We’ve been writing about the attractiveness of home builders for awhile and finally have decided to pull the trigger on buying D.R. Horton (DHI, Financial) for one of our stock portfolios. (Full disclosure: We’ve bought the stock for some clients and once a few portfolio and tax housekeeping measures are done we plan on buying it for the remainder of our clients).
Previously we wrote about several economic trends that made the housing market attractive and why we liked D.R. Horton and Lennar (LEN, Financial) the best of the publicly traded builder stocks. So, we figured it’s fair to finish up by sharing the last of our research and what finally convinced us to pull the trigger and invest in D.R. Horton.
In the previous articles we showed how homes were becoming more affordable due to falling commodity prices, the home ownership rate looks like it might finally be bottoming out, and most importantly millions of previous homeowners who suffered foreclosures during the financial crisis will have that derogatory item removed from their credit report.
But before we can confirm our thesis we have three important questions to answer. Do people still want to own a home or is renting better? Can people afford to buy a home? And finally, does the country need a significant number of new homes built to satisfy new demand?
Is home ownership desirable?
The U.S. is rather unique internationally with an above average rate of home ownership. Home ownership has always been the quintessential American dream and viewed as one of the “punch card items” of becoming an adult. However, the financial crisis may have changed all that. How attractive is home ownership these days?
From a financial standpoint, home ownership is quite desirable. A recently released study by Trulia found that buying a home was roughly 23% cheaper on average for young adults (25 to 34) than renting a home. Indeed, they found that buying beat renting in 98 out of 100 markets. Now given that the study was released by Trulia we can assume it probably had some bias toward making purchasing a home look better so I’d encourage you to read the entire study and its methodology here.
Taking a look at some unbiased data from the Federal Reserve and U.S. Census Bureau we can see that rental vacancy rates have plummeted from 11% at the height of the housing boom to below 7%.
This is a pretty good indication that the rental market is tight and although Trulia may be biased due to the nature of its business the study is probably spot on. The next question is if buying is better than renting, is buying a home affordable for most people?
Is buying a home affordable?
The biggest issue for many is the fact that a new home is just not affordable because of the required down payment. Average home prices are around $300,000, which means a $30,000 down payment (at minimum). For millennials saddled with large student debts it’s tough to save up the required down payment. It’s also likely going to be tough for people who suffered through a foreclosure due to the recession to save up for a down payment as well. In fact, it’s tough for anyone. Most Americans report having less than $1,000 in savings!
On the other hand interest rates and thus mortgage rates are at record lows. The chart below shows that mortgage debt service payments as a percentage of disposable income is near all-time lows.
The affordability issue is the biggest risk to our thesis. In the end we believe that a combination of the financial attractiveness of buying versus renting, a continually (slowly) improving economy and loosening lending standards (lower down payments) will drive a sustained rebound in housing. We are also betting that the American dream of home ownership is still alive in most and people will find a way to save up what’s needed for a down payment.
Do we need new homes?
Even if we establish that the housing market will see an influx of new buyers that doesn’t necessarily mean that home builders will prosper. It could be the case that the previous housing bubble means a sufficient stock of single family homes exists to satisfy potential new buyers and a significant number of new homes aren’t necessary.
We don’t believe that is the case. The graph below shows the absolute number of vacant housing units available.
The number of vacant homes has steadily decreased since the height of the recession.
More important is that the vacancy rate (the number of vacant units in proportion to the population) has fallen to 1.8% which is close to its pre-bubble number which looks to be around 1.4% to 1.6%.
This is pretty good evidence that the current housing stock is inadequate to support a sustained upturn in demand and that many new single family homes will need to be built.
There is the possibility that there is a stock of previously foreclosed homes or single family rental units that could simply be sold as demand picks back up. This is highly unlikely.
Take a look at the condition of many foreclosures and rental units in the market. Most will need a decent amount of work to bring them up to the same condition as a typical used or new home. I’ve also spoken with several realtors, and there is little demand for homes that need work. They say that the vast majority of their clients are looking for move in-ready homes.
Summary
There is a pretty good amount of evidence that the demand for new homes will pick up over the next half decade. D.R. Horton has an attractive combination of geographic diversity and average home sale price point to take advantage of this trend. We feel that the answer to two of our biggest questions was yes (buying is better than renting and new homes are needed) and the answer to our third question was a “maybe.” In the investment business no thesis will ever be perfect and no investment will ever be riskless. We think two and half out of three ain’t bad so decided to move ahead with an investment in D.R. Horton.
Disclosure: We own shares of D.R. Horton in some client accounts
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