times consensus 2022 and 2023 earnings. That is half the average of 8.0 times in recent years and 40% of the long-term average of 10.0 times. Such a low valuation obviously reflects concerns that actual earnings will fall short of consensus estimates. Yet, the builders remain upbeat about in their performance for 2022, due to the elevated backlog levels that they had at the start of the year and early year sales trends that have been positive.
Those backlogs, which were built in part on strong order growth from urban renters seeking the security of suburban homeownership to escape the pandemic, have remained high due to supply chain disruptions and labor shortages which have lengthened construction cycle times across the industry. Some builders say that supply chain disruptions will not stabilize until the second half of 2022, but most expect to begin catching up on their backlogs during the course of the year. These factors are incorporated into their outlooks for 2022 earnings, as of February when they reported 21Q4 results.
The next major round of homebuilder earnings reports, for 22Q1, will begin later this month. Two builders – KB Home and Lennar – reported their fiscal first quarter results in March. Those reports focused mostly on the continuing difficulty of delivering out the backlogs as a result of continuing supply chain disruptions. Both said that order activity has held up well so far – with average orders flat vs. the prior year; but mortgage rates have continued to move higher since then.
In its forecast for 2022, the Mortgage Bankers Association expects that purchase mortgage originations will be down 1.2% in number, but up 7.7% in dollars. Its forecast assumes that existing home purchase originations will be down both in number and dollar value in 2022, but new home purchase originations will be up 4% in dollars, which implies a decline in loan volume of 4%-5%. The Association’s forecast may be optimistic, however, because according to my eye, purchase loan volume has been running down 10% on average since the beginning of the year. Its forecast therefore presumes that prior year comparisons will become noticeably more favorable as the year progresses.
In this next set of quarterly earnings reports, besides providing an update on supply chain issues, builders will almost certainly address the impact of the sharp rise in mortgage rates on recent sales activity (including in the weeks since the March 31 quarter close).
Mortgage rates have risen more than 100 bp since February 28, the end of the quarter covered in Lennar’s and KB Home’s reports. While move-up buyers are better able to adjust to the rate jump, entry level buyers have less flexibility. Except for the partial offset from increases community counts, orders for most builders were probably headed lower in 2022 anyway, against a very tough prior year comparison. The rise in mortgage rates will cause more of decline. For those builders reporting in the next few weeks, orders were probably hurt most for one month out of the three, the month of March. If rates remain high, order rate comparisons for 22Q2 and beyond will likely show a more meaningful decline.
Besides recent order trends, analysts and investors will want to know whether the rate rise has also presented problems for buyers in the backlog who are waiting to close on their homes. I suspect that most buyers have been able to adjust successfully for now, either because they have locked-in mortgage rates or made other adjustments, such as scaling back upgrade options to reduce the total price of the home (and therefore the amount to be borrowed). Yet, upgrades are more prevalent among move-up buyers. Entry level buyers have fewer options, so those who qualify for a now smaller loan may either have to come up with more equity or seek a reduction in price. Otherwise, the sales contract is more likely to be cancelled.
It would not be surprising, therefore, to see some increase in backlog cancellation rates, which would also help to bring backlogs down to a level that is more consistent with the current pace of deliveries. This, in my mind, would be an appropriate adjustment to current conditions.
New orders and backlogs may be cushioned by sales to investors in single-family rental properties, especially for entry level homes. Such sales may account for as much as 9% of all single-family housing starts, according to data cited by the Wall Street Journal.
Considering all of these factors – although it it likely that there will be net declines in orders and an increase in contract cancellations, backlogs should remain elevated and expectations for deliveries should remain little changed, which should temper a possible reduction in the earnings outlook for 2022.
Investor concerns will then focus mostly on the outlook for 2023 earnings and beyond. There, the outlook is definitely more uncertain. Orders will need to remain robust for 2023 earnings to match 2022. But with house prices up 20% year-over-year and the Freddie Mac 30-year average mortgage rate at 4.72% last week, up 160 bp since the start of the year and nearly 100 bp since the beginning of March, the combination of high house prices and high mortgage rates has reduced affordability dramatically. Many entry level buyers have been pushed out of the market. There will be fewer buyers to chase prices higher. Prices may therefore have to come down or at least hold steady in order to sustain demand.
