Breaking News ….

April 9, 2022

Rising mortgage rates are clobbering home building stocks. Now may be the time to buy

Few sectors of the stock market have been hit as badly as U.S. home builders this year, as investors worry that rising interest rates will clobber demand for new homes.

The stocks are worth a closer look, though, if you can handle some ugly numbers: D.R. Horton Inc. DHI-N +0.63%increase, Toll Brothers Inc. TOL-N +0.20%increase, Lennar Corp. LEN-N +0.33%increase and PulteGroup Inc. PHM-N +1.04%increase have tumbled an average of more than 30 per cent in 2022.

There’s no mystery behind the dramatic downturn. With inflation bubbling at multidecade highs, bond yields have soared. That has pushed up mortgage rates and raised concerns about housing affordability.

This week’s release of minutes from the Federal Reserve’s monetary policy meeting in March added to the concerns, revealing that Fed officials have been considering aggressive rate hikes of half a percentage point each.

“Barring some really bad economic news in coming weeks, or miraculously good inflation news, the Fed looks to ramp up its tightening cycle,” Sal Guatieri, senior economist at BMO Capital Markets, said in a note this week.

For home builders, which have been coasting on low mortgage rates, the backdrop is challenging. But is the stock market overreacting?

By most accounts, the U.S. housing market is on solid ground. Even as 30-year mortgage rates climbed to 4.9 per cent in March – the highest level since 2018 – the number of mortgage applications actually nudged higher.

Matthew Pointon, senior property economist at Capital Economics, expects that mortgage rates shy of 6 per cent will support mortgage applications.

Housing starts, which measurehome-building activity, are also strong. In February, starts rose to nearly 1.77 million at an annualized pace, an increase of 6.8 per cent from January, and their highest level since 2006.

While confidence among home builders, as measured by the National Association of Home Builders, has declined for four straight months, the level of confidence remains strong. The latest reading is higher than it was in 2019, before the pandemic.

The deep sell-off in home-building stocks this year, then, reflects a sharp deterioration in the housing market that hasn’t happened yet – and might not happen for years.

That leaves a compelling bullish case that rests on strong housing demand, reasonable affordability and cheap stocks.

Daniel Oppenheim, an analyst at Credit Suisse, said in a report this week that the U.S. housing market has been defined by a supply deficit over the past seven years, meaning construction hasn’t been keeping up with demand.

He expects the deficit will remain wide through at least 2025, even with annual housing starts averaging 1.5 million.

Affordability isn’t a problem, either. While monthly mortgage payments as a percentage of household income have risen to 21 per cent, the ratio is not in worrisome territory, Mr. Oppenheim said. The historical average is 17 per cent, and the ratio climbed above 35 per cent during the last boom.

And the cost to rent a home is roughly balanced with the cost to own a home, despite rising home prices.

“This is a key positive and a sharp contrast from the 2004-06 housing boom, when the wide gap between the cost of owning and renting pointed to froth in the for-sale market,” Mr. Oppenheim said in his note.

As for stock valuations, a number of analysts are arguing that the sell-off has left them too cheap to ignore.

Susan Maklari, an analyst at Goldman Sachs, estimated that stocks in the sector trade at about their tangible book value, a substantial discount to the historical average of 1.5 times book value.

In late February, Bank of America analyst Rafe Jadrosich upgraded his recommendations on Toll Brothers and PulteGroup to “buy” after the stocks fell at the start of the year.

“In our year-ahead report, we noted that homebuilders stocks could face a challenging setup with rising interest rates. But valuations are now trading at the low-end of the historical range and the spike in mortgage rates is now already well known to investors,” Mr. Jadrosich said in his note.

The stocks have fallen further since the upgrade, highlighting the risk of buying too soon. But it could make the rebound sweeter if the housing market survives rising rates.

“We continue to see ample evidence from the field that current buyers remain deeply committed to purchasing a home and also have the financial flexibility to adjust to higher rates,” Buck Horne, an analyst at Raymond James, said in a recent note.

You May Also Like…

Before the Bell: May 16

Before the Bell: What every Canadian investor needs to know today Equities Wall Street futures moved higher early...

0 Comments

Submit a Comment