It seems almost universally accepted that we are on the verge of a homebuilding renaissance. The widely held belief is that this resurgence will not only boost the construction sector, but also maintain growth throughout most of the economy.
Recently, homebuilders like D.R. Horton (DHI), PulteGroup (PHM) and Lennar (LEN), have all benefited from this optimism. Their stocks have risen tremendously over the past year. But there is a concern that expectations for the industry, and especially the pricing of homebuilder stocks, may have become a bit overoptimistic. Some evidence might suggest that future gains in home building might not be as large or as protracted as currently priced into the market.
There are three factors that may restrict future homebuilder gains.
1. Sustainability of home buying demand
The sustainability of current home buying demand may be difficult. Recent home sales data seems to show a substantial number of investor buyers are driving results rather than homeowner buyers. Evidence of significant investor activity can be found in reports that indicate up to 30% of homes in some areas being bought for cash. It is likely that cash buyers cannot sustain demand for homes. The majority of these buyers are probably purchasing for investment. Some may be hoping to buy property at a distressed price and flip it to get a relatively quick capital gain. Others may be looking to hold for a longer period and take advantage of a good rental market.
A trend in buying single-family homes to rent could be entering a mini-craze phase. There has been huge institutional interest in this area. It has been reported that homebuilders like Beazer Homes are setting up entities to increasingly purchase and hold a portfolio of single-family homes for rent. Others have gone further and created single-family home rental REIT’s to specifically scoop up distressed properties. The first publicly traded ones have hit the market with Silver Bay Realty and Altisource Residential.
It looks like the single-family rental boom has been a major influence in the current housing demand and price rise. While it may continue to be good in the short-term, the sustained benefits are questionable over the long-term. The meaningful addition of single-family rental properties, plus other rental properties, may reduce demand from the main driver of the housing market, the owner-occupying buyer.
Besides the increase in single-family properties, traditional multi-family rental capacity also seems to be on the rise. For example, homebuilder Toll Brothers is expanding its rental operation. Toll plans to develop around 600 apartments in the Washington D.C. area. The company is already building a like number of rental units in New Jersey and Pennsylvania.
Homebuilder Lennar is also expanding its multi-family presence. It recently announced plans to start construction on about 3,000 apartment units in 2013 with total development costs of about $560 million.
This increased rental capacity, either single-family or multi-family, could provide a longer-term headwind for housing demand by the critical live-in-owner buying segment.
2. Sustainability of home price gain
The sustainability of home price gains may also be difficult. The housing collapse seemed to prove the general economic thesis that home price rises should follow the same trajectory as that of income growth.
Data from periods before the housing bubble indicate that home prices usually rise, on average, roughly 2.5x the gain in personal income. Personal income being the median weekly average hourly earnings for full-time and salary workers.
Personal incomes rose around 2% in 2012. This indicates an anticipated average home price rise of about 5%. Given the recent price rise of about 7.4% year-over-year, it might be expected that future gains could be limited.
3. Sustainability of homebuilder valuation
The price rise in homebuilder stocks may be hard to sustain. Homebuilder metrics have certainly risen from their trough, but share prices may have already anticipated more than enough business improvement.
In 2006, near the height of the housing bubble, homebuilding stocks showed an enterprise value (stock market equity value plus long-term debt) to sales ratio of 1.05x to .86x. D.R. Horton had an enterprise value (EV) of $14.6 billion on sales of $13.9 billion, Pulte had an EV of $13.4 billion to $14.7 billion in sales and Lennar's EV was $12.0 billion with sales coming in at $13.9 billion.
Using a metric of EV at 1x sales, D.R. Horton would have an EV of roughly $6.8 billion based on analyst fiscal 2014 revenue estimates. Its corresponding equity value would be $4.5 billion or roughly $12 per share if it was to match 2006 valuation levels.
Pulte would have an EV of $6.2 billion based on analyst 2013 estimates and its equity value would be about $3.2 billion or $8 per share, Lennar with an EV of $7.0 billion based on fiscal 2014 estimates would have an equity value of $3.0 billion or about $13 per share to resemble a 2006 valuation comparison.
There is little doubt that there is a housing recovery going on, but there also seems to be evidence that expectations to its scope and duration might be too optimistic. Investors may want to be cautious when considering the sector. Any disappointing data might cloud the current sentiment and could meaningfully alter valuations to homebuilder shares.