These developments were reflected in homebuilder sentiment about the outlook for housing sales last month and probably will be more so in the next reading on April 18. The NAHB/Wells Fargo Housing Market Index (HMI) slipped two points in March to 79, down from 84 in December and 90, its all-time high in November 2020. (Readings above 50 are positive.) The component of the HMI that measures current sales conditions was still robust at 86, down from 89 in February; but sentiment about the sales outlook six months from now dropped 10 points to 70, presumably because of the increase in rates and uncertainty in the economic outlook caused by the war in Ukraine. 70 is still a solid reading, but it is down meaningfully from the earlier pandemic highs. With the sharp rise in mortgage rates since the last reading, April’s HMI will likely show another decline.
The rise in mortgage rates has been fast and steep. As noted, the average 30-year mortgage rate has increased 160 bp since the start of the year. The increase in mortgage rates follow similar sharp increases in yields on U.S. Treasury bonds.
I’m not an expert on the mortgage market; but I have tracked the spread between the Freddie Mac mortgage rate and the 10-year Treasury yield for more than two decades. Over that period, the spread has averaged 175 bp. There have been periods where the spread has spiked higher – typically during market dislocations, like the 2008 financial crisis and the first weeks of the 2020 pandemic, but it always has returned to the 175 bp level (within a range). As shown in the chart below, the spread has risen in recent weeks to more than 220 bp, a reflection of the volatility currently being experienced in the U.S. Treasury market and other fixed income markets.
Although I cannot state with certainty the cause of the wider spread, I suspect that mortgage underwriters are being cautious in making commitments to potential borrowers. They are probably quoting higher rates (at wider spreads) because their commitments must remain in place for 30-60 days until the loan closes and is packaged for sale and they do not want to get squeezed by rising funding costs during that time. If my assessment is correct, the spread should eventually narrow as the Treasury market stabilizes.
Of course, the question is then when will the Treasury market stabilize and at what level? If the Fed follows through on market expectations that the Fed Funds rate will rise to 2.50% by year-end, the 10-year Treasury yield could go higher. Others worry that the yield curve will invert because higher short-term rates will push the economy into recession. I believe that it is unlikely (at least in the near-term) that the Fed will raise short-term rates as much as the markets currently anticipate. This should cap the upside on the 10-year yield at or near current levels. If I am right, then the average 30-year mortgage rate could drop 50 bp eventually just on a return to the normal 175 bp spread vs. the 10-year.
To sum it up . . . my near-term outlook anticipates that mortgage rates will stabilize soon and eventually begin to recede within the next few months. This should take some pressure off the housing industry. Elevated house prices will still likely impede demand, so the industry will probably have to make some adjustments – either by reducing or holding prices steady – to allow affordability to rise so that more entry-level buyers can come back into the market. Lower prices may crimp builder profit margins, but there should be some offsets, especially on the cost side of the equation, as supply chain disruptions and labor shortages ease.
All-in-all, my 2022 earnings expectations for the homebuilders are lower now and the outlook for 2023 is lower still; but with the average consensus forward multiple of 4.0 times, homebuilding stocks could absorb even a double-digit reduction in earnings estimates and the forward multiples would still be well below the long-term historical average of the homebuilders. Consequently, I believe that these stocks can still rebound from current levels, even as earnings estimates are reduced.
From a technical perspective, my homebuilder stock price index (as shown above) has been in a steep downtrend since the beginning of the year and there is no evidence yet that the selling is over. The chart shows that the index should find support around (or perhaps slightly below) current levels, but then I would normally expect it to build a base (i.e. trade sideways) for perhaps some time before mounting a new advance.
Conceivably, if mortgage rates remain high or go higher, there still could be some downside risk; but given the dynamics of 30-year mortgage rate/10-year Treasury yield spread and the likelihood that inflation will ease in the months ahead, there is also upside potential from declining mortgage rates. I believe that this year’s correction in homebuilder stock prices has shifted the near-term risk-reward balance, giving homebuilding stocks more favorable upside prospects than downside risks.
April 13, 2022
Stephen P. Percoco
839 Dewitt Street
Linden, New Jersey 07036
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