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By Jeremy Glaser | 05-20-2010 05:37 PM

Homebuilders Resting on Stable Foundation

Morningstar's Eric Landry and Rick Tauber make the case that the homebuilders are poised to capitalize on the economic recovery, but the debt is more attractive than the equity right now.

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. The homebuilders have been in focus for years now as the housing crash and subsequent stabilization has been on a lot of investors' minds. I'm here today with associate director Eric Landry and credit analyst Rick Tauber to talk about the state of the homebuilding industry and if there are any opportunities for investors. Gentlemen, thanks for joining me.

Eric Landry and Rick Tauber: Thank you.

Glaser: Eric, has the housing market really stabilized?

Landry: I think so. We've had some help. The Government's been there giving $8,000 credits until last month. The Fed's been in there buying mortgage-backed securities. But there's sort of a hidden stabilization factor here and all the trouble that's happening over in Europe is giving our bond market a big lift.

So mortgage rates right now are as attractive as they've been in a long, long time: so the more trouble that happens over there, the better our mortgage rates look, the cheaper houses look on a monthly payment basis. So I think things are looking OK for the US housing market right now.

Glaser: So the housing starts still are pretty low, and there haven't been a lot of new houses built. Do you think they're at a sustainable level now or will production have to come back up?

Landry: I hope they're well below a sustainable level right now. I mean we've talked about this before, right. You've got somewhere on a million-three to a million and a half households potentially formed every year. If there is a job for each household, those households will be formed instead of shacking up with each other.

So now that we look to be in what might be a sustainable job creation cycle, hopefully that household formation will kick up more to normal levels around that low million, million and a half level. And, you know, with starts at less than 700,000 annually for the last two years, something's got to give here at some point.

Glaser: Have the homebuilders been able to take advantage of the stabilization to clean up their balance sheets or to move into more attractive markets?

Landry: Well, maybe "take advantage" is not the best way to put it but they've definitely done an excellent job throughout the whole downturn of liquidating their balance sheet and in the process, producing significant amounts of cash, paying down debt and really re-liquefying themselves throughout the whole downturn. Not just the last year, which has basically been stable, but from 2006 until today they have been working tirelessly in getting themselves more liquid and they are really in pretty good shape right now.

Glaser: So thinking of the major players, which are some of the ones that you would be most excited about to own stocks of and which are the ones you would avoid?

Landry: Well, as far as owning stocks goes, NVR is a wonderful, wonderful business and you just don't see that a lot in homebuilding. This is a cash-producing machine and management is always in there buying back stock at very, very cheap prices. So they're buying back stock in good times at less than intrinsic value, which is another kicker to equity holders.

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