Is Your Portfolio Prepared For A Shortage Of Homes?

The housing market has been booming since March 2020. People are fleeing major cities for the spacious and affordable suburbs. This trend has caused housing prices to soar in suburban areas across America (especially the Southeast and Midwest), and the supply of homes cannot keep up with the demand. The inventory we see today for homes is minimal, and it continues to dwindle.

Fall 2021 marked the end of the 2020 mortgage forbearance period. In 2021, there were people sitting on backed mortgages with no way of paying them upfront. These homeowners essentially had two options 1) the homeowner could defer these backed mortgage payments to the end of the loan or 2) the owner could sell the house in the booming real estate market. The latter option was most likely exercised (seen in Chart 1 below) causing a small bump up in inventory listings in the last part of 2021. However, since the end of 2021, housing inventories have fallen harder than before. Below in Chart 1 is the housing inventory in the United States. You can see the massive decline from 2019 to 2021 and the slight pick-up last fall in supply. A new supply of homes is needed to meet demand or home prices will continue to rise across the nation to unaffordable levels for the majority of the population.

Chart 1: Housing Inventory (FRED/Realtor.com)

Enter in home builders. The supply of new homes needs to come from somewhere, and the domestic home builders are likely to prosper more than we have seen in just the last year. The problem is home builders have supply constraints and labor shortages limiting their expansion. Though this is a major problem to get the supply of homes out to the market, this problem can be an argument to further the runway for this investment thesis into a multiyear outlook instead of one year or less.

Below in Chart 2 from FRED, you can see housing starts are still well under the early 2000’s real estate market starts. The housing starts are, however, accelerating fast from the lows back in 2020. I believe we have much more room to grow here as the market can easily get to the mid-2000’s level, which would be a 30% or more increase from here.

Chart 2: New Single Family Housing Starts (FRED)

The counterargument to this investment thesis is mortgage rates are rising rapidly, and the Fed is going to continue to raise interest rates to offset inflation. This is correct, and mortgage rates definitely play a role in the real estate market. However, a look at Chart 3 below shows us that the level of fixed 30-year mortgage rates in 2022 are not even close to what they were in 2006-2008 when the real estate bubble grew to extreme levels. At 5% interest rates today, we are still 25% below early 2000’s levels and houses were being built much more aggressively back then than they are today. I do not think a 1% rate increase in the next year will slow this movement at all. Even a 2% increase will only get us back to pre-financial crises mortgage rate levels.

Chart 3: Average 30-Year Fixed Rate Mortgage in the U.S. (FRED)

Now that the thesis for home builders is laid out, the key is picking the right companies to take advantage of this long-term trend. Two of the largest companies by market capitalization in this space are Lennar (LEN) and D.R. Horton (DHI). There are also some smaller home builders that have potential in this market based on geography. I am only going to touch on three companies here at a high level based on my research: DHI, LEN, and PHM.

Fundamentals:

The rotation of the stock market from high flying growth stocks to value stocks has just begun. With the value sector being unloved for almost a decade, there are a lot of strong companies to choose from in the real estate sector to capture this rotation in your portfolio.

DHI:

DHI is trading at a Price to Sales of 0.7x and a Price to Book of 1.7x. Compare these ratios to your favorite FAANG stock with an average Price to Sales of 5x and average Price to Book of 10x (even after multiple 20% draw-downs in these mega-cap names) and you begin to see the disconnect. DHI is building itself to hold a stronger balance sheet as well. The company has kept debt flat while buying back shares every year for the last several years at an increasing rate. The company is producing positive cash flow, which grew at an annual rate of 20%+ from 2017-2020. DHI has beat earnings estimates for the last 7 quarters by a good margin (5-20% beats).

A potential red flag with DHI is there has not been any insider buying for years with the stock, but a lot of exercising of options/ insider selling has occurred. This lack of insider buying seems to be a theme among major companies right now though, but I am flagging this as a risk to the thesis. If the insiders are buying, especially heavily, you should take notice. The same is true for the opposite as well.

On top of this, there have been significant labor shortages in the United States, especially in the construction industry, causing jobs to be done slower or not at all. This trend could drastically hold back efficiency and production for the DHI and the housing market. The last red flag here is the home building sentiment is at a one year low, which is not saying much in a super-hot market. However, this is something to look out for in judging an investment in all of these companies.

LEN:

LEN has been a value stock for some time now. The company currently has a book value per share of $70 and the stock is trading near $77. Taking out any potential for further gains, this company is almost trading at book value, which gives us a good margin of safety for holding the company. LEN has also produced an average ROE of close to 13% over the last 5 years and the company currently has a Market Cap to NTM Cash Flow of 11. With a NTM P/E ratio of 4.5, this is an excellent fundamental back drop for a company estimated to grow an average of 10% per year for the next 3 years.

The company has purchased back stock aggressively for the last 3+ years. This along with the repayment of debt has cleaned up their balance sheet from a debt to equity of 99% in 2017 to 31% in 2021. A huge improvement from a few years ago and exactly what you want to see in a financially competent management team.

PHM:

PHM is a smaller company, but still a value stock. The company has a book value per share of $31 and the stock is trading just above $40. PHM has also produced an average ROE of close to 20% over the last 5 years, and the company currently has a Market Cap to NTM Cash Flow of 6. The last 12 quarters, PHM has beat earnings estimates 10 times. The company has expanded their EBITDA margin over the last 10 years from 5% in 2012 to just under 19% today. With a NTM P/E ratio of 4, this is an excellent fundamental back drop for a company with consensus growth estimates of 15% per year for the next 3 years.

The downside to PHM is there have been no management stock purchases recently. The company has bought back shares for years at variable amounts, but of the two executives who made transactions in the last 12 months, both sold shares. Additionally, PHM is a smaller company compared to LEN and DHI, which has its own set of challenges in a competitive market.

Conclusion

We are entering back into a financial market environment where cash flow is more important than revenue multiples, and essential business operations are more valuable than the latest fad. It is important as investors to wake up to the fact that America is in desperate need of homes as the next generation moves from the “young professional” stage of life to the “family matters” stage. This movement can only be a benefit long term for these home builders.

Disclosure: Funds I control are long PHM.

Note: This post consists of high level commentary on research conducted by Tetelestai Capital, LLC into a few companies in the home building space. Though compelling, your own research should always be done before investing into any security. This post should not be viewed as investment advice. If you have any questions about the research Tetelestai Capital conducts, please reach out through the website for more information.