America Builds
The Recent Outperformance of Homebuilders Could Last
Since the beginning of the year, Homebuilders' equities have been markedly outperforming the broader market. Despite the rise in mortgage rates, demand for housing has continued to rise. The combination of low housing stock, consumer demand, and strong balance sheets has buoyed demand for the granddaddy of all consumer goods. We dig into the macroeconomic and demographic reasons why homebuilders are doing so well.
Industry Structure and Key Players
Residential investment comprises 4.6% of US GDP on average over the post-war era. The Homebuilding Industry in the United States is large and fragmented and one in which only a handful of large public companies compete. Growth rates have increased from a muted .85% in 2018 and 1.8% in 2019, to an extraordinary 5.97% in 2020. In 2022 the Homebuilding Industry was estimated to have a market value of $129.3B, of which the top three public companies (D.R. Horton, Lennar Corp, and Pulte Group) combined for just under 60% of the total.
Homebuilding is highly capital intensive and very sensitive to the business cycle. Between 2007 and 2009, real GDP in the United States contracted by 2.5%, while residential investment contracted by a staggering 41%. Companies must invest on the basis of forecasts that extend several years into the future. Once they commit to their strategy, changing it is like steering an ocean liner. Homebuilders therefore face an acute tradeoff between overbuilding and underbuilding, and after their collective bad experience of 2007, have been cautious and pursued (read: over-pursued) balance sheet robustness at the expense of capturing growth. For example, in the wake of 2007-2008, the industry leaders had to take massive write downs to reflect inventory that was suddenly worth far less than it had cost to build:
DHI: $2.5B, 2008
LEN: $1.9B, 2007
PHM: $2.3B, 2007
TOL: $756MM, 2009
As an industry, the concept of revenue drivers seems simple enough – homebuilder revenue follows the cycle of real estate prices but there are additional underlying drivers to support the growth of homebuilder industry. Chief among them is the growth of household formation, which in recent years has been fueled in part by the entrance of the millennial generation (nearly 66 million of them) into the home ownership market. According to the National Association of Realtors as of April 2022, millennials (those born between 1981 and 1998) now make up 43% of homeowners and have represented the largest cohort of homeowners since 2014.
Homebuilding companies operate based on the following models:
Buy land and develop into new homes (undeveloped or developed lots)
Buy contracts on land with option to develop
Buy options on fully developed land
Key costs for the industry include:
Cost to acquire land
Labor (construction, usually sub-contractors)
Sales (usually in-house teams on commission)
Commodities such as lumber, steel, and concrete
Critical factors to the risk evaluation include:
Inflation (which until recently would not have materially impacted the market, but the industry faces in the current environment)
Supply chain management/inventory impairment (which, of course, during the pandemic, was materially impaired)
Cancellation exposure due to the period between contract and delivery of home (mitigated in part by deposits, etc., but inventory carrying costs are significant in the industry)
The home builder industry has in recent years benefited from rising per capita disposable income, accommodative interest rates and improving macroeconomic conditions prior to the pandemic. Housing shortages and mass relocations created willing buyers, which ignited a rise in home prices and a significant ramping up of production by dedicated home construction firms. While this additional demand has abated recently due to the rise in home prices and mortgage interest rates, it continues to increase despite secular headwinds.
Key Trends
The Homebuilding Industry is in a period of expansion. Favorable demographic drivers and financial discipline have combined to stand the industry leaders in an admirable position to capture economic profit. As you can see from the chart below, the United States was over-housed with regard to its population level. Due to the forced liquidation of homes and the impact of foreclosures on non-foreclosed homes, home prices in general took a beating. Consider the S&P/Case-Shiller US National Home Price Index:
The fall in house prices occurred over a period of six years from 2006 to 2012. Homebuilders had responded to the runup in prices in 2004 with a commitment to build and kept building until 2008 when it became clear that supply had far outstripped demand, resulting in the fall in house prices seen in the prior chart. It took approximately 11 years to work off the excess inventory, as you can see below in the Housing Inventory Estimate chart, which shows total housing units per population level.
So, while current demand is robust, it appears to be in response to clear demographic factors, rather than speculative exuberance. Typically, demand growth in the homebuilding industry is dependent upon household formation. While household formation is in turn dependent upon population growth and net immigration, it is also influenced by the size and composition of households. Whereas historically households were comprised of married heterosexual families, more untraditional households have begun to emerge as well, and accordingly the rate of household formation has risen above the rate of population growth. (See Figure 2, Growth in Households, 2000-2021.)
