Rising Costs Shouldn't Deter Homebuilders

Charles Gross: On a seasonally adjusted basis, new home construction has been running at a 1.29 million unit pace for the year, in line with our 1.3 million unit forecast, and still showing positive momentum versus the prior year.

This quarter, we reviewed trends in homebuilding input costs and show that homebuilders still have plenty of reason to keep building despite rising costs. Lumber prices are up 30% versus last year, while construction labor is up 4%, both figures well ahead of broader inflation metrics. However, those costs are being more than covered by a 7% increase in new home sales prices per square foot. As homebuilders steadily move down market, building smaller homes, we expect starts to march higher to a peak of 1.9 million units by 2021, before fading to a 1.5 million unit pace in the long run.

Turning first to wood product companies, valuations have flown higher over the last six months. This has largely been driven by a substantial price run for both lumber and panel products. These price increases have primarily been driven by significant shipment reductions out of British Columbia due to constrained rail service as union negotiations took place. As is often the case, equity valuations on these names hinge too much on near-term pricing, leaving them overvalued at today's prices. However, we think long-term investors could do well if these stocks pull back as these short-term constraints ease and lumber prices fall as the year wears on. Over the coming five years, demographics, rather than temporary supply issues, will support strong lumber prices.

Among the homebuilders, shares of Lennar and Toll Brothers look attractive. In regard to Lennar, we think the market is too skeptical of its recent merger with CalAtlantic. We expect Lennar to realize meaningful synergies from this merger, which should create shareholder value.

Toll Brothers serves a more affluent customer base, so we don't expect it to benefit as much from an uptick in first-time buyer demand. That said, it's an interesting stock for investors who want exposure to the U.S. housing market but are wary of rising interest rates because in our view, its affluent customer base makes the firm less exposed to mortgage rate risk.