Homebuilder Rankings Overview
Every quarter, we publish our Homebuilder Rankings where we update readers on the sector. We rank homebuilders within the sectors based on different valuation metrics and update these rankings every quarter with new developments.
Homebuilding Sector Overview
The homebuilding sector (ITB and XHB) is a highly competitive and fragmented industry. The top ten largest builders account for roughly a quarter of the total new home sales, but this concentration has intensified since the recession. In our Homebuilder’s index, we track nine of the largest homebuilders, which account for roughly $60 billion in market value: D.R. Horton (DHI), Lennar (LEN), PulteGroup (PHM), NVR (NVR), Toll Brothers (TOL), CalAtlantic (CAA), KB Home (KBH), Meritage (MTH), and MDC Holdings (MDC).
Quality is a function of the company’s average home selling price and the average rating of the school district. Homebuilding segments can be roughly split into four categories: entry-level, move-up, luxury, and retirement. As construction and regulatory costs have risen, homebuilders have shifted their focus towards higher-end units which command high-enough margins to offset these increased costs. The average new home price was $377k in November 2017.
(3Q17 Company Reports)
In all, there are more than 20 publicly traded homebuilders. The smaller builders tend to be more regionally-focused and include Taylor Morrison (TMHC), AV Homes (AVHI), Beazer (BZH), Cavco (CVCO), CSS Industries Inc. (CSS), Hovnanian (HOV), LGI Homes (LGIH), William Lyon (WLH), and TRI Pointe (TPH). As we’ll discuss shortly, size and scale are a critical factor for homebuilders. Access to capital markets (or lack thereof) was the primary reason that the larger builders were able to avoid bankruptcy during the housing collapse.
Recent Performance Of Homebuilders
Homebuilders were one of the best-performing sectors in 2017. The key theme of the year was bifurcation: the largest builders significantly outperformed the smaller builders amid intense margin pressure from rising costs. Our index of the nine largest homebuilders returned nearly 80% in 2017, while the broader homebuilding ETFs rose 60%.
The bifurcation can be best illustrated through a review of recent quarterly earnings. Even within our index, which only includes the largest builders, the critical importance of scale becomes clear through the wide gap in operating margins, which declines linearly with decreasing size. The smallest builder in our index, MDC Holdings, operates at a measly 4.5% operating margins compared to the 13% average for the largest four builders.
Following that trendline, it becomes clear that the smallest individual private builders struggle to turn a profit on new home construction. Without that profit motive, it’s no wonder that the housing recovery has been so lethargic.
(3Q17 Company Reports)
Across the sector, new home sales rose a healthy 11% in 3Q17, significantly outpacing the national average of 7%. Gross margins across the sector peaked in 2014 at 22% and have since declined to roughly 20% so far in 2017. Operating margins show similar trends of compression as construction costs, and regulatory costs have shown steady appreciation since the end of the recession. Operating margins, however, were improved from 2016, rising 70bps across the sector.
Over the past quarter, several important developments changed the dynamics of the homebuilding sector heading into 2018.
Tax Reform Will Alter Economics Of Homeownership
While the fate of tax reform was still very much in question, lobbyists representing the homebuilding and realtor industry came out in full force against the plan. It seems that these once-powerful industry groups overplayed their hand and have been forced to walk back their more-dire hyperbolic predictions after their efforts failed to influence the final legislation. The perennially optimistic National Association of Realtors, for instance, forecasted a downright dire outlook for the housing markets if the tax reform package passed as outlined in the original proposal. From the National Association of Realtors:
By doubling the standard deduction and repealing the state and local tax deduction, the plan would effectively nullify the current tax benefits of owning a home for the vast majority of tax filers. Current homeowners could very well see their home’s value plummet and their equity evaporate if tax reform nullifies or eliminates the tax incentives they depend upon, while prospective homebuyers will see that dream pushed further out of reach.
The National Association of Homebuilders expressed similar dire concerns in an attempt to influence the legislation. From the NAHB:
By sharply reducing the number of taxpayers who would itemize, what’s left is a tax bill that essentially eviscerates the mortgage interest deduction and strips the tax code of its most vital homeownership tax benefit. This tax blueprint will harm home values, act as a tax on existing home owners and force many younger, aspiring home buyers out of the market.
As it became clear that the interests of these lobbying groups were not going to sway the final legislation, these groups attempted to walk back these predictions and put a positive spin on this quite apparent failure. After passage, the NAHB chairman said, “Change is inevitable.”