The Homeownership Rate in the United States spiked during the COVID-19 pandemic as Americans bought homes at rates unseen since 2007. That spike subsided as restrictions subsided, relocation rates settled, and the temporarily displaced returned to the cities they had earlier fled. After a moderation, it has begun to trend higher once again. This is a welcome development for a housing industry that, burned by the oversupply and massive inventory write-downs following the GFC, remains reluctant to invest in building a lot of inventory.
Theoretically, renting a home is a substitute for buying; thus, their prices—rents on the one hand, and principal and interest payments on the other—should move inversely with each other. However, prices to rent and to buy are rising at once, signaling a supply-demand mismatch that is working itself out in the form of a higher clearing price for shelter in general. In the chart below, you can see that Mortgage Payments and Rents have been highly correlated, indicating tight supply. The chart below shows that the inverse correlation one would expect has reversed in the second half of the last twenty years.
Median principal and interest monthly payments to own are keeping pace with the price of renting. As you can see from the chart below, after achieving near parity in the trough of the pandemic slump, they have risen to 1.44 times the median asking rent. Owning is still more costly than renting, and though deductibility of mortgage interest, state and local taxes has been impacted by the Tax Cuts and Jobs Act of 2017, the two have not wildly diverged. Indeed, the top quartile of monthly mortgage payments is below the median asking rent, meaning that buying is a better deal for the most creditworthy consumer.
Although interest rates have trended higher as the Federal Reserve attempts to damper down inflation, mortgage rates are not so high as to prove overly burdensome to new buyers. Given higher home prices and higher mortgage rates that haven’t been seen since the days before the fall in global yields, mortgage credit is still being extended to creditworthy buyers as is evident in the chart below. Mortgage credit availability is on a par with the average of the last fifteen years, though not so much as during the low-interest rate regime of the quantitative loosening epoch we’re now seeing the tail end of.
The median payment for conventional loans implies an average home price of $375,000 – 400,000.This suggests that homebuilders who build homes with a finished price around this level will find the largest market for their inventory.
In the chart below, you can clearly see that the average mortgage size has come down over the last six months to something that approximates their longer-term average. Our expectation is that prices will stabilize in this range, while builders cut amenities or square footage to accommodate their consumers’ preferred price point. Furthermore, as the cap on SALT and mortgage interest deductions have put pressure on home prices at the upper end of the market, we should expect to see greater demand toward the middle of the market.
As aforementioned, the largest demographic group since the Baby Boomers is now entering the housing market. Approximately 65% of new buyers are buying their first home or move-up home, indicating that it is the builders of these homes that should first benefit from the demographic wave.
Further, the US population is shifting away from former population centers and toward the sunnier, warmer, and less-developed sun and sand belt. Here, lower cost of land, easier zoning, year-round construction, and lower cost of labor favor the development of tract housing as compared to the Northeast and Midwest, which have seen both population declines and lower homebuilder activity.The chart below shows those markets that have seen the largest number of mortgage applications to buy in the United States.With a couple of exceptions where we see fast growth due to base effects, buyers are looking to purchase in the south and west.
Approximately 80% of residential growth in 2021 was in suburban areas and small towns, rather than cities or urban areas. These buyers are no longer focused on urban areas, where zoning laws inimical to new construction have inflated prices too high for those seeking to buy at the entry level. This affordability crisis, coupled with the increased prevalence of remote work, has seen more first-time and step-up home buyers seek more square footage in suburban and exurban, small-town locales.
Primary Performance Metrics
Return-on-Equity
Return on Equity is perhaps the most important performance indicator for homebuilders. Homebuilders are primarily equity-funded and carry very low amounts of leverage. To attract equity capital—which sources include banks, hedge funds, private equity, and insurance companies—they must offer very high levels of return on equity.
Inventory Turnover
Inventory Turnover is similarly critical for homebuilders. They make significant investments in inventory and have to turn it over quickly to satisfy the providers of debt and equity capital. It’s high sensitivity to the business cycle, changes in interest rates, and changes in mortgage rates mean that it needs to sell homes quickly or else be saddled with losses due to carrying wasting assets. A high turnover ratio indicates that it is building homes and then offloading those homes to buyers in an efficient and expeditious manner. As evidenced by the huge write-downs in the aftermath of the GFC by the industry incumbents, unsold inventory is a sizable risk exposure.
