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Take a Guarded Approach to Homebuilders

Yes, the sector is on the upswing, but the market has already priced in a rebound.

Basili Alukos, CPA, CFA, 10/22/2013

For much of the past decade, the housing sector has dominated the economic news. There was the run-up in prices from 2002 until 2007, resulting in rampant house flipping and a bubble. The bubble burst in 2008, causing a worldwide financial crisis. For much of the time since, housing has been a drag on the economy, as ruined credit and high unemployment killed demand. Over the past 12 months, however, optimism in the sector has risen, and home building and housing-related stocks have rallied. Has the housing sector turned the corner? To find out, I sat down with Morningstar industrials analyst James Krapfel. Our discussion took place Aug. 13.

Basili Alukos: I’d like first to lay a foundation for where we’re at in the sector. How do you judge the health of the market?

James Krapfel: We look at the new-home sales market, which includes single-family sales as reported by the U.S. Census Bureau, and our estimate of multifamily sales, because of its direct impact on the homebuilders that we cover. From 1964 to 2001, industry cycles were relatively modest in amplitude. Average new-home sales were 746,000 per year during that period.

But then, of course, we had the boom in housing from 2002 to 2007. New-home sales peaked in 2005 at 1.4 million. We estimate the industry built a surplus of 2.6 million homes during that period. During the ensuing housing recession of 2008 to 2012, we estimate that the surplus narrowed by 1.7 million homes to a surplus of 900,000 homes. With approximately 480,000 new-home sales expected for 2013, we estimate that that surplus has narrowed by a further 250,000 homes to under 700,000. Meanwhile, new and existing home inventory points to undersupply as months’ supply of inventory remains near historical lows. We think that this bodes well for new-home sales over the next several years.

Two key factors drive new-home sales. One is the household formation rate, and that has started to recover. People are moving out of their parents’ houses. Second is the home ownership rate, which rose very strongly during the housing boom, but has since corrected somewhat. We expect that to correct further going forward, but at a decelerated rate, and believe the new-home sales market should cyclically recover over the next few years.

We forecast the new-home sales market to progressively rise to 830,000 by 2017, our midcycle year, from 391,000 in 2012 and near the historical average of 790,000.

Alukos: What’s been the driver of a recent improvement in housing sales?

Krapfel: Investors have played a key role to get the housing supply/demand equation more in balance. Cash purchases as a percent of total purchases spiked during the downturn. You saw a lot of companies such as Blackstone BX go in and buy single-family homes to rent out to people. Large companies were formed based on this business model, with three having gone public since late 2012. This phenomena has helped to bring the supply of homes on the market down, which helped stem the decline in housing prices. In 2012, prices stabilized and started to move meaningfully higher. Also, although credit standards remain tough, they have started to slowly improve. The job market is still not great, but the unemployment rate continues to trickle down.

Basili Alukos, CPA, CFA, is a stock analyst with Morningstar.

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