Translation: “Oops!” Obviously, the “significant improvements” did not address the biggest concerns of the NAR and NAHB: the doubling of the standard deduction and the repeal of state and local tax deductibility. Zillow estimates that 44% of US homes currently utilize the mortgage interest deduction. Because of the doubling of the standard deduction, less than 10% of homes will now find it advantageous to itemize their deductions, eliminating a key incentive for homeownership. We discuss the effects of tax reform throughout this report.
The Big Got Bigger In 2017
Outside of tax reform, the most significant developments of the past quarter were the continued consolidation within the homebuilding space. In October, D.R. Horton closed on the acquisition of Forestar Group (FOR) in a move that is expected to, per the press release, enhance “the strategy of increasing its optioned land and lot position to enhance operational efficiency and returns.”
Not to be outdone, Lennar announced in October that it entered into an agreement to buy CalAtlantic Group (NYSE:CAA), the sixth largest homebuilder. Clearly indicating that scale is essential in the homebuilding space, these two moves may just be the beginning of a wave of consolidation. D.R. Horton and Lennar will strengthen their grip as the largest two homebuilders, accounting for nearly 90k new home deliveries in 2017, more than 15% of the roughly 600k new home sales in 2017.
Over the past 52 weeks, the homebuilder ETF (XHB) has risen and more than tripled the performance of the S&P 500. During this time, US REITs are essentially flat on a total return basis.
Housing Data: Disappointing 2017 As Slow Recovery Continues
Following a strong start to 2017, housing starts have cooled considerably into year-end. At the end of 2016, economists projected that total housing starts would rise 6.5% in 2017, led by a 10% rise in single-family and a 3% rise in multifamily. Despite the strongest rate of economic growth in a decade, housing starts came up short of estimates yet again, the fifth straight year that economics overestimated progress in the housing recovery.
Over the prior twelve months (November 2016-November 2017), total housing starts have risen less than 4%. While single-family starts rose a healthy 8.5% in 2017, multifamily pulled back considerably, dipping more than 6% from 2016 levels. Economists are again optimistic about housing markets in 2018, again calling for a 6% rise in starts. We’d again “bet the under,” but believe that starts should rise a healthy 3-5% in 2018.
(US Census Bureau)
Both new and existing home sales have strengthened modestly into year-end. New home sales rose to a 733k SAAR in November, the highest rate since 2007. The headline number is deceiving, however, as the previous two months were revised lower and the TTM growth rate actually slowed from 8% to 7%. Existing homes were sold at a 5.81 million annualized rate in November, 3.6% above the November 2016 rate. This rate remains healthy by historical standards.
At around 7% per year, the turnover rate of existing homes is roughly in line with pre-2000 levels. Existing home inventory remains near historically low levels, primarily a result of the tepid pace of new home construction in the aftermath of the recession. Other effects are at play, too, including the increased institutional presence in the single-family rental markets and the rising rate of homeownership among the older demographics.
(US Census Bureau, NAR)
Home prices have risen at least 5% YoY in every month since late 2012. Median household income, on the other hand, has risen roughly 3.5% per year during this time. The Case-Shiller national index showed 6.4% YoY growth in October, up from 6.2% in the prior month while FHFA’s purchase-only index showed 6.6% YoY growth in October, slightly faster than the 6.5% rate in September. Zillow’s index saw home prices rising 6.5% YoY in November, slowing from the 6.8% in October.
Home prices have regained most or all of the ground lost during the recession. On a nominal basis, home prices are now 5% above the pre-bubble peak from 2006. On a real basis, however, home prices are still 12% below peak levels after accounting for the effects of inflation. Home price appreciation has settled into a tight 4-6% range since late 2014, which has consistently outpaced both rent growth and median income. We have been a bit surprised by the reacceleration in home prices seen in 2017 given the backdrop of moderating rents and declining homeownership affordability.
3 Reasons To Be Bullish On Homebuilders
1) Favorable Demographics & Positive Economic Backdrop
Demographics suggest a significant increase in demand for single-family housing, based on historical trends of homeownership preference. The average age of a first-time home buyer is 30-34 years old. There will be nearly one million more 30 to 34 year-olds over the next six years than the prior six years. Further, this cohort has experienced far better job prospects and income growth during their mid to late 20s as the prior six-year mini-generation.