Debt-to-Equity Ratio
While Return-on-Equity is important to the providers of equity capital, homebuilders nonetheless make substantial use of debt in their operations. Yet the largest companies in the homebuilding sector carry surprisingly low levels of leverage, in many cases .3 Debt-to-Equity ratios or less. The primary source of debt financing for homebuilders are banks, and banks—often due to their own capital regulations—are reluctant to lend to homebuilders without very healthy balance sheets. For this reason, homebuilders tend to have very low Debt-to-Equity ratios so that banks are not precluded to them as a source of debt financing, both because they have the largest ability to lend, and because they have the lowest cost of debt capital.
Key Success Factors
Costs of Real Estate, Commodities, Labor Do Not Exceed Sales Price
In many ways, Homebuilders are like retailers, but for the largest good a person will ever buy. When they manage their input costs well and sell it at their target price, then they can realize large margins over time on large quantums of capital.
Demand for Housing Stock Is Robust, and Supply Is Not
The Homebuilding Industry is highly cyclical. Strong economies make people confident in the future and encourage them to make large financial commitments. When housing stock is tight, then selling prices are higher, supporting margins.
Inventory Turns Over Quickly
High Return-on-Equity and low Debt-to-Equity depend upon quickly building and selling inventory. When inventory turns over quickly, Homebuilders can reinvest their capital quickly and further support a virtuous cash conversion cycle.
Key Risk Factors
Input Cost Inflation
Higher input prices are problematic for homebuilders for two reasons. First, homebuilders contract to build homes in advance. They take deposits and agree upon a final price which they receive upon completion. High inflation can cause the cost of goods and labor to rise from the time of contract agreement to the time of completion, which period of time averages 12-18 months. At 5% inflation, the homebuilder surrenders 33% of its margin.
The second reason is that, in order to combat uncontrolled price increases, the Central Bank must raise the interest rate to cool down the economy. Since the interest rate is the basis of the mortgage interest rate, higher interest rates mean higher mortgage rates, which mean higher monthly payments for homeowners and a reduced ability to finance higher home prices. Lower home prices mean lower margins for homebuilders.
Economic Contraction
When the business cycle turns from expansion to contraction, demand destruction occurs for all goods, but most of all for big-ticket items like durable goods and housing. Given that homebuilders employ leverage, they are especially exposed to economic downturns.
Inventory Impairment
Demand destruction leads to lower selling prices and longer inventory turnover cycles. When a homebuilder has a reasonable belief, either through experience or market comparables, that they will not be able to recoup the costs incurred in the building of inventory, then they are required to record an impairment of inventory. This reduces assets, which reduces equity, and worsens the Debt-to-Equity ratio. It also reduces margins, which further impacts Return-on-Equity.
Conclusion
The homebuilder industry is vastly fragmented, with a core of key players. While competition is fierce (amongst the industry mainstays and with resale properties), the industry is not a zero-sum game: there is room for multiple successful players.
Companies that focus on energy efficient healthy homes built and purchased on spec for entry level homeowners in the Sunbelt will support near and sustained growth. This underserved market, exploding in breadth given the new generation of homeowners, requires affordability (and they care about environmental sustainability). The challenges facing these companies aren't meaningfully unique to their strategy and reflect mostly general market and environmental realities, the key one being supply shortage (cancellations are, in part, a byproduct of inventory strain resulting from such shortages).
Companies with a historically disciplined approach to financial management, including as to land acquisition underwriting and thoughtful expansion practice should prime them for the ability to weather housing cycles. Moreover, thoughtful attention to consumer experience (online to in-person), and deep understanding of the market’s needs and desires, will help to support these companies' ability to consistently serve the market as it evolves over time.
A willingness to experiment in the build-to-rent space provides an interesting datapoint to evaluate the riskiness of these companies' growth strategies. Understanding a practical shift arising from economic and market conditions away from the capacity or willingness for home ownership, the entrance into the build-to-rent market would not constitute a pivot, but rather a tiptoe into a tangential market in which agile companies are primed to leverage their existing competitive advantages. Of course, as buying and renting are substitutes for one another, it may provide these companies with a solution to their Days of Inventory Outstanding problem, and insulate them from the risks of economic contraction to some degree.