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Our Top Housing-Related Pick

Robust third-quarter housing data has stretched most valuations.

Compelling third-quarter data allowed a collective sigh of relief among investors holding housing-related stocks. Earlier in 2019, disappointing construction data fueled speculation that home construction had peaked, but building is back. Demand is robust, mortgage rates and rents are down, and builders are eager to work. These improving fundamentals have sent valuations of related coverage sky-high.

We still expect builders to break ground on 1.3 million new homes in 2020 before gradually climbing toward our midcycle estimate of 1.4 million homes annually. That leaves us above consensus over the next few years, and yet, from homebuilders to apartment real estate investment trusts, every related industry looks overvalued at current prices. Investors are right to believe that management execution matters, but they may underestimate how relevant the housing environment is to business fundamentals.

We believe residential construction growth will hover between 3% and 5% over the coming years, but not without growing pains. Builders are dealing with scarce labor and higher land prices. REITs face slowing rental rate growth. Lumber companies are awash in overcapacity. Retailers are fighting fierce online competition, and waste management companies can’t continue to achieve peak growth rates indefinitely. We expect these factors to support weaker earnings than market valuations currently imply. As the coming years unfold, this expectation mismatch should drive current share prices lower.

However, our above-consensus homebuilding view contributes to our optimism about the shares of Lennar LEN, which trade below our fair value estimate. Lennar’s emerging multifamily and starter-home businesses should benefit from growing demand for smaller properties, stimulating top- and bottom-line growth. We believe the market underestimates the future benefits of Lennar’s shift down market, along with the risk reduction that comes with a more land-light strategy.

While we believe D.R. Horton DHI has the strongest entry-level position among the five homebuilders we cover, Lennar should appeal to this type of buyer as well because management has placed a greater focus on expanding its entry-level communities. Entry-level homes now account for approximately 40% of Lennar’s homebuilding business, and management expects the company’s entry-level mix to increase.

Lennar is reducing its exposure to owned land, which should improve returns on invested capital and derisk its balance sheet. Lennar has entered into agreements with regional land developers, which will increase 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. Optioned land currently accounts for 30% of Lennar’s land position; management expects to improve this ratio to 40% within two years.

Lennar’s investment in its multifamily businesses distinguishes it from many other homebuilders and should create significant shareholder value down the road. Lennar’s multifamily business is relatively young but will remain a growth driver 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.

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