Housing demand and household formation have historically exhibited a strong correlation with economic growth. More specifically, job creation and wage growth have been key determinants of demand for new homes. The US economy added 2.1 million jobs in 2017, the seventh straight year that job growth exceeded 2 million. Hiring growth has shown only modest signs of slowing, an indication that the long-dormant “slack” in the labor markets may be reentering the workforce.
(ADP, US Census Bureau)
While nominal wage growth has seen slow growth since the end of the recession, real wage growth continues to be modestly impressive, a result of low inflation. Real wages have seen one of the best periods of growth in 40 years. Real wages have increased 7.5% since 2014. Again, the combination of strong labor markets and solid wage growth have historically been a good recipe for single-family housing demand.
(US Census Bureau)
2) Housing Shortage Means Few Fears Of Oversupply
Single-family housing experienced a sustained period of overbuilding from 1995 to 2005, resulting in significant oversupply which eventually triggered the housing ‘bust’ and the subsequent financial crisis of 2008. The financial shock and devastation were particularly acute in the homebuilding sector. As we’ll discuss shortly, hundreds of small private builders went bankrupt during the crisis as credit markets froze up.
Single-family housing starts tumbled from nearly 2 million units per year in 2006 to just 350k units per year in 2009. Housing construction has seen a grindingly slow recovery since 2010, which has allowed the oversupply to be gradually absorbed. The pendulum appears to have swung as housing demand is now exceeding housing supply on a rolling 5-year basis.
(US Census Bureau)
Multifamily housing construction boomed in the aftermath of the recession but has pulled back considerably in 2017 amid fears of oversupply in certain higher-end apartment categories. If we are indeed at or near the end of the construction cycle, it’s fair to say that supply growth was more moderate than past cycles. Residential spending remains 45% below the 2006 peak after adjusting for construction inflation. Considering that the average age of the US housing stock is above 40 years, the higher rate of obsolescence will also act as a limit on supply growth. Overall, even if new single-family home construction surprises to the upside for several consecutive years, oversupply at the national level is unlikely to become an issue over the next decade.
(US Census Bureau)
3) Size Matters: Large Builders Expand Competitive Advantage
While our overall outlook on the homebuilding sector is more negative than Wall Street analyst consensus, we believe that the bifurcation within the sector will continue as the largest homebuilders expand their competitive advantage over smaller players. Access to capital markets was a key factor in the survival of large builders in the aftermath of the housing crisis. As shown below, the largest builders quickly recovered while smaller builders such as Beazer Homes trade for a fraction of their peak value. Of course, for hundreds of smaller builders, the equity value was wiped out during the downturn.
(US Census Bureau, YahooFinance)
Professor Michael Porter used the homebuilding sector as an illustration of the “Five Competitive Forces” at play in a 2003 presentation. With amazing precision, Porter correctly forecast that the competitive advantage of the largest homebuilders would expand over the coming decades, primarily a result of a regulatory environment that made it nearly impossible for small builders to compete. Land-use zoning and “Not-In-My-Backyard-ism” limits available land and serves to raise the barriers to entry by increasing the cost of construction and limiting margins.
(Harvard Business School)
As is often the case, government regulation results in consequences that are exactly opposite of the original intent: a higher concentration of power in the hands of fewer. The implications of this are that while the overall housing recovery will continue to be sluggish, the larger homebuilders should continue to outperform the broader sector.
3 Reasons To Be Bearish On Homebuilders
1) Constraints On Demand Remain: Affordability And Attitude
While favorable demographics and the strong economic backdrop seem to forecast robust demand for single-family homes, survey data and homeownership data indicates that millennials remain stubbornly out of the ownership markets. The combination of unaffordability and negative attitudes towards homeownership are key constraints that are unlikely to abate in the near and medium term.
The homeownership rate among households less than 44 years old has fallen considerably more than the overall rate since the recession and has been moving sideways since bottoming in 2015. The largest climb in homeownership rate in 3Q17, interestingly, was among the 65+ demographic.
(US Census Bureau)
First-time homebuyers made up 29% total existing home sales, down from 32% in October 2016. The rate of first-time homebuyers remains stubbornly below the pre-bubble level of 40-45% and the bubble-peak of 52%. Despite the occasional “click-bait” headline, we have yet to see the younger demographics enter the homeownership markets in any significant numbers.
An August 2017 survey by Experian revealed that attitudes towards homeownership have shown little sign of improvement in recent years. According to the survey, 27% of young consumers are not planning to buy a home in the next decade, up from 19% in 2016. For a generation that came of age during the financial crisis, the strong aversion to debt and the high-value placed on the optionality of renting remain significant hurdles keeping them out of the ownership markets.
While mortgage credit availability has loosened considerably since 2011, lending remains significantly tighter than the pre-recession period. Investors should not expect a return to the ridiculous sub-prime credit availability levels of 2003-2006 as mortgage lending standards and documentation requirements are closely scrutinized by regulators.
The total student debt outstanding is now $1.4 trillion up from $0.6 trillion in 2006. Surveys conducted by the National Association of Realtors continue to find that student debt significantly delays homeownership by as much as five years. 42% of 18 to 30-year-olds currently have student debt outstanding according to Harvard IOP.
2) Margin Pressure From Regulatory And Construction Costs
Rising construction and regulatory costs have explained much of the rise in home prices and have continued to pressure homebuilder margins. Construction costs have significantly outpaced inflation over the past five years and are the primary source of “tightening” in the construction markets.
Rising construction costs tend to discourage marginal new construction projects and increase the value of real estate assets by increasing replacement costs. Using the two most easily tracked cost measures, wages and materials, we estimate that construction costs from these components alone are rising roughly 3% YoY. Financing, land, and regulatory costs are estimated to be rising at faster rates.
(US Census Bureau)
The rise in the wage component of construction prices continue and is attributable to a shortage of skilled construction labor, an issue that is likely to be amplified by tighter enforcement of immigration laws. A Pew Research study estimated that 12% of the construction workforce is undocumented. A significant reduction or crackdown on undocumented labor can be expected to put upward pressure on construction costs.
The most significant driver of housing cost inflation in recent years, though, is regulatory costs related to land entitlement. A NAHB study found that government regulations account for nearly 25% of the final price of a new single-family home, an increase of 30% since 2011. Roughly two-thirds of these costs come during the permitting process and one-third comes from fees, taxes, and ‘unnecessary’ code-related guidelines that do little more than serving to drive up the costs of construction.
3) Affordability Is Weakened Further By Tax Reform
As described above, the apparent and obvious failure of the homebuilding and realtor industry lobbyists to favorably influence tax reform legislation should be a significant concern for investors. The NAR and NAHB are in the awkward position of either admitting to “bluffing” about the dire outlook for housing markets or remaining consistent by assuming a harshly negative outlook on their own industry.
We think the reality is somewhere in the middle: The changes to the housing market are not dire, but they are significant and should not be overlooked. Doubling the standard deduction, capping the deduction on SALT taxes, and lowering the cap on mortgage interest deductibility for homeownership all tilt the buy vs. rent equation towards the rent side.
We continue to discuss home price affordability (or lack thereof) and how we believe that rental demand will continue to surprise to the upside as potential homebuyers remain in the rental markets for longer than expected. In our Buy or Rent index, we continue view renting as the more affordable option for the average household. Tax reform will only exacerbate the affordability issues.
Valuation And Rankings Of Homebuilders
A notoriously cyclical industry, homebuilders have historically traded at discounted valuations to the broader US equity sectors. From 1991 to 2016, we estimate that homebuilders have traded for an average forward P/E of 10-12x. After the historic surge in 2017, homebuilder valuations appear stretched, averaging 14x.
Using a forward P/E and PEG ratio analysis, and under our belief that the largest builders will continue to outperform the smaller builders, we see value in PulteGroup, Lennar, and D.R. Horton.
Bottom Line: Go Big Or Go Home
A decade after the housing collapse, Wall Street is once again feverishly bullish on homebuilders. Homebuilders surged more than 60% in 2017 despite a disappointing 7% rise in new home sales. Size and scale have become essential for homebuilders. Stifling regulations, rising construction costs, and sluggish demand have squeezed margins and made it nearly impossible for smaller builders to compete. While the housing recovery is still in the middle innings, the constraints on new home supply continue to linger.
The rapid recovery in home prices since 2012 has made the economics of homeownership unfavorable relative to renting. Tax reform has tilted the scale even further towards renting. Homebuilders are banking on a wave of millennials flooding into the housing markets. Homeownership data shows little evidence of this as unaffordability and attitudes towards homeownership remain constraints on demand.
To the victor go the spoils. We remain negative on the homebuilding sector relative to consensus. Restrictive zoning (NIMBY), rising construction labor costs, and buyer affordability issues will continue to hold back the recovery. While the overall housing recovery remains lethargic, we expect continued bifurcation as the competitive positioning of the largest homebuilders has strengthened amid continued consolidation.
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Disclosure: I am/we are long VNQ, SPY.
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