Our Top Housing-Related Pick

We’ve been generally disappointed with the strength of the U.S. housing market so far in 2019. Indeed, key indicators of housing demand, including existing-home sales, construction permits, and housing starts, are all down year over year through the first eight months of the year. However, several favorable developments have emerged over the past few months that, in our view, point to a rebounding housing market, as declining mortgage rates and moderating home prices spur demand. First, the public homebuilders reported 7% order growth during the second quarter after two straight quarters of year-over-year declines. Similarly, year-to-date new-home sales are up 4% year over year. Second, existing-home sales increased 1% in July and 3% in August after 16 consecutive months of year-over-year declines. Finally, based on our analysis, underlying housing demand is still outpacing supply.

However, as the trade war with China escalates and with the yield curve recently inverting, the specter of an imminent recession may be keeping some buyers out of the market. While we can’t predict when the next recession will begin, nor do we assume that one will occur over our 10-year housing forecast, we are confident that when it does arise, the effect on the housing market will be nowhere near as severe as it was during the last recession. In our view, tight lending standards and the underproduction of new homes during the current cycle should keep supply and demand more balanced during the next economic contraction.

We continue to project a gradual climb in new-home construction to over 1.4 million starts by 2025, driven by increased household formation and homeownership among millennials. However, we expect demand from this large cohort will be bottlenecked to some extent by financial constraints, such as student debt and underemployment. We project single-family starts to increase at over a 3% pace through 2025, reaching nearly 1.1 million starts. We think multifamily starts are near peak levels, though, and will decline at a 2% compound annual rate through 2025 to 330,000 units, which is still above the 30-year average annual rate for multifamily starts. Over the next decade (2019-28), we project 13.7 million cumulative starts.

Lennar Is Our Top Homebuilder Pick Lennar LEN, which trades more than 20% below our fair value estimate, is our top homebuilder pick. While we continue to believe that D.R. Horton DHI has the strongest entry-level position of the five homebuilders we cover, we expect Lennar to perform well with this type of buyer too because management has placed a greater focus on expanding its entry-level communities. As an example, during Lennar's second-quarter earnings call, CEO Rick Beckwitt said that over the past 18 months, 75% of the land Lennar purchased in Texas will be developed as entry-level communities. Over the coming years, we expect the entry-level market will represent the strongest growth opportunity for homebuilders.

Lennar continues to focus on a lighter land-acquisition program, which should help it improve returns on invested capital and derisk its balance sheet. Lennar has entered into agreements with three regional land developers, which will increase its access to optioned land. Management has said that these relationships will allow Lennar to acquire land at a discount to its market value and/or participate in land development profits. Lennar expects these relationships will give it access to 20,000 lots, which should increase its optioned lot count as a percentage of total lot count to over 30% from 25% currently. Management still expects to improve this ratio to over 40% over the next several years.

Lennar’s investment in its multifamily businesses distinguishes it from many other homebuilders and could create significant shareholder value down the road. Lennar’s multifamily business is relatively young, so we think it will be a part of the company for the foreseeable future. Lennar began its multifamily strategy as a merchant builder that builds, stabilizes, and sells rental properties. Through the creation of Lennar Multifamily Venture, the company will use internal and third-party capital to build and hold its income-producing rental assets. We think this strategy will reduce the company’s cyclicality and strengthen cash flows as the business matures.

With an improving balance sheet and free cash flow, and given Lennar’s share price, management has felt comfortable repurchasing shares, which is notable because the company had not repurchased a noteworthy amount of stock since fiscal 2006. Since the fourth quarter of 2018, Lennar has repurchased 8 million shares for approximately $450 million. Given that Lennar’s stock trades at a sizable discount to our fair value estimate, we think share repurchases are a good use of shareholder capital.