We are seriously considering adding investments in D.R. Horton (DHI, Financial) and Lennar Corp. (LEN, Financial) to our portfolio.
At first glance they might not seem like great investments. The businesses are extremely capital intensive with builders needing to hold on to huge tracts of a land (which take years to permit and develop) and large inventories of spec homes. Companies also face intense competition from other national homebuilders as well as local and regional players with no real ability to distinguish their products from competitors.
A well built good quality home from National Builder ABC Co. is just as good as the same size and style home built by Joe Bob Local Builder a half mile down the road. As such operating margins hover around 10%, and it’s a struggle for returns on capital to reach double digits, why would we want to buy either of these companies? Well, they are cheap and have tremendous growth prospects.
We’ve gone over the macro case for homebuilders in a previous article. In that article we pointed out several important trends that should benefit the housing industry.
First, the price of raw materials (particularly lumber) has dropped substantially over the past few years, which means profit margins may expand for homebuilders or they may elect to pass on savings via lower home prices to drive sales. Either way it’s good for builders.
Second, we are reaching the seven-year anniversary of the foreclosure peak from the housing crisis, meaning that over the next two years many people will see past foreclosures fall off their credit reports and will now be eligible for mortgages at reasonable rates.
Third, the millennial generation is in the decades-long process of reaching its peak earnings and household formation years which should increase the demand for entry-level housing. If you want to read more about the macro thesis you can read our article here.
We are most interested in D.R. Horton and Lennar because of their price, size, geographic diversity and market position in the industry.
Horton trades at below market P/E of 14 as does Lennar with a P/E of under 13. Over the past five years and the current trailing 12 months both companies have generated annual revenue growth of 21%. Of course much of that was coming off the recession and recently revenue growth has slowed to around 4% year over year for both companies.
Both companies sell relatively affordable homes. According to the U.S. Census Bureau the median (weighted monthly) sale price for a new home in 2015 was $294,950. Horton's homes had an average sale price of $285,700 in 2015 making it more of an entry-level builder. Lennar had an average selling price of $344,000 in 2015, which was slightly above the national average.
The reasons why we don’t like the other major homebuilders as much as Horton or Lennar are below.
Toll Brothers
Toll Brothers (TOL, Financial) is a luxury home focused builder and delivered homes with an average total sale price (base plus added features) of $780,000 in its last fiscal year. Because newly formed millennial households and buyers coming off previous foreclosures will make up a large portion of the growth in the housing market in the years to come, Toll Brothers probably will not see as much growth as the lower price point home builders.
Pulte Group
Pulte Group (PHM, Financial) is currently embroiled in a battle between the outgoing CEO and the founder (along with his grandson) over the direction and strategy of the company. The company’s average selling price for homes in 2015 was $338,000 which was more than Horton but a tad lower than Lennar. Perhaps more importantly Pulte has been very conservative in purchasing and developing land resulting in sales growth well below peers. While the conservative strategy may be prudent in a downturn, it takes a long time to buy and develop land; even with a more aggressive strategy in place with a new CEO, Pulte may miss out on the wave of new homeowners that is coming.
NVR Corp.
NVR Corp. (NVR, Financial) could be a decent choice since the builder is concentrated in the less volatile Eastern regions of the country. However, the company has an average sale price of $379,900 in 2015 which is a good bit above the national median.
KB Home
KB Home (KBH, Financial) gets almost half of its sales (46% to be exact) from the west, primarily California. California happens to be the most volatile real estate market in the country along with Phoenix and Las Vegas (also in the West of course). We’d prefer to invest in a builder with a more diversified geographical exposure.
CalAtlantic
CalAtlantic (CAA, Financial) has two strikes against it for our purposes. It’s a luxury focused builder with 85% of its home sales classified as luxury or move-up homes, and its average selling price of $477,000 in 2015 is well above the national median. It’s also the builder with the second most exposure to the West with 29% of deliveries coming from that region.
Mortgage origination issues
Our reasons for thinking about buying Lennar along with Horton despite Horton seemingly looking like the best fit (lower average sales price and lower exposure to California) have to do with homebuilders' mortgage origination practices. Almost all national homebuilders originate and hold for sale mortgages related to the homes they build and sell. Most home builders do not have any interest in becoming a bank and mortgage servicing company so they eventually sell off all the loans they originate. However, the loans they sell come with certain representations and warranties.
From D.R. Horton's 10-K:
Mortgage loans are sold with limited recourse provisions derived from industry-standard representations and warranties in the relevant agreements. These representations and warranties primarily involve the absence of misrepresentations by the borrower or other parties, the appropriate underwriting of the loan and in some cases, a required minimum number of payments to be made by the borrower. The company generally does not retain any other continuing interest related to mortgage loans sold in the secondary market. The majority of other mortgage loans consist of loans repurchased due to these limited recourse obligations. Typically, these loans are impaired and some become real estate owned through the foreclosure process.
The subprime mortgage crisis should be all the proof you need that the loan origination process is foolproof and that mistakes and misrepresentations can be made by borrowers and originators alike. Because of that the homebuilders can be held liable and made to repurchase previously sold loans (usually at a steep loss to them). Here is the relevant section from D.R. Horton’s 10-K showing their loan loss reserves.
The company has recorded reserves for estimated losses on other mortgage loans, real estate owned and future loan repurchase obligations due to the limited recourse provisions, all of which are recorded as reductions of financial services revenue. The loss reserve for loan repurchase and settlement obligations is estimated based on an analysis of loan repurchase requests received, actual repurchases and losses through the disposition of such loans or requests, discussions with mortgage purchasers and analysis of mortgages originated. The reserve balances at Sept. 30, 2015 and 2014 were as follows:
In the wake of a crackdown on lending standards and a (slowly) growing economy it’s no surprise that loan loss reserves are currently low (Horton made roughly $750 million in profit in 2015). However, when the economy heads south or if we have another real estate bubble loan loss reserves can climb and start to become meaningful. For instance, in fiscal year 2009 Horton had book loan loss reserves of $43.6 million.
It can be very difficult to detect small changes in a company’s lending practices. Deterioration of lending standards is often a gradual process. A small change to down payment changes here, lax income verification there, some aggressive accounting over here, and on and on over the course of years. Additionally, it can be very hard for an investor to corroborate management’s estimates of potential loan losses. Because it can be hard to detect we feel more comfortable buying a few home builder stocks that meet our criteria to help protect ourselves (and our clients) in case we miss something potentially catastrophic in a company’s loan operations